The prescribed rate will rise to 5% as of April 1 based on Government of Canada three-month Treasury bill yields, representing the fourth consecutive quarter that the rate has risen by one percentage point.
At that rate, “it’s very unlikely” a client would use a prescribed rate loan strategy to achieve income splitting, said Jamie Golombek, managing director of tax and estate planning with CIBC Private Wealth in Toronto.
“It’s very hard to get any kind of guaranteed fixed income return above 5%,” Golombek said, adding that the strategy loses most of its advantages once the prescribed rate goes above 3%. “The real opportunity was at 1% or 2%.”
The prescribed rate was 1%, the lowest possible, from July 1, 2020 to June 30, 2022.
A prescribed-rate loan strategy involves someone in a high tax bracket loaning money for investment purposes to a spouse, common-law partner or adult child in a lower tax bracket so the investment income is taxed at that lower rate, thus achieving income splitting and tax savings. The loan must be executed with a minimum interest rate as dictated by income tax regulations, known as the prescribed rate.
As long as annual interest on the loan is paid by Jan. 30 of the following year, the rate remains the same for the life of the loan and the income earned on the loan amount will not be attributed back to the lending spouse for tax purposes.The lower the rate, the greater the opportunity for tax savings through income splitting.
Other key factors in determining whether to set up a prescribed-rate loan are the amount of the loan, the difference in family members’ marginal tax rates and the type of investment income earned on the invested amount.
While the lower-income spouse can deduct the interest paid on the borrowed amount, the higher-income spouse must report the interest earned on the loan as fully taxable income.
Why is the prescribed rate rising?
According to section 4301 of the Income Tax Regulations, the prescribed rate is based on the average yield of Government of Canada three-month Treasury bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage.
The auction yields for three-month T-bills were 4.36% on Jan. 3, 4.45% on Jan. 17, and 4.46% on Jan. 31. As the average of those three yields is 4.42%, the prescribed rate will rise to 5% for the second quarter of 2023.