LOW PRESCRIBED INTEREST RATES: POTENTIAL TAX PLANNING
As noted near the end of this letter, the government recently announced the prescribed interest rates that apply for the first quarter of 2018. The basic prescribed rate remains at 1%, where it has been since July 2009 (except for one quarter in 2013). The low 1% rate makes certain tax planning techniques particularly attractive.
Interest-free employee loans
An interest-free loan from your employer will subject you to an imputed interest benefit that is included in your income. The benefit is based on the prescribed rate of interest, so a $100,000 interest-free loan at a 1% prescribed interest rate throughout a taxation year would mean only a $1,000 income inclusion for the year. However, if the prescribed rate goes up during the course of the loan, the benefit would increase accordingly.
On the other hand, if the loan is used to purchase a dwelling that you will live in, it is a “home purchase loan”. In this case, the prescribed rate at the time the loan is made effectively "caps" the interest rate for the first five years of the loan.
So, in the case of a home purchase loan, if the prescribed rate goes up during a year, you will only include a benefit based on the lower rate that was in effect at the time the loan was made. So a loan made now, with the 1% current rate, would be subject to an effective 1% cap. At the end of the five years, if the loan remained outstanding, the new interest rate “cap” would be the prescribed interest rate at that time.
Avoiding income attribution
If you give or lend property to your spouse (or common-law partner) or your minor child, income attribution rules typically kick in and attribute any income from the property back to you (including taxable capital gains in the case of your spouse or common-law partner).
However, if you lend money at the prescribed rate of interest at the time of loan, the attribution rules will not apply as long as your spouse or child actually pays you the interest for each year by January 30 of the following year. Furthermore, even if the prescribed rate increases during the term of the loan, you can keep charging the original rate of interest and avoid attribution. Interestingly, there is no maximum term limit for this rule, so, for example, even a 10 or 20-year loan made at the current rate of 1% would work to avoid attribution.
Assume you are in a much higher tax bracket than your spouse.
On January 1, 2018, you lent your spouse $500,000 and charged the current 1% prescribed rate of interest. The term of the loan is 10 years. Your spouse invests the amount and earns a 6% return each year, or $30,000 ($500,000 x 6%). She pays you the 1% interest per year, which is $5,000.
Each year, your spouse will include the $30,000 investment income, and will be allowed a deduction for the interest paid to you, so your spouse will include the net amount of $25,000.
You will include the $5,000 of interest in your income. So you have effectively shifted $25,000 of income to your spouse.
In addition, if your spouse further invests the $25,000 of investment income, any income earned on that amount (“secondary income”) will not be subject to attribution and will be taxed to your spouse.
A similar exception to the income attribution rules applies where you sell property to your spouse or minor child in return for indebtedness, if the debt is at least equal to the fair market value of the property and carries the prescribed rate of interest at that time. However, in the case of a sale to your spouse, you must elect out of the tax-free “rollover” that normally applies to transfers of property between spouses. Therefore, for example, if the property has an accrued gain at the time of the sale, the capital gain will be triggered and the resulting taxable capital gain (1/2 of the gain) will be included in your income for the year of the sale. So it normally makes sense to transfer a property with little or no accrued gain.
Deferring tax instalments or tax balance for the year?
If you pay your tax instalments or tax balances late, an additional 4% is added to the prescribed rate. So the current rate for late taxes is 5%, compounded daily.
Therefore, deferring the payment of your tax instalments during the year, or the payment of your tax balance for the year past the April 30 deadline of the following year, makes sense only if you can otherwise earn much more than 5% on the cash that you would otherwise use to pay the tax payments. You need to be able to earn much more, because the interest you earn is taxable, while the interest you pay on balances or instalments owing to the CRA is non-deductible. Thus, for example if you're in a 50% tax bracket, you need to earn 10% on your money to compensate for having to pay 5% interest.
Furthermore, if your interest charges for late instalments exceed the greater of $1,000 and 25% of the interest that would be payable had you made no instalments, you will be assessed an extra penalty. So deferring the payment of your instalments is typically not a good idea, unless you can otherwise earn a very healthy return on your investments.