Prescribed Rate Loans: Income Splitting Guide

The Attribution Problem

Normally, if you give or lend money (interest-free) to your spouse:

• Investment income "attributes" back to you
• You pay tax on that income at your rate
• No income splitting benefit

How Prescribed Rate Loans Work

To avoid attribution rules, you can lend money at CRA's prescribed interest rate:

Requirements

• Written loan agreement
• Interest rate at least equal to prescribed rate at time of loan
• Interest paid by borrower within 30 days of year-end
• Interest payment every year (miss one and attribution kicks in)

Current Prescribed Rate

The prescribed rate is set quarterly by CRA:

• Check current rate on CRA website
• Rate is locked in for life of the loan
• Higher rates in recent years make this less attractive

Step-by-Step Implementation

Step 1: Create Written Agreement

The loan agreement should specify:

• Principal amount
• Interest rate (at least prescribed rate)
• Payment terms
• That interest is due by January 30 annually

Step 2: Transfer Funds

• Higher-income spouse lends money to lower-income spouse
• Use cheque or bank transfer (documented)
• Keep records of the transfer

Step 3: Invest the Funds

• Lower-income spouse invests in their name
• Their investment account, their decisions
• Can invest in stocks, bonds, mutual funds, etc.

Step 4: Pay Interest Annually

• By January 30 each year
• Lower-income spouse pays interest to higher-income spouse
• Document the payment

Step 5: Report on Tax Returns

• Higher-income spouse: Reports interest received as income
• Lower-income spouse: Deducts interest paid, reports investment income

Example Calculation

Assumptions:

• Loan amount: $200,000
• Prescribed rate: 4%
• Investment return: 6%
• Higher spouse's marginal rate: 50%
• Lower spouse's marginal rate: 20%

Without Prescribed Rate Loan

Higher-income spouse invests directly:

• Investment income: $12,000
• Tax (50%): $6,000
• After-tax income: $6,000

With Prescribed Rate Loan

Lower-income spouse invests:

• Investment income: $12,000
• Interest paid to spouse: $8,000
• Net income: $4,000
• Tax on $4,000 (20%): $800

Higher-income spouse:

• Interest received: $8,000
• Tax on $8,000 (50%): $4,000

Total tax: $4,800

Tax savings: $1,200/year

When This Strategy Works Best

• Large income disparity: Bigger gap = bigger savings
• Low prescribed rate: More income shifts to lower-earner
• Higher investment returns: More excess income to split
• Long time horizon: Benefits compound over years

When It Doesn't Work

• Similar incomes: Minimal tax rate difference
• High prescribed rate: Too much interest back to high earner
• Low returns: Investment returns below prescribed rate
• Short term: Setup cost not worth small benefit

Variations on the Strategy

Loan to Family Trust

• Establish a family trust
• Loan to trust at prescribed rate
• Trust invests and distributes to beneficiaries (spouse, children)
• More complex but more flexibility

Loan to Adult Children

• Same concept for adult children
• Must be genuine loan with interest payments
• Can help children build investment portfolio

Important Considerations

Must Pay Interest Every Year

If interest isn't paid by January 30:

• Attribution rules apply retroactively
• All income attributes back to lender
• Strategy is broken permanently for that loan

Capital Gains

• Capital gains attribute back to lender
• Only regular income (dividends, interest) stays with borrower
• Strategy mainly benefits dividend/interest income

Documentation

Keep detailed records:

• Loan agreement (signed and dated)
• Transfer of funds documentation
• Annual interest payments
• Investment statements in borrower's name

Tax Reporting

Lender (Higher Income)

• Report interest received on Line 12100
• Must report even though from spouse

Borrower (Lower Income)

• Report investment income normally
• Deduct interest paid on Line 22100
• Keep receipts of interest payments

Common Mistakes

• Missing interest payment: Ruins the entire strategy
• Below prescribed rate: Attribution still applies
• No written agreement: CRA may challenge
• Interest rate fixed wrong: Use rate from quarter loan made
• Commingling funds: Keep investment account separate

Getting Professional Help

Consider consulting professionals for:

• Drafting loan agreement
• Setting up family trust (if using trust)
• Tax planning and optimization
• Ongoing compliance