Income splitting is the concept of transferring income from a high-income taxpayer to a lower income family member thereby reducing the amount of tax paid as a family unit. The income tax act has rules designed to prevent this type of tax planning referred to as “attribution” rules which attribute the income earned back to the tax payer that provided the capital thereby eliminating the opportunity to income split.
An exception to these attribution rules is if the lender pays interest on the loan at the prescribed rate of interest (currently 1%). One possible strategy to take advantage of this opportunity is to create a family trust and have the high-income tax-payer loan money to the family trust at the prescribed rate. A family trust is a flexible structure that allows income to be distributed to beneficiaries each year on a discretionary basis thereby allowing the family to allocate the income and tax burden to the family members that will pay the least amount of tax on that income.
Let’s look at a simple example of how this strategy can be executed in the following situation. Let’s assume that we have a high-income taxpayer with $1M of savings in a non-registered investment account earning a 5% annual return. This taxpayer has a spouse with minimal income and two minor children with no income. For simplicity we will assume that all of the investment income is interest but the tax savings can be even higher on dividends and capital gains which have favorable tax treatments compared to interest.
The current situation is that the investment income is being taxed in the hands of the taxpayer and that $50,000 of investment income would result in taxes payable of $26,765 (top tax rate in Ontario is 53.53%).
In contrast if this taxpayer were to loan the $1M to a family trust at the prescribed rate, the taxpayer would only have interest income of $10,000 and taxes payable of $5,353. The Investment income of $40,000 ($50,000 of investment income minus the interest paid of $10,000) would belong to the family trust and could be allocated to the spouse and two children. The result is that each of the three family members would have income of $13,333 which they would pay no tax on because of their personal tax credits. In this very simple example this strategy saves the family $21,412 per year in taxes.
If you multiply these savings out over 20 years considering compound returns the family would have an extra $743,409 just by executing this simple strategy. The prescribed rate of interest is locked in for the life of the loan so as the prescribed rate of interest increases the amount of interest paid on the loan remains constant and is fixed at the prescribed rate at the time the loan was made.
Income splitting through prescribed rate loans is not a new concept but it is particularly attractive at the moment because the prescribed rate of interest is at an all time low and investment rates of return are comparatively much higher which creates the ideal opportunity to take advantage of this strategy. As the prescribed rate of interest starts to increase, this strategy will become less attractive but there are a lot of tax payers taking advantage of this at the moment to lower the family tax burden.
The prescribed rate of interest is set to increase to 2% as of July 1st so if this strategy is of interest to you now is the time to implement this strategy.
