Prescribed interest rate loans allow higher income earners to split income with lower income earning family members. The steps involve the higher income earner loaning money directly or via a trust to the lower income earner. The lower income earner then invests the funds in order to earn investment income. If assets other than cash are loaned, consideration must be given to potential taxes that may arise on the transfer.
In order to avoid the application of the income attribution rules (which cause the income earned from the loaned property to be taxed back into the hands of the higher income earner), the loan must bear interest at least at the “prescribed interest rate”. At the moment, the prescribed interest rate is at the historically low rate of 1%. This rate will be increasing to 2% as of April 1, 2018. This plan creates a tax-saving opportunity due to the spread between the prescribed interest rate paid and the income actually earned. As a result, now is a good time to implement or even increase an existing prescribed interest rate loan plan.
The advantage of setting up the loan when the prescribed interest rate is 1% is that the Income Tax Act only requires the lender to charge the prescribed interest rate at the time the loan is originally made.
It should be noted that the tax rules require that the prescribed interest rate is actually paid for each calendar year to the lender by January 30th of the following year.
If the lender or borrower is a U.S. person for tax purposes, the implications of this type of planning must also be considered.
Please contact your Lipton advisor if you would like to discuss this tax planning opportunity further.
