Best Income Splitting Strategy – Prescribed Rate Loan

Allan Madan, CA
 Jan 7, 2014
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Are you in a higher tax bracket than your spouse and tired of paying way too much in taxes to the government? If yes, then use the best income splitting strategy – the Prescribed Rate Loan.

Income Splitting

The best income splitting strategies are able to effectively transfer income from the higher income spouse to the lower income spouse. As Canada employs a marginal tax bracket system, the lower income spouse will pay less tax on the transferred income than would the higher income spouse. When the transfer is done using legitimate methods, you can reduce your family’s net tax liability. However, it is important to note that the Income Tax Act has specific attribution rules, which are designed to limit income-splitting opportunities.

No Income Splitting Means High Taxes

Best Income Splitting Strategy – Prescribed Rate Loan Method

A properly implemented prescribed rate loan method will avoid income attribution rules. Under this method, the higher income spouse will lend money to the lower income spouse. The funds will then be used by the lower income spouse to purchase investments; any income earned from these investments will be taxable in the hands of the lower income spouse (at the lower marginal tax rate). To avoid attribution rules, this loan must have the following characteristics:

  1. A promissory note must be written for the loan, specifying the principal amount and interest rate.
  2. The interest rate must be equal to or greater than the prescribed interest rate set by the Canada Revenue Agency (CRA) at the time the loan is made.
  3. The interest owing on the loan for a calendar year must be paid by the lower income spouse to the higher income spouse by January 30th of the following tax year.

If the loan has the above characteristics, investment income earned by the lower income spouse using transferred funds will not be attributed back to the higher income spouse and you will have successfully split income with your spouse. Please note that the interest received by the higher income spouse is included in his/her taxable income. However, the lower income spouse will claim a deduction for the interest paid.

Best Income Splitting Strategy

Prescribed Interest Rate

The prescribed rate loan method is most advantageous when the prescribed interest rate is low as this will minimize the interest income for the higher income spouse. As stated above, one the of the characteristics of the loan is that the interest rate must be equal to or greater than the prescribed interest rate set by the CRA at the time the loan is made. The prescribed interest rate is adjusted quarterly by the CRA but once the prescribed rate loan is entered into, the interest rate is locked-in throughout the loan, regardless of whether the prescribed rate increases in a later period.

Effective on January 1, 2014, the prescribed rate will be reduced to 1%. The CRA had previously increased the prescribed rate to 2% in the fourth quarter of 2013 so now is the perfect time to take advantage of this income splitting opportunity.

If you are looking for effective methods to split income with your spouse, you should strongly consider the prescribed rate loan. Please contact your tax expert for assistance in issuing a prescribed rate loan to ensure attribution rules do not apply.

Disclaimer

The information provided on this page is intended to provide general information. The information does not take into account your personal situation and is not intended to be used without consultation from accounting and financial professionals. Allan Madan and Madan Chartered Accountant will not be held liable for any problems that arise from the usage of the information provided on this page.

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