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Is it Time for a Prescribed Rate Loan?

Is it Time for a Prescribed Rate Loan?

Before we get into whether or not a prescribed rate loan is right for you and your family, we should answer the question as to what a prescribed rate loan is. A prescribed rate loan is a loan made from a higher income earning spouse to a lower income earning spouse, adult family member, minor child or family trust at the “prescribed rate of interest.” The use of such a loan can transfer income from a higher income earner to a lower income earner, tax the income at lower tax rates and reduce the family’s overall tax burden.

This planning works where the return on the invested funds exceeds the prescribed rate of interest paid on the
loan. This is easiest to see by way of example. Assume we have a Taxpayer with investment capital of $500,000 earning a 5% rate of return and the income is subject to tax at 48%. This Taxpayer would be paying taxes of $12,000 on this income.

Now let’s assume the Taxpayer makes a loan of $500,000 with interest at the current prescribed rate of 1% to a spouse, child or family trust. The funds are invested and earn a return of 5%.

In this case, the loan recipient has investment income of 5% or $25,000 and incurs interest expense of 1% or $5,000. The net investment income of $20,000 will be taxed at their respective tax rate. Assuming this is 25%, the taxes payable by the spouse or child would be $5,000.

In addition to this the Taxpayer has investment income of 1% or $5,000 that is still subject to tax at 48% or $2,400. The total taxes are reduced from $12,000 to $7,400. This would result in tax savings of $4,600 annually. As the investments grow and the return increases these savings will increase exponentially.

As mentioned earlier, this works where the investment return exceeds the prescribed rate of interest. The Canada Revenue Agency sets the prescribed rate quarterly. The interest rate on the loan does not have to be adjusted each time the prescribed interest rate changes. Instead, the applicable prescribed rate for the loan is the prescribed rate in effect at the time the loan is entered into.

Currently, the prescribed interest rate is at 1%, but is expected to increase to 2% on July 1, 2022. Where a loan is established before July 1, 2022, the lower 1% prescribed interest rate will apply as long as the loan stays in good standing.

To ensure that a prescribed rate loan is set up properly:

  • It is important that the interest on the loan be paid no later than 30 days after the end of the calendar year; and,
  • The loan be documented with repayment terms or as a demand loan.
With the increase in the prescribed rate coming on July 1, 2022 now might be the time for a prescribed rate loan!

Written by Brad Berry, CPA, from Mowbrey Gil. This document was written for our quarterly bulletin, Canadian Overview, published by Canadian member-firms of Moore North America.