Many of you have been reading my newsletters for years and have read many postings from me about family income splitting using low rate inter-family loans.
There are rules in the Income Tax Act, referred to as the income attribution rules, which will, in certain circumstances, attribute income earned by one taxpayer to another. For example, if I give money or other property to my spouse or to a minor, the Act will attribute the investment income earned to me and tax it in my hands.
There are some notable exceptions to the income attribution rules. Although income and capital gains will be attributed from a spouse, there is no attribution of capital gains from a minor. So, if, for example, I give or lend money to a minor to invest in a mutual fund generating capital gains, there would be no attribution. The same investment in the hands of my spouse would trigger attribution of the capital gain.
One often forgotten exception to the income attribution rules is using gifted or loaned funds to generate business income, as opposed to investment income. If I give or lend money to my spouse or to a minor to be used for business purposes, the business income is not attributed.
There is often a fine line between income from business and income from property, so professional advice should be obtained to ensure that the use of the funds will avoid the attribution rules.
However, if the funds are loaned to a lower rate taxpayer, or to a family trust, AND interest is charged at the prescribed rate AND the interest is actually paid, the investment income and any capital gains generated will be taxed in the hands of the borrower, not in the hands of the lender. This is the case even where the funds are used for investment purposes.
The prescribed rate is currently 2%.
Don’t forget the interest payments
In order to avoid the attribution of income on the loaned funds and any property purchased with the loaned funds, the interest has to be payable, and actually be paid, no later than 30 days after the end of the taxation year. No matter how insignificant, this interest must be paid by January 30th, not January 31st, and a paper trail should be kept. Not only should paperwork be kept to show the payment, but the lender should be including the interest received in his or her tax return for the year of receipt of the interest.
Once the loan is in place, the prescribed rate at the time of the loan will continue to be applicable to the outstanding balance of the loan, even if the prescribed rate increases.
It is important that all proper paperwork, including a promissory note to document the loan itself, must be prepared.
It may seem silly to be concerned about interest at 2% on a loan of, perhaps, $100 to purchase shares in a family company, but it is crucial. A lot of good, and expensive, tax planning could go out the window for the lack of paying two or three dollars of interest.
There is another problem that can arise of the interest is not paid. Many taxpayers establish family trusts for the benefit of their various family members. At the end of 21 years, a trust is deemed to sell all of it property at fair market value, and a substantial taxable capital gain can arise. One of the solutions to this is to transfer the assets out of the trust to the beneficiaries. As long as the beneficiaries are residents of Canada for tax purposes, this can generally be done at the tax cost of the assets, without triggering any capital gain. BUT, if the interest on the loan has not been paid, EVERY YEAR, the ability to transfer the property out of the trust at its tax cost will be lost .
As always, I would be pleased to work with you and your advisors to ensure that you take advantage of all possible income splitting opportunities.