LAST CHANCE TO GET AHEAD OF PRESCRIBED RATE INCREASE
Under the Income Tax Act and Income Tax Regulations, there are several different “prescribed rates” of interest. The most commonly known ones are the interest rate on overdue tax payments (currently 5% compounded daily), and the rate that needs to be charged on certain loans (currently 1%). These rates are found in section 4301 of the Regulations, and are adjusted quarterly based on current Government of Canada Treasury Bill rates.
These 5% and 1% rates have not changed since July 2009, except for the last quarter of 2013 when they were each one percentage point higher. Due to increases in the Treasury Bill rates, these rates are expected to go to 6% and 2% respectively, starting April 1, 2018.
There’s not much you can do about the increase in the rate on late payments. If you have a tax bill owing to the CRA that you can’t pay, you’ll have to live with paying the higher rate. (And note that interest you pay to the CRA on overdue income tax amounts is non-deductible.)
However, the increase in the prescribed rate for family loans might encourage you to take some action, before April 1, 2018.
Loans to family members can be a useful method of income splitting. Suppose you have a high income and your spouse has a low income. You’re paying tax at, say, 53% on each additional dollar earned, and your spouse is paying, say, 21%. (The rates vary by province and tax bracket, and the brackets increase each year for inflation.)
If you simply give money to your spouse to invest, the income on that money will be “attributed” back to you under the Income Tax Act’s attribution rules, so you’ll pay tax on the income at your high rate.
However, if you lend money to your spouse, then there is no attribution as long as your spouse pays you interest at the prescribed rate by January 30 each year for the previous year. And for this purpose, the prescribed rate is the rate at the time the loan was made, and this can continue forever.
Example (assuming you and your spouse pay tax at the 53% and 21% rates shown above):
You have the opportunity to earn 6% interest on a $100,000 investment in a mortgage.
But instead, you lend the $100,000 to your spouse.
Your spouse pays you 1% interest, or $1,000, each January 15.
And your spouse, instead of you, makes the mortgage investment and earns $6,000 per year.
You’ve effectively transferred $5,000 from your annual income (where it would cost you $2,650 in tax) to your spouse’s annual income (where it costs your spouse $1,050 in tax).
So each year you save $1,600 in after-tax money. Of course, if you transfer “too much” income this way, your spouse’s marginal tax rate will go up, and the savings per dollar of income transferred will be reduced.