For almost two years now, the prescribed rate under the Income Tax Act has been at an all-time low of 1%. This low rate has made using a family trust or spousal loan to split income with minor children, grandchildren and a spouse very attractive – which is in contrast to past years when the rate hovered at around 4%.
As a refresher, using a loan at the prescribed rate to fund a trust for children, grandchildren and a spouse who have a lower marginal tax rate than the higher income family member making the loan who may be at the top marginal rate allows for income to be split among family members.
If a family trust is used, the income earned by the trust on the borrowed funds can be flowed out to children and grandchildren and taxed at their marginal tax rates and used for a number of expenses, such as school fees, education expenses, summer camp, lessons, sports activities, and other appropriate expenses. Using a prescribed rate loan ensures that certain tax rules do not attribute the income back to the lender, provided that the trust is properly structured. As a result, many children’s and grandchildren’s expenses can be paid using “before tax” dollars, and not “after tax” dollars. For more information on using a family trust to split income, see our Advisory “Using a Trust in Your Estate Plan”.
Given that each taxpayer has a basic personal credit of almost $14,000, if there are family members with no or little other income, no or little tax will be paid on approximately the first $14,000 of income allocated to a beneficiary. If there are three family members with no or little income, that means approximately $42,000 on which no or little tax will be paid. Income above the basic personal credit will be taxed at a lower effective rate until the top marginal tax rate is reached, resulting in further savings.
A prescribed rate loan to a spouse with little or no income has a similar result. However, a spouse could be included as a beneficiary of the family trust without the need to use a separate spousal loan, where appropriate and desirable.
As the prescribed rate goes up, the margin goes down and a greater investment return on the income earned on the borrowed funds is needed to make the strategy effective. Interest on the loan must be paid to the lender on or before January 30 each year. Once the loan is made, the interest rate continues for the period the loan is outstanding, which can be unlimited, hence the desirability to make a loan while the rate is only 1%.
The prescribed rate for the second quarter from April 1, 2022 to June 30, 2022 remains at 1%. The prescribed rate is based on a simple average of the interest rate on three-month government treasury bills for the first month of the prior quarter. The prescribed rate was 2% from April 1, 2018 until June 30, 2020, and decreased to 1% on July 1, 2020.
Prescribed rate loans to a family trust or a spouse are very effective strategies to lower the family tax bill, and have been used for such purpose for decades. In an environment where interest rates are forecast to go up, consideration should be given to using them for income-slitting and to locking in a prescribed rate loan at 1% while it remains at this historically low level.
— Margaret O’Sullivan