The Prescribed Rate Loan Strategy
You might wish to consider using an irrevocable inter vivos trust to implement a prescribed rate loan structure. This strategy can facilitate income splitting by taking advantage of the marginal tax rate of family members with a lower income.
For this strategy to work, you need to play out the following scenario involving a mythical Canadian, Alex. Alex will make $100,000 loan to such a trust at a prescribed rate, which is currently 1%. The trust will then use this money to purchase portfolio-type investments such as stocks. The net income earned by these investments in the trust after the deduction of the interest expense paid to Alex may be distributed to the family members who are currently taxed at a lower rate, since lower tax brackets apply. The result of this strategy is that there will be more after-tax income available for the family, thereby generating a larger total family asset base.
A formal loan arrangement must exist between the parties. The rate of interest must be at least the CRA’s prescribed interest rate at the time the loan is established. The rate is currently 1% on such loans. Also, the interest must be paid by the borrower to the lender annually, no later than a prescribed date. This is currently January 30 of the following calendar year.
Upon receipt of the $100,000 loan from Alex, the trust invests the money in stocks that yield a 5% annual return. The trust thus earns a gross investment return of $5,000 annually, of which it will be required to pay Alex $1,000 a year in interest on the loan. The trust will be able to deduct this expense. This leaves $4,000 for distribution to the beneficiaries. If a beneficiary receiving the $4,000 has no other income, this income won’t attract any income tax at all due to the basic personal tax exemption. It would have otherwise attracted tax at Alex’s top marginal rate. The resulting differential is the positive tax arbitrage realized by the family.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Tax group at Shea Nerland LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.