LOANS FOR VALUE - INCOME SPLITTING TOOL
this option to split income without attracting the attribution rules
Loans for value are an effective approach to legally circumventing the attribution rules to permit income splitting between spouses or to minors. The prescribed rate declined to 1%, as low as the formula can go without negative returns on Treasury Bills, effective July 1, 2020 where it will remain until at least September 30, 2020. As a result, many advisors are again considering such loans. For example, these were discussed in articles by Jamie Golombek in the Financial Post (June 19, 2020; There’s a great opportunity for income splitting coming up) and Investment Executive (July 3, 2020; Prescribed rate loan planning).
The attribution rules do not apply where the low income borrower pays fair market value for any capital received from a person normally subject to the attribution rules (including a spouse, parent, grandparent, sibling, uncle or aunt). They can pay for such investment capital with properly structured loans, commonly referred to as “loans for value”.
In order for such a loan to be considered valid consideration, and avoid the attribution rules, several criteria must be met (Paragraph 74.5(1)(b) and Subsection 74.5(2)):
- 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.
sending annual reminders of these interest payments
However, 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 2019 was required to be paid by January 30, 2020. If the interest was not paid, attribution would apply for 2019 and all subsequent years.
whether existing loans at rates higher than 1% should be restructured
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 (see VTN 385(16)). However, where a pre-existing loan requires higher interest (such as the 2% rate in effect to June 30, 2020), 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.
taking advantage of market declines
Where assets are transferred between spouses, the attribution rules will apply unless the transferor spouse elects that the transfer occur at fair market value (electing out of Subsection 73(1)). This means that any gains inherent in the property transferred must be realized by the transferor spouse, attracting income taxes. Any losses would be superficial losses (Section 54), and would, therefore, not be realized by the transferor spouse (Subparagraph 40(2)(g)(i)), but would be added to the transferee spouse’s ACB (Paragraph 53(1)(f)). This is not an issue for transfers to other family members as the disposal will be deemed to take place at fair market value, although the stop loss rules may apply on transfers to a trust. Where values are temporarily depressed and expected to recover in the future, a quick transfer can reduce gains realized and the loan principal, for more effective future income splitting.
ensuring T5 slips are filed by partnerships and trusts
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. Of course, the lender must report the interest as it is received each year. T5 slips may also be technically required, depending on the borrower (e.g. partnerships and trusts have been required to file T5s since 2018 (Regulation 201(1)(b)(ii)), but no requirement exists for individuals).