*Update* The Canada Revenue Agency (“CRA”) recently softened its position on the refinancing arrangements of prescribed rate loan planning. Please see the paragraph in bold below for more information regarding the update.
On June 22, 2020, the Canada Revenue Agency (“CRA”) announced that the quarterly prescribed interest rate for the third quarter of 2020 (“2020Q3”) was reduced to 1%, down from the previous 2% during the second quarter of 2020 (“2020Q2”). This rate will hold steady at least through the fourth quarter of 2020 (“2020Q4”). In light of the new low prescribed rate, as well as the current tumultuous circumstances due to COVID-19, it is an opportune time to consider income splitting using prescribed rate loan planning. If feasible, it might also be an appropriate time to revisit loans previously made at higher interest rates, in order to verify whether it is possible to take advantage of the decreased rate.
Income splitting is an advantageous way for high-income earners to allocate income to family members who earn less income than they do, and thus pay a lower personal tax rate on said income. This planning tool was severely restricted with the arrival of the tax on split income rules in July of 2017. However, prescribed rate loan planning is still available to taxpayers as a form of income splitting. With the advent of the new low prescribed interest rate, this type of plan will be even more attractive to taxpayers than it was previously.
Generally, when a taxpayer transfers property to his or her spouse or minor child, there are the attribution rules to worry about. The attribution rules serve to attribute income or capital gains back to the original transferor, essentially negating the benefit of transferring the property in the first place, since the transferor pays the tax on same. However, there is an exception to this rule in the context of a loan, provided that the interest rate on the loan is at least equal to the lesser of:
and provided that the interest that was payable in a year on the loan is actually paid by January 30 of the following year.
As a result, if a loan is made from a high income family member to a low income family member during 2020Q3 or 2020Q4, the interest on the loan is at least 1% and said interest is actually paid by January 30 of the following year, the tax result is that the income derived thereof will not attribute to the high income earning family member. Thus, the high earner “splits” income with his or her family members to reduce the overall tax payable for the family.
Since the prescribed rate has been reduced, it is also an excellent time to re-examine loans made at higher interest rates. As noted above, loans are made at the applicable prescribed interest rates in effect at the time the loan agreement is entered into. For example, if a loan was made during 2020Q2, the relevant interest rate would have been 2%. As a result, it would be advantageous to change the interest rate to the 1% rate that currently applies. That being said, taxpayers need to make sure that they are very careful with this, in order to prevent the CRA from applying the attribution rules.
The safest way to adjust the interest rate on a loan made at a higher rate in the past is to have the loan repaid entirely and create a new loan agreement with new terms. This must be done with careful attention to detail, since according to the CRA, it is a question of fact whether the second loan is a new loan or whether the original loan has been repaid. In the context of prescribed rate loan refinancing, the CRA reviews all of the circumstances surrounding both the old and new loan, including the terms of the loan agreements and the particular source of funds used to repay the original loan (CRA Views 2002-0143985, “Refinancing Prescribed Rate Loan”).
The CRA has recently softened its administrative position on refinancing arrangements by specifying that if the initial investments purchased with the loan have grown in value and a portion are disposed of in order to repay the initial loan, the retention of the remaining investments will not cause the attribution rules to apply. Before this announcement, the position was that it was necessary to liquidate the entirety of the investments and satisfy the initial loan in order to be able to borrow at the new lower rate.
However, the repayment option is not always optimal in the circumstances. For example, if the funds have already been invested, it may not make sense to liquidate the investments in order to adjust the interest rate from 2% to 1%, particularly with the recent market fluctuations caused by COVID-19. Additionally, liquidating investments might reap other unwanted consequences, such as for example capital gains triggering tax consequences or hefty brokerage fees. In this case, taxpayers may be tempted to simply adjust the terms of the old loan agreement by amending it to reflect the new lower interest rate. However, as mentioned above, doing so may cause the attribution rules to apply, since the CRA requires an entirely new loan agreement to be entered into. As a result, this method is strongly discouraged.
For more information with respect to the possibility of implementing prescribed rate loan planning or to revise a loan made prior to July 1, 2020, please contact your Crowe BGK tax advisor.