In a decreasing interest environment, there are tax consequences that may require taxpayers to reconsider some tax planning previously put in place.
Prescribed rate loans
A common way to avoid adverse tax implications on income splitting strategies is to utilize a loan that carries the prescribed interest rate, oftentimes referred to as a “prescribed rate loan”. Absent a prescribed rate loan, many income splitting strategies can fail due to the application of the attribution rules, which can shift income earned in the hands of the debtor back to the creditor, defeating the intention of the tax strategy. In general, if a loan to a family member or family trust carries the prescribed rate of interest applicable in the fiscal quarter the loan was entered into, the debtor can use those funds to invest in income-earning portfolios and avoid attribution. The loan can be made individually between family members directly but can also be made to a family trust to earn investment income to be subsequently allocated to beneficiaries.
This type of planning becomes more attractive as interest rates decrease, since a prescribed rate loan carries the prescribed rate of interest applicable in the fiscal quarter the loan arises indefinitely. This is ideal, because the interest payable is taxable to the recipient, who is typically a high-income earner (and paying tax at the highest marginal tax rate) that is intending to split income with their family.
Modifying an existing prescribed rate loan
Taxpayers with prescribed rate loan structures in place already may be stuck with a loan carrying a higher rate of interest. As a result, taxpayers may want to consider dismantling their current structure and take advantage of the lower prescribed rate starting Q1 2025. The rules for doing so can be strict, and typically amending the interest rate on the existing loan is insufficient to lock in the new interest rate. Instead, the debtor would need to liquidate their investments, incur the relevant tax implications due to the sale, repay the existing loan, and introduce a new loan carrying the new prescribed rate. Taxpayers considering this would need to model the triggered tax costs associated with liquidation against the possible tax benefits from re-establishing a new loan.
Utilizing a family trust versus direct loans
With new legislative amendments to alternative minimum tax (AMT) effective Jan. 1, 2024, family trust structures are becoming more costly. AMT is, generally, a parallel tax calculation applicable to certain individuals, estates and trusts that is computed using special rules that do not often coincide with typical Canadian tax rules. While AMT can be recoverable in future years, family trusts are not typically structured in a way to be able to recover the tax, and as a result AMT can often be seen as a permanent tax.
The main issue with using a family trust in 2024 is that many expenses, such as interest expense and other carrying charges, are only 50 per cent deductible for AMT purposes. Unlike individuals, family trusts do not benefit from a minimum AMT exemption amount, which increases the likelihood of AMT applying to a trust’s income. While certain tax planning can be considered to minimize AMT, the tradeoff may be paying ordinary income tax at the trust level at the highest marginal rates, which would generally negate the benefit of using a trust.
Consequently, direct prescribed rate loans to family members may become more attractive than loans made to family trusts, on the AMT front. Individual taxpayers do have an AMT exemption amount of approximately $173,000 starting in 2024, which means less AMT exposure as a result.
Other loans
Shareholder loans
Certain loans made by a corporation to a non-corporate shareholder can be included in the shareholder’s income in the year in which the loan was made. There are some exceptions to this rule, such as if the loan is repaid within one year after the end of the taxation year in which the loan was made. In situations where the entire amount of a loan is not included in income for a taxpayer, if interest charged on a shareholder loan is less than the prescribed interest rate, a taxable benefit would arise based on the time the loan was outstanding and the delta in interest rates.
Declining interest rates equates to a smaller deemed interest inclusion for shareholder loans. As a result, shareholders can consider temporarily entering into these loans for personal needs.
Employee loans
Similar to shareholder loans, certain employee loans can also create a deemed taxable benefit based on the prescribed rate of interest. Most commonly, this can be applicable when an employer offers their employee a loan to purchase a home. However, unlike other types of loans, employee loans have an automatic five-year “refresh”, which deems a new loan to arise at that time for tax purposes. This diminishes the value of entering into a loan when interest rates are low, since the prescribed interest rate will only last five years for purposes of computing the deemed employee benefit. That being said, locking in a lower interest rate for five years can still be valuable, and taxpayers can try and structure their employee loans to be in place when the prescribed interest rate falls in Q1 2025.
Capital investment
Typically, lower interest rates are coupled with increased capital investment. There are many tax incentives to further encourage capital investment that are expected to be available during 2025. For example:
- Zero emission vehicles and automotive equipment are afforded a 75 per cent first-year deduction if acquired and available for use before 2026.
- Draft legislation, introduced in the 2024 Federal Budget, will permit a 100 per cent first-year deduction for “productivity-enhancing assets”, including assets such as data network infrastructure equipment.
Interest denial regimes
As companies consider making more capital investment, it is important to consider the application of interest denial regimes for tax purposes. Canada has introduced new rules under the excessive interest and financing expense limitation (EIFEL) regime, which applies to deny interest expense deducted to the extent it exceeds a certain percentage of tax-EBITDA. Alongside various interest denial regimes from other jurisdictions, such as section 163(j) of the Internal Revenue Code in the United States (which is currently at risk of facing amendments in light of the upcoming second Trump administration), this can severely diminish the value of debt financing. It is important to keep any limits in mind before considering any type of planning.
Interest rates are still in flux
Despite the trend showing that interest rates are decreasing, it is impossible to know what Q2 2025 and beyond has in store for interest rates. No matter what the future holds, tax implications closely follow the economics, and keeping a keen eye on how prescribed rates fluctuate can help taxpayers optimize their tax planning.
