Income Splitting: Can you benefit from a low interest rate environment?

Income Splitting – the concept:

Higher income earners attempt to reduce their family's overall tax burden by shifting their income and capital gains to the family members with less income and as such are subject to lower marginal tax rates.  This concept is known as income splitting.  The Income Tax Act, however, sets out rules, known as the "attribution rules", intended to prevent income splitting.

The attribution rule:

The attribution rules prevent taxpayers from reducing taxes by shifting investment income to family members.  It comes into play when income-producing property is transferred or loaned to a non-arm’s length party with certain exceptions. The income from the property will be attributed back to the person who originally gave it to the non-arm’s length party.

Exception to the Attribution rules:

Attribution rules may not apply to any income or gains earned on the transferred funds, provided that the following requirements are met:

The transferor received fair-market-value consideration in exchange for the property; or

The transfer is a loan and the transferor received interest payments within 30-days after the end of both the year in which the transfer occurred and each subsequent year.

What is a Prescribed Rate?

The CRA announces the prescribed interest rate on a quarterly basis, based on a three-month average of short-term government of Canada T-bill rates and rounded up to the highest whole percentage number.

The Canada Revenue Agency (the “CRA”) has lowered the prescribed rate for the third quarter of 2020 to 1% (reduced from 2% in the second quarter). 

How does the low prescribed loan rate matter?

The interest rate on the loan is at least equal to the lesser of (i) the CRA prescribed rate in effect at the time the loan is made, and (ii) the rate of interest that would apply on a loan between arm’s length parties.

At the current rate of 1%, as long as the transferor got paid the interest before January 31 while the loan is outstanding, tax liability on income greater than 1% is effectively transferred to the lower income family member. 

The rate is locked in for the life of the loan even if they rise in the future.

Other strategies where the attribution rule will not apply:

1. Income earned from properties transferred to adult children

2. Spousal RRSP contribution:  If you expect your spouse will have a lower tax rate during retirement, this will help to split your income during retirement years.  

3. TFSA contribution to spouse:  No attribution when money is gifted to your spouse for TFSA contribution:    However if money is withdrawn and subsequently invested outside the TFSA, attribution may apply to the income generated from this investment. 

Everyone’s tax situation is different; before implementing any tax strategy, please make sure you speak with your tax advisor to assess whether a particular strategy is beneficial for your situation.