Households looking for a way to split income could take advantage of a new announcement by the CRA
For many families that want to minimize their tax exposure, the introduction of rules surrounding tax on split income (TOSI) has been a major impediment. But a recent update from the Canada Revenue Agency (CRA) could present a new tax-planning opportunity.
In a recent blog post, Lesley Kim of Miller Thompson LLP said that the CRA has announced a prescribed rate of 1% for the third quarter of 2020, which took effect on July 1. The prescribed rate, she explained, is set each quarter “based on the average yield in the first month of the last quarter for Government of Canada three-month Treasury Bills, rounded up to the next whole percentage.”
While the volatility in the current markets due to the COVID-19 pandemic would give many investors pause, some might take it as a buying opportunity on the assumption that the situation will not last. “It may therefore be a good time to consider prescribed rate loans as a method of splitting investment income, in both the public company and private company context, with a lower earning spouse or child,” Kim said.
As she explained, attribution rules mandate that when an individual transfers property, including money, to their spouse or minor child, income earned on that property (along with capital gains, in the case of a spouse), will be included in that individual’s income for tax purposes.
But in cases where an individual loans money to a spouse or minor child, the attribution rules will not be applied to income or gains earned on the borrowed funds, assuming two conditions are satisfied:
- The interest rate on the loan is at least equal to the CRA prescribed rate in effect at the time the money is lent, or the rate of interest that would apply on a loan between arm’s length parties, whichever is lesser; and
- The interest that was payable in a year on the loan was actually paid by January 30 of the following year.
“The same tax result arises whether property is transferred directly to the spouse or minor child or indirectly through a trust of which the spouse and/or minor child is a beneficiary,” Kim said, explaining that this would further require that the income of the trust be allocated to the spouse and/or minor child before the end of the year, and that the amounts are properly paid or payable on demand to beneficiaries under the trust.
If all those boxes are ticked, the lower-earning family member will be taxed on any investment income, including capital gains, earned using the loaned funds at their lower marginal tax rates. But for this approach to be worthwhile as an income-splitting strategy, Kim said the income from the investment in a year must exceed the interest earned on the loan, as the interest must be paid in each year and counted in the lender’s income for tax purposes. She further clarified that the interest rate is locked in as of the date of the loan.
In other words, it’s more beneficial to engage in planning that involves extending a loan during the effectivity period of the CRA’s lower prescribed rate, as that effectively sets a lower hurdle on returns from investments made through the loan.
There are additional caveats to consider. In cases where a loan is made to a trust, with the beneficiaries being the lender’s spouse and/or children, the TOSI rules may still apply to any distributions of income or capital from the trust, as “split income” that’s taxed at the highest marginal tax rate for individuals includes distributions from a trust in certain situations.
“However, there is an exemption from TOSI where the only assets held by the trust are publicly listed shares, subject to certain factual considerations,” she said, noting that advice from a tax specialist should be sought in such situations.
