Prescribed Rate Loans

“the real benefit is the ability to increase the spread as future investment returns increase.”

We discussed income splitting opportunities using loans in Tax Tip No. 04-22, when the rate was 2%. Prescribed rates are calculated every calendar quarter with the next update effective October 1, 2013.  The prescribed rate is calculated based on a formula in the Income Tax Act (the “Act”) which rounds the amount up to the next highest whole percentage. We have run the numbers and it looks like the formula will yield, before rounding, 1.02%.  That means the next highest whole percentage will likely be 2%.   Although the CRA has not yet confirmed this new rate the Act doesn’t give the CRA the ability to modify the formula.

Unlike other loans that are required to be reset after a number of years, such as home purchase loans, income splitting loans to individuals or trusts are locked in at the prescribed rate in effect at the time the loan is made.  Given the likely increase to 2%, consideration should be given to making income-splitting loans like those discussed in Tax Tip No. 04-22 (or topping existing loans up) before October 1, 2013 in order to benefit from the 1% prescribed rate.

The possible spread between the prescribed rate and possible returns in today’s investment environment may seem small.  However, the real benefit is the ability to increase the spread as future investment returns increase. If return on investment increases to 5% in the future, the fact that someone locked the rate on an income splitting loan at 1% could be much more significant than it seems now.  If the same person has to lock in at 2% because he waited until after September 30, 2013 to make the loan, the spread (using a 5% return) is reduced by 25%.  This can even be done in today’s environment as dividends can yield 5%.

You may want to consider making income-splitting loans before October 1, 2013 to take advantage of the current prescribed rate before it increases (likely on October 1, 2013). Your TSG representative would be happy to discuss this planning with you.

TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.

The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.

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