CRA announced this week that it will maintain its 1% prescribed rate through to June 30th.
While that news didn’t make headlines, from a tax point of view it should have.
After RRSPs and tax deductibility of interest, I think a prescribed rate income splitting loan is the most effective way for wealthy high income earners to reduce their tax bill.
And a 1% interest rate offers an unprecedented window of opportunity.
Here’s how it works:
A high income earning individual may loan funds for investment to a family member with no or little income – such as a spouse, child or grandchild (note: indirectly through a trust if minors are involved) .
Canada Revenue Agency stipulates the borrowing family member must pay the prescribed interest rate of 1% annually on the loan amount.
The family member invests the funds earning, say, 6% per year. Income and capital gains earned on the funds, net of the interest paid on the loan, are then taxed in the hands of the lower-tax rate family member – thus reducing the total family tax bill.
Borrow at 1% and invest at 6%. On a $1 million loan, that’s net income of $50,000, annually, that can be taxed at lower rates.
What’s more, the 1% interest rate is ‘locked in’ so it stays in place for the entire life of the loan – regardless of how much interest rates fluctuate. Given rates are expected to rise mid-year, you can bet the 1% won’t last much longer.
Some of our clients use this strategy to fund private school education for their children or grandchildren. Others to assist family members in funding business interests. It’s a low-risk planning option that offers a lot of possibilities — if potentially not a lot of time before the rate increases.