Plan Carefully When Using Family Loans To Split Income
Special attribution rules prevent the shifting of income between certain related people (including a spouse, parent, grandparent, sibling, uncle or aunt). Consider the situation where high-earning Spouse A gives investments to low-earning Spouse B so that investment income can be taxed at Spouse B's lower tax rate. The attribution rules prevent this by requiring the earnings to be taxed in the hands of the transferor, Spouse A.
However, these rules do not apply where the low-income person pays fair market value for the capital received. One way to pay for such investment capital is with properly structured loans, commonly referred to as “loans for value”.
The loan must satisfy several conditions to facilitate income splitting:
• the loan must bear interest;
• the interest must be at a rate no lower than the CRA prescribed rate at the date the loan is advanced; and
• the interest for every year must be paid no later than January 30 of the following year.
Missing a single interest payment invalidates the loan for the year in respect of which the interest accrued and all subsequent years. For example, interest for one year must be paid by January 31 of the following year. If the interest is not paid, attribution would apply to the individual providing the loan for the year in which the loan was provided and all subsequent years.
The borrower (commonly a trust for minor children or grandchildren) can then invest the borrowed funds and earn income. Because the borrowed funds are used to earn income, the borrower is entitled to deduct the interest incurred as a carrying charge. To the extent the return on their investments exceeds the interest, the difference will be taxable to the lower-income borrower.
The CRA has confirmed that the interest rate can be fixed at the time the loan is advanced, without further adjustment when the prescribed rate changes. However, where a pre-existing loan requires higher interest, the rate cannot be adjusted downwards as it is also locked in at initial advance. Where there is an existing loan at 2% (or higher), refinancing at the lower 1% rate would require that the borrower repay the original loan. A new loan could then be advanced at 1% interest. Where appreciated assets must be transferred or sold to repay the loan, accrued gains would need to be reported.
Premium Accounting and Tax Assistance - call Nicholas Kilpatrick at 604-327-9234 to find out more for your business and click here to see our latest first-time offers.
TAKEAWAY:
Consider setting up a loan for value if there is significant investment capital available, and a family member at a lower marginal tax rate.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebook.com/Burgess Kilpatrick for more information on our firm.