A window of tax saving opportunity is closing.

We have written before about the “unprecedented window of opportunity” for wealthy families to save tax as a result of CRA’s historically low 1% rate on prescribed rate loans.  See our blog post A window of tax saving opportunity…for how long? The prescribed rate dictates the minimum interest that must be charged on income-splitting loans to spouses and family trusts. A popular, low-risk form of tax planning with many of our clients.

Truth be told, when we wrote that blog piece back in 2010 we didn’t expect the 1% rate would still be in effect in 2013. And from what we hear, it won’t be much longer.

Though CRA hasn’t announced it, our intelligence suggests the prescribed rate will be increased to 2% effective October 1, 2013. That’s a signal to anyone who’s been contemplating an income splitting strategy to act sooner than later.

To recap, here’s how prescribed rate loans work:

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).

CRA stipulates the borrowing family member must pay a prescribed rate of interest. 

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(s) – thus reducing the total family tax bill. 

For the time being you can still borrow at 1% and invest at 6%. On a $1 million loan, that means net income of $50,000, annually, that can be taxed at lower rates. More importantly, the 1% interest rate is ‘locked in’ the entire life of the loan, so the tax savings can compound for years. As interest rates rise, as we expect, the annual tax savings increase, proportionately.  

If CRA’s prescribed rate goes up to 2%, as expected, delaying could cost up to $4,600 each year on the same million dollar loan. If investment returns exceed 6%, the cost would be even higher. 

Some of our clients use this strategy to fund private school education for their children or grandchildren and provide an asset base to better educate heirs on effective investment management. Others to assist family members in funding business interests. If you want to see how the strategy may work for you, please do get in touch. We’ve done lots of them for our clients and can walk you through the details. 

As with any tax planning, individuals should consult their tax advisors prior to implementing this income splitting strategy.