Jamie Golombek: July brings a greater opportunity for income splitting

This coming July 1 will be particularly special. Sure, Canada will be celebrating its 158th birthday that day, but even more exciting for some of us is that the

Canada Revenue Agency

’s prescribed interest rate will drop to three per cent on that date, providing a greater opportunity to split income with a spouse or common-law partner, (grand)children or other family members.

Prescribed rates are set by the CRA quarterly and are tied directly to the yield on Government of Canada three-month treasury bills. The calculation is based on a formula in the Income

Tax

Regulations, which takes the simple average of three-month treasury bills for the first month of the preceding quarter rounded up to the next highest whole percentage point. As a result, the prescribed rate can never be zero, and one per cent is the lowest possible prescribed rate, which it was for a couple of years during COVID, specifically between July 1, 2020, and June 30, 2022.

The prescribed rate has not been as low as three per cent since December 2022. Here’s how to use this lower prescribed rate to your advantage, either by making a loan directly to family members or, where minors are involved, using a family trust to do so.

Income splitting is the transferring of income from a high-income family member to a lower-income family member. Since our

tax

system has graduated tax brackets, by having the income taxed in the lower-income earner’s hands, the overall tax paid by the family may be reduced. But you can’t simply give money to your spouse or kids to invest and hope to have the income taxed in their hands. This is because of the attribution rules in the Income Tax Act that prevent most types of income splitting by generally attributing income or gains earned on money transferred or gifted to a family member back to the original transferor.

The Tax Act does, however, provide an exception to the attribution rule if funds are loaned, rather than gifted, to family members, provided you charge interest at the prescribed rate, and the interest is paid annually within 30 days after the end of the year.

For loans put into place between July 1 and September 30, 2025, the three per cent rate would be locked in for the duration of the loan without being affected by any future increases since the Tax Act only requires you to charge the prescribed rate in effect at the time the loan was originally extended. The net effect of this strategy will be to have any investment return generated above the three per cent prescribed rate taxed in the hands of the lower income family member.

Prescribed rate loans can also be used to help fund minor children’s expenses, such as paying for private school and extracurricular activities, by making a prescribed rate loan to a family trust with the minor children as beneficiaries. Each year, the trust’s annual income above the three per cent interest charge is “paid” to the kids who are typically in zero or very low marginal tax brackets. This distributed trust income is then used to pay the kids’ expenses.

But what if you enter into a prescribed rate loan at three per cent, but the rate drops again in the future? To be eligible to use the lower prescribed rate, the family member should sell any investments made with funds from the original three per cent loan and repay the loan to you. You can then enter into a completely new loan agreement using the new, lower prescribed rate.

The problem with this plan is that it could trigger unwanted consequences, such as capital gains tax or brokerage fees. While you may be tempted to simply either adjust the rate on the loan or refinance it at the lower rate, both of these alternative measures may put you offside. In fact, the CRA has stated that simply repaying a higher prescribed rate loan with a lower rate loan could trigger the attribution rules.

The upcoming drop in the prescribed rate is also important for business owners who make loans to their employees. Under the tax rules, if you loan an employee money, that employee is deemed to have received an employment benefit with respect to the interest-free or reduced interest loan. The amount of this benefit is calculated as the difference between the interest actually paid by the employee and the interest computed at the prescribed rate on the outstanding loan balance. This benefit must be reported in Box 14 of the T4 slip and in the “Other information” area, using code 36 for the interest benefit.

There is, however, a special rule that applies if you give an employee a loan to assist them in buying a home, formally called a “home purchase loan.” Under this rule, the employment benefit for the first five years is calculated using the lesser of the prescribed rate in effect for the quarter in question and the prescribed rate that was in effect at the time the loan was granted, reduced by any interest that the employee actually paid.

This rule is favourable in that it guarantees that the employment benefit calculated in respect of the interest won’t increase if the prescribed rate for a subsequent quarter increases. At the same time, it also allows the employee to benefit if the prescribed rate drops.

For example, let’s say you loaned an employee money to buy a home in January 2022 when the prescribed rate was one per cent. Even though the prescribed rate will soon be three per cent, the employment benefit related to the interest-free loan is still calculated at the original prescribed rate of one per cent.

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If, on the other hand, an employee were granted a home purchase loan when the prescribed rate was four per cent or higher, come July 1 they would only have to include the interest benefit using the lower three per cent rate for the upcoming quarter.

Jamie Golombek,
FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto.
Jamie.Golombek@cibc.com

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