One positive to take out of the current economic downturn will be the lowering of the prescribed rate to 1% between April 1 and June 30, 2009. This presents opportunities for higher income earners to income split with their spouse, children, or grandchildren.
For income splitting purposes, the prescribed rate is used to determine whether the attribution rules of the Income Tax Act (the "ITA") apply to loans made to one's spouse, children or grandchildren, as well as any trust for such individuals.
The attribution rules operate to deem any investment income earned on a loan made to a spouse, child, or grandchild, or a trust for such individuals, to be taxable in the hands of the lender.1 However, where such a loan was made at the prescribed rate (which applied at the time the loan was made) and the interest is paid within 30 days of the end of each calendar year, the attribution rules do not apply.2
A simple example of how income splitting using the prescribed rate can work is where a husband lends $1 million to his wife at the prescribed rate of 1%. The wife then invests the $1 million and earns a 5% return. At the end of one year, the wife will have earned $50,000, $10,000 of which she will have to pay as interest to her husband. The wife will keep the remaining $40,000 and pay tax on this amount at a lower rate than her husband. In addition, the wife will be able to claim a deduction for the $10,000 of interest paid to her husband. Also, any future income the wife earns on the $40,000 of investment income (known as "secondary" income) will not be attributable to the husband.
New loans made between April 1 and June 30, 2009 at the prescribed rate of 1% per annum and which require interest be paid within 30 days of the end of each calendar year are generally a simple and safe means of minimizing tax by income splitting.
Re-Financing Existing Loans at the Prescribed Rate
Individuals with existing loans set up for income splitting purposes and who are looking to re-finance at a lower prescribed rate face the risk of losing the protection of subsection 74.5(2) (and 56(4.2)), and triggering the attribution rules.3 The Canada Revenue Agency have stated that "we would need to review the terms of the previous loan and the particular source of funds that in fact repay that loan" before being able to determine if such a re-financing would trigger the attribution rules.4To ensure a refinancing is considered a new loan, as many features of the old loan should be changed as possible: principal amount, maturity date, parties (ex. loaning to a trust for spouse and children rather than to spouse directly), etc. It might also help to repay the old loan and then wait for a period of time before refinancing. Whether a refinancing will be considered to meet the requirements of 74.5(2) will be a question of fact in each case. Individuals should carefully consider this risk before re-financing a loan at a lower prescribed rate.