The attribution rules in the Income Tax Act prevent income splitting by taxing the income earned on the transferred property in the hands of the transferor
Individuals are generally not allowed to “income split” by transferring money or other income-earning property to a spouse, common-law partner or child who would be taxed at a lower tax rate on the income earned from the property. The attribution rules in the Income Tax Act (Canada) (the “Act”) prevent income splitting by taxing the income earned on the transferred property in the hands of the transferor.1 However, the attribution rules currently do not apply to individuals who lend money to their spouse, common-law partner or minor children (including a family trust set up for the benefit of these people) if the loan is made under a written agreement that sets out the repayment terms and stipulates an interest rate that is at least equal to the prescribed interest rate in effect under the Act at the time the loan is made. There is no maximum limit on the term of the loan, but the borrower must pay interest at the stipulated rate on the outstanding loan by January 30 of each year following the year in which the loan was entered into and remains outstanding, or else the attribution rules will apply.
What is the benefit of prescribed rate loan planning for families?
These loan arrangements, if set up correctly, can produce significant long-term tax savings for families. Although the lender is taxed on interest income earned on the loan at the prescribed interest rate each year the loan remains outstanding, any investment income earned annually by the borrower on the loaned funds that exceeds the prescribed interest rate will be taxed at a lower tax rate than the rate at which it would have been taxed if it had been earned by the lender instead of the borrower. Further, the interest payments are generally deductible to the borrower, provided the loan proceeds are used for the purpose of producing income (e.g., income from investments) that is not exempt from tax.
What is the benefit of prescribed rate home purchase loan planning for employees?
If an employer makes a loan to an employee, the employee is generally required to include in income for each year the loan is outstanding an employment benefit equal to the prescribed rate of interest in effect during that time on the amount outstanding under the loan. However, a special rule provides that for the purpose of determining the taxable benefit on an employee home purchase loan, the applicable rate of interest for the first five years of the loan is instead the prescribed rate of interest in effect at the time that the loan was received by the employee.
What is changing?
The current 1% prescribed rate of interest under the Act, which has been at an all-time low since April 1, 2009, is expected to double to 2% on October 1, 2013.
What can you do?
Lock in the 1% prescribed rate on family loan arrangements by ensuring your loan arrangements are finalized at the latest by September 30, 2013.