Income splitting with family members
Prescribed rate loans and other tips for reducing taxes, by Gergely Hegedus and Keith Hennel of Dentons’ Edmonton Tax group
Gergely Hegedus (left) is a senior associate in the Tax Group in Edmonton at Dentons Canada LLP. Keith Hennel (right) is a partner at Dentons Canada LLP and serves as chair of Dentons’ Edmonton Tax Group.
EDMONTON – There are a variety of tax planning strategies and tools available to taxpayers to reduce the overall amount of income tax paid within a family unit. Some of the ideas explored in this article relate to prescribed interest rate loans, Tax Free Savings Accounts (“TFSAs”), Registered Retirement Savings Plans (“RRSPs”), Registered Educational Savings Plans (“RESP”), gifts and family trusts. While not all of these may be right for you, knowing what is available is important. You never know when you might be in a position to reduce your taxes with one or more of these strategies and tools.
Prescribed Rate Loan Planning
The Canada Revenue Agency (the “CRA”) will lower the prescribed rate of interest to the lowest possible rate of 1% (down from 2%) starting on July 1, 2020. The last time the prescribed rate fell to 1% was on April 1, 2009, following the financial crisis in 2007-2008, after which prescribed rate remained at 1% (but for one quarter at the end of 2013) until April 1, 2018 when it moved up to 2%.
There are various tax planning strategies which enable taxpayers to take advantage of the low prescribed rate of interest. One such strategy is for taxpayers to loan cash or other income-producing property to family members (either directly or through a trust) who earn less income. If done properly, the income earned by, or distributed to, the family member from the loaned property will be taxed at a lower tax rate than if it had been earned by the higher income earning taxpayer. The result of this planning is to reduce the amount of overall tax paid within the family unit.
However, the Income Tax Act has tax attribution rules that generally prevent taxpayers from transferring property to their family members in order to reduce their taxes. Under these rules any income, gain or loss that arises from the property that a taxpayer loans or transfers to a family member is attributed back to the transferor taxpayer and is taxed in the hands of the transferor taxpayer and not the family member. These rules generally apply to transfers of property and loans to minor children, minor nieces and nephews, spouses or common-law partners. However, taxpayers can avoid these attribution rules on loans to family members if the loans meet the following conditions:
- the loan must carry interest at the CRA’s prescribed rate in effect at the time the loan was made;
- the borrower must make interest payments within 30 days of the end of each calendar year; and
- if the property is loaned or transferred to a taxpayer’s spouse or common-law partner, the taxpayer must elect for subsection 73(1) of the Income Tax Act to not apply in his or her tax return in the year in which the property was transferred. If the election is made, it will result in the transferor spouse realizing any accrued gains on the property at the time of transfer.
If these conditions are not met the attribution rules will apply and any income, gains and losses from the loaned property, will attribute back to the lender. The attribution rules will not only apply for the year in which the conditions are not met but in all subsequent years. Therefore, if the family member fails to pay interest on the loan in one year, all of the following years will be tainted. If, however, the above-noted conditions are met, then the attribution rules will not be triggered and the income, gain or loss that arise from the property will be taxed at the marginal tax rate of the family member to which the property is loaned. Also be mindful that the attribution rules will apply to property substituted for the initially loaned property. For example, if a taxpayer loans a spouse $1,000 to which the attribution rules apply and that spouse uses the $1,000 to buy publically traded shares, those shares would be considered substituted property and any dividends, gains etc. realized on those shares would attributed back to the lender and be taxed in their hands.
Interest earned by the lender is taxable and the interest paid by the borrower is tax deductible (assuming the borrowed funds are used for an income-earning purpose). Starting July 1, 2020 taxpayers can lock in the 1% prescribed interest rate even if the prescribed rate subsequently increases. There is no limit to the term or the amount of the loan. Those with existing prescribed rate loans outstanding that are at a rate that is higher than 1% should consider unwinding the existing loan arrangement and entering into a new one at the 1% rate.
In order for a prescribed rate loan to be worthwhile, the rate of return earned on the loaned property will have to be greater than the prescribed rate of interest and any administrative costs paid by the family member in respect of the loan. However, it is possible to take advantage of accrued losses or a low rate of return on the transferred property by deliberately triggering the attribution rules (by having the family member stop paying the interest for example). In this case, any income earned, or loss incurred if the property was disposed of by the lower income earning family member, would attribute back to the transferor taxpayer who may be able to make use of such losses.
TFSAs, RRSPs and RESPs
There are tax registered savings plans and registered savings accounts that taxpayers should be using to help reduce taxes and increase wealth. The RRSP, RESP and the TFSA are examples.
Income earned or gains realized in a TFSA are generally tax-free. A taxpayer’s investments in an RRSP or an RESP are generally not taxed until the funds are withdrawn and the taxpayer receives a tax deduction for the amount of the RRSP contributions made each year. A taxpayer can also contribute to their spouse or common law partner’s RRSP.
Taxpayers can help save for their child’s education by contributing to an RESP for their child. The funds invested in an RESP grow tax-free. Taxpayers do not get a tax deduction for the funds put into an RESP, but contributions may trigger government grants that further top up RESP contributions. Funds paid out of the RESP as an Educational Assistance Payment to the child who is a student are taxed in the hands of the child. Since most students have little to no income, they can usually take out these funds with little tax.
Therefore, taxpayers may wish to contribute to their TFSA or RRSP, their spouse or common-law partner’s RRSP, or their child’s RESP to ensure the maximum benefit is being obtained from these investment vehicles. They may also gift money to their spouse or common-law partner so that their spouse or common-law partner can contribute to their TFSA. However, taxpayers who have maximized contributions to these investment vehicles may wish to use prescribed rate loans as described above in order to further reduce the overall amount of tax paid within the family unit.
Taxpayers can transfer property to their family members by way of gift. However, as mentioned earlier the attribution rules may be triggered on gifts to certain family members to which the transferor would be liable for any taxes on income earned from the gifted property and taxes arising from the ultimate disposition of the property. Losses from the transferred property may also attribute back to the transferor.
Taxpayers can gift property to adult children without triggering the attribution rules; however, taxpayers will lose control over the gifted property. Therefore, taxpayers may wish to loan the property to adult children (or other family members) in order to retain control over the funds rather than granting an outright gift.
Another way for a family to reduce its tax burden without transferring control over property to a family member is by loaning property to a trust and having the trust invest the property in publically-traded securities. Any net income from the investments, including dividends or interest, could then be distributed to spouses, common-law partners and children as beneficiaries of the trust and the income taxed at their respective marginal rates. The trust may also help protect the property from claims by creditors or the spouses of children or other beneficiaries on a marriage breakdown.
It should be noted that there are additional attribution and income splitting rules that apply to trusts that are outside the scope of this article. It is critical that the trust be established correctly to ensure that the intended tax planning goals are obtained.
Rotman Master of Finance
Summary and Caution
Taxpayers may wish to take advantage of the historically low prescribed rates of interest by issuing loans to family members, either directly or through a trust, after they have exhausted other investment vehicles (such as TFSAs, RRSPs and RESPs). In doing so, they should take care not to trigger the attribution rules or the Tax on Split Income (“TOSI”) provisions. While not the topic of this article, TOSI needs to be considered in any planning involving family members. If TOSI applies it could defeat any tax benefits. The above strategies, if executed property, can be implemented without attracting TOSI.
Given all the traps in designing and implementing any tax plan, it is very important that taxpayers seek and obtain professional advice from their tax advisor.
 Income earned from private corporations or related businesses may be considered “split income” and, if so, they would be taxed at the highest marginal rate.
Gergely Hegedus is a senior associate in the Tax Group in Edmonton at Dentons Canada LLP. Keith Hennel is a partner at Dentons Canada LLP and serves as chair of Dentons’ Edmonton Tax Group. Photo by Pixabay from Pexels.