Prescribed Rate Loan
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A prescribed rate loan is a strategic financial arrangement primarily used to shift investment income from a high-income earner to a family member in a lower tax bracket. This tax-driven strategy must be properly aligned with the Income Tax Act (Canada), wherein a person with a higher marginal tax rate lends money to a spouse, common-law partner, or a family trust rather than simply gifting the funds. To satisfy the legal prerequisites of the Canada Revenue Agency (CRA), the loan must carry an interest rate at least equal to the official prescribed rate set by the government at the time the loan is established. This rate is reviewed quarterly and is based on the yield of three-month Government of Canada Treasury bills. By formalizing the transfer as a loan, the parties can ensure that any investment growth above the prescribed interest rate is taxed in the hands of the lower-income recipient.
The primary reason for using a prescribed rate loan is income splitting, which can lead to significant annual tax savings for a household. Due to Canada's progressive tax system, the first dollar earned by a low-income spouse is taxed much less than the last dollar earned by a high-income spouse. If the high-income spouse simply gives money to the other to invest, the attribution rules in the Income Tax Act usually kick in, forcing the income back onto the higher earner's tax return. However, a properly structured prescribed rate loan serves as a legal exception to these attribution rules. This allows the family to keep more of their investment returns by utilizing the lower earner's personal tax credits and lower tax brackets. (See Income Tax Act, sections 74.1(1), (2), 74.2)
The legal boundaries of these loans are strictly governed by the Income Tax Act to prevent tax evasion and ensure the arrangement is genuine. One of the most critical legal requirements is that the interest on the loan must be paid annually, specifically no later than January 30 of the following year. If a single interest payment is missed or paid late, the attribution rules are permanently triggered for the life of that loan, meaning all future income will be taxed back to the lender. Furthermore, the loan must be a bona fide legal obligation, usually evidenced by a written promissory note that outlines the terms of repayment. The CRA does not allow for retroactive adjustments to the interest rate if it rises or falls after the loan is signed; the rate is locked-in at the time the loan is made. (See Income Tax Act, section 74.5(2))
To establish a prescribed rate loan, the lender must first determine the current CRA prescribed interest rate for the quarter in which the loan is being initiated. Once the rate is confirmed, the parties should draft a formal loan agreement or promissory note that clearly states the principal amount, the interest rate, and the requirement for annual interest payments. It is highly recommended that the funds be transferred via a traceable method, such as a wire transfer or a bank draft, to create a clear paper trail for future audits. The borrower must then invest these funds in an account held solely in their name or within a trust specifically designed for this purpose. This separation ensures that the income generated can be easily tracked and attributed to the borrower rather than the lender. (See Income Tax Regulation 4301)
Ongoing management is just as important as the initial setup to maintain the tax benefits of the arrangement. Every year, the borrower must calculate the interest due based on the principal and the locked-in rate, then physically transfer that amount to the lender by the January 30 deadline. The lender is then required to report this interest as income on their own personal tax return, while the borrower may be able to deduct the interest expense if the funds were used to earn investment income. Documentation is the best defense in this scenario, so keeping records of every payment and bank statement is essential for demonstrating compliance to the CRA. If the prescribed rate drops in a future quarter, a family may choose to collapse the old loan and start a new one to lock in the lower rate, provided they follow all the legal steps again. (See Income Tax Act, section 74.5(2)(b))
While the strategy is most common between spouses, it can also be used with a family trust to benefit minor children or grandchildren. Because children typically have little to no income, the tax savings on investment gains can be even more dramatic when compared to a high-earning parent. In this version, the trust borrows the money at the prescribed rate and invests it, later distributing the net income to the beneficiaries for expenses like private school tuition or extracurricular activities. This remains a popular tool for multi-generational wealth planning, as it provides a structured way to fund a child's future while minimizing the overall family tax bill. However, the complexity of managing a trust means that legal and accounting professional advice is usually necessary to avoid costly administrative errors.
Ultimately, a prescribed rate loan is a powerful and CRA-sanctioned method for optimizing a family's financial position through disciplined income shifting. It requires a long-term commitment to record-keeping and a clear understanding of the federal interest rate cycles. When the prescribed rate is low, it becomes an especially attractive option for those with significant non-registered capital to invest. By following the strict timelines and documentation requirements, Canadians can effectively lower their effective tax rate while building wealth for their family's future. As long as the interest is paid on time and the loan is legally documented, it remains one of the most effective tax-planning strategies available in the Canadian landscape.
To learn how our legal team can help you implement estate planning and wealth management strategies, contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
IMPORTANT NOTE: This website is designed for general informational purposes. The site is not designed to answer specific questions about your individual situation or entitlement. Do not rely upon the information provided on this website as legal advice in respect of your individual situation nor use it as substitute for individual legal advice. If you want specific legal advice, you need to engage a lawyer under established legal engagement procedures that have been specifically agreed to by that lawyer.
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