Much has been written, by me and others, since Finance Minister Morneau introduced his infamous tax proposals on July 18th, 2017. Despite all of the evidence presented that these proposals are bad tax policy and bad for the economy, Trudeau and Morneau are determined to continue their attack on small business and the middle class.
Although some of the proposals have been abandoned, and others revised slightly, the day of splitting income using dividends from private companies is, for the time being, a thing of the past.
Many years ago, high tax individuals used to lend money to spouses and children in order to generate investment income in the hands of lower rate family members. This included loans made directly to individuals and loans to family trusts. The Courts said, in many rulings that a loan is not a transfer. The income attribution rules were amended to include attribution on these loaned monies. If the loan proceeds were used to buy property, say shares of a family company, the attribution rules would apply to have all dividends paid on the shares, and all capital gains realized on disposition of the shares taxed in the hands of the lender. But there is an important exception for loans made that charge interest at the prescribed rate for income tax purposes (currently 1%).
If a high rate taxpayer lends funds to a lower rate taxpayer, or to a family trust, AND interest is charged at the prescribed rate and actually paid, the income and any capital gains generated will be taxed in the hands of the borrower, not the lender.
In my posting in September, 2017, I suggested that we need to keep our eye on the prescribed rate for possible increases.
In the Financial Post on January 24th, Jamie Golombek explains how the prescribed rate is determined and why we should expect the prescribed rate to double to 2%, effective April 1st, 2018. Since 2009, with the exception of 1 quarter in 2013, the prescribed rate for inter family loans and certain other benefits, has been 1%.
Although some of us can remember prescribed rates of 14%, the doubling of the prescribed rate is significant for families that want to continue some form of income splitting.
Accordingly, if this form of income splitting is of interest, there is an urgency to putting the pieces in place before March 31st, 2018.
As with all income tax planning, I strongly recommend that any loans be documented with promissory notes in writing.
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.
It is important that all proper paperwork, including a promissory note to document the loan itself, must be prepared.
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.
It may seem silly to be concerned about interest at 1% 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.
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.