Prescribed-Rate Loan Strategy for Trusts (and Tax Concerns)
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A prescribed-rate loan strategy involves a high-income individual lending personal capital to a family trust at the prescribed interest rate set by the Canada Revenue Agency (CRA). In the absence of such a loan, the attribution rules under the Income Tax Act (Canada) would normally require any income earned on gifted funds to be taxed in the hands of the high-earner who provided the money. By formalizing the transfer as a loan at the official prescribed rate, the lender aims to legally bypass the adverse consequences of these rules. This allows the trust to invest the borrowed funds and distribute the resulting net income to lower-income beneficiaries, such as children or a spouse, who then pay tax at their own significantly lower marginal rates.
The primary mechanism for income splitting lies in the spread between the investment returns generated by the trust and the interest rate paid back to the lender. For example, if the CRA prescribed rate is 3% (as it is for the first quarter of 2026) and the trust earns a 7% return on its investments, the 4% difference can be allocated to beneficiaries for taxation. This strategy is most potent when the prescribed rate is low, as it reduces the hurdle rate that the trust's investments must exceed to achieve tax savings. Because the interest rate is locked in at the time the loan is established, the strategy can remain effective for decades, even if market interest rates rise significantly in the future.
To maintain the legal integrity of this strategy, the trust must strictly adhere to specific implementation requirements, most notably the January 30th interest payment deadline. Each year, the trust must actually pay the interest owing on the loan to the lender by January 30th of the following year; simply accruing the interest or issuing a promissory note is insufficient. Failure to meet this deadline (even by a single day) will trigger the attribution rules for that year and all subsequent years, permanently neutralizing the tax benefits of the loan. Furthermore, the lender must report this interest as taxable income on their own return, which partially offsets the family's total tax savings but is necessary to comply with the loan for value exception.
Beyond the attribution rules, the Tax on Split Income (TOSI) remains a critical concern when implementing trust-based strategies, particularly if the trust holds shares in a private corporation. While TOSI generally targets dividends and income from a family business, it does not typically apply to interest, capital gains, or dividends from a portfolio of publicly traded securities. Consequently, most legal practitioners recommend using prescribed rate loans to invest in diversified market portfolios rather than private company assets. If the trust’s investments are not carefully chosen, the TOSI rules could apply the highest marginal tax rate to any distributions made to minor children, effectively defeating the purpose of the income splitting (more on tax on split income strategies).
Furthermore, individuals must consider the Alternative Minimum Tax (AMT) and the costs associated with the trust's ongoing administration. Recent changes to the AMT regime in Canada have expanded its reach, and significant capital gains or certain deductions within a trust could inadvertently trigger this tax, reducing the net benefit of the strategy. Additionally, the legal fees for drafting the trust deed and loan agreement, as well as the annual costs of filing T3 trust returns, must be weighed against the projected tax savings. Because of these complexities, a prescribed rate loan is generally most appropriate for larger capital sums (typically $500,000 or more) where the tax alpha significantly exceeds the professional and administrative overhead.
Contact our law firm today to learn how our legal team can help you plan for the future, including wills, trusts, powers of attorney, personal directives and other estate planning documents, or deal with the legal demands associated with the passing of a loved one. Contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
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