August 6, 2013
You should act quickly to realize future tax savings before the CRA’s 1% prescribed interest rate for family income-splitting loans rises to 2% on October 1, 2013. Taking advantage of the current historically low interest rate can provide significant long-term benefits to your family.
The current 1% interest rate, which has remained unchanged since April 1, 2009, is at its lowest possible level, creating a great opportunity to enter into income-splitting loan arrangements with family members. Similarly, employees who have entered into qualifying home purchase loans with their employers may have a unique tax planning opportunity to reduce the related taxable benefit.
To be sure you can lock in loan arrangements at 1%, you’ll need to finalize all arrangements by September 30, 2013. Making a family loan arrangement now will set you up to realize income-splitting tax benefits when interest rates and investment returns exceed 1%.
Secure family loan arrangements for future income splitting
You may be able to achieve significant future tax savings by locking in a family loan at the prescribed 1% interest rate and shifting income earned on the investment of the lent funds to your spouse (including common-law or same-sex spouse) or another family member, including a minor child by way of a family trust, who has little or no other income and thus pays little or no tax.
In effect, if you lock in the loan by September 30, 2013, you can arrange for all investment income over 1% to be taxed at a lower-income family member’s tax rate indefinitely. Ordinarily, if you lend funds to your spouse or a trust for the benefit of minor children, the attribution rules will apply and any income earned on the lent funds will be taxed in your hands. However, if the loan is governed by a written agreement that stipulates the terms of repayment and an interest rate at least equal to the CRA’s prescribed rate at the time the loan is made, then the attribution rules will not apply.
In a typical inter-spousal arrangement, the higher-income spouse lends a sum of money to the lower-income spouse. Under a written loan agreement, the lower-income spouse agrees to pay interest at the prescribed rate of 1% (if entered into by September 30, 2013). The lower-income spouse invests the borrowed funds and subsequently earns a higher rate, say 3% (to generate tax savings through this strategy, the lower-income spouse must earn a rate of return of greater than 1%).
Provided the lower-income spouse makes annual interest payments by the following January 30 of each year, 2% of the income in our example (that is, the difference between the 3% rate of return and the 1% prescribed rate) will be taxed in the hands of the lower-income spouse. In this example, on a $100,000 loan, the amount of income shifted to the lower-income spouse would be $2,000 annually.
Lock in interest rate benefit on employee home purchase loans at 1%
Employees may also achieve significant future tax savings by renewing their home purchase loans by September 30, 2013, thereby ensuring that the interest rate benefit for the next five years remains at 1%.
Here’s how this strategy works: If you receive a low-interest or interest-free loan from your employer, you are considered to have received a taxable benefit from employment. The benefit is set at the CRA’s prescribed rate of interest, which varies each quarter, minus any interest you actually pay during the year or by January 30 of the following year. But if the loan is used to purchase a home, the prescribed interest rate applied in calculating the imputed interest for the first five years is capped at the prescribed rate in effect at the time the loan is made. After five years, the loan is considered a new loan and the prescribed rate at that time becomes the rate in effect for the next five years.
So if you enter into a new home purchase loan in the third quarter of 2013, the interest rate benefit will not exceed 1% for the next five years, no matter how high interest rates actually climb.
Employees with existing home purchase loans may be able to take further advantage of the 1% rate if they can arrange to take out a new loan to replace the current one and restart a new five-year period at 1%. The definition of “home purchase loan” in the tax rules extends to any loan used to repay a home purchase loan, and the prescribed interest rate in effect on the date the substituted home purchase loan is entered into will be the new “ceiling” for the next five years. You must ensure that the old loan is repaid and a new loan taken out, or that a novation has occurred, as evidenced by a newly negotiated loan agreement having, for example, terms and conditions that differ significantly from the original loan.
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To maximize the tax benefits of these strategies, interest payment terms and other loan arrangements must be properly structured and other requirements met. As such, these arrangements should only be undertaken with appropriate professional advice. To explore these or other tax planning opportunities, please contact your KPMG Enterprise adviser.
Information is current to August 5, 2013. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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