Many businesses and their stakeholders are experiencing significant challenges to their short-term liquidity due to the COVID-19 pandemic. Plummeting interest rates posted by the Bank of Canada and the Canada Revenue Agency may entice taxpayers to borrow to bridge the cash crunch, but is additional debt a good idea in these uncertain times? This article discusses how borrowing in a low-interest rate environment can present certain Canadian tax opportunities.
INCOME SPLITTING WITH FAMILY MEMBERS
Income splitting is a tax planning strategy that can reduce a family’s overall tax burden when family members, such as a spouse or children, are subject to lower marginal tax rates. This generally involves shifting taxable income from a high income tax rate member to a lower income tax rate member, directly or indirectly (for e.g. through a family trust).
The quarterly prescribed interest rate set by the CRA in Canada will decrease from 2 per cent to a historic low of 1 per cent effective July 1, 2020. Income splitting using a prescribed rate loan among Canadian family members may therefore become more attractive. Two examples are described below.
One trap to be aware of with intra-family prescribed rate loans is that the Income Tax Act (Act) contains certain attribution rules that can deem the income earned from loan proceeds to be attributed back to, and taxed in the hands of, the lender. There is a specific exclusion to these attribution rules for loans made to a spouse, or common-law partner, of the lender or to a related minor (the latter strategy is typically done through a trust), if interest is charged at a rate generally equal to or greater than the CRA prescribed rate.
For example, assume that wife lends husband $100,000 for husband to invest and earn a return (of greater than 1 per cent). Wife could charge husband the 1 per cent prescribed rate on the loan and she will be taxed on the 1 per cent interest paid to her while husband claims a deduction for the interest paid. The family unit would be better off overall from a Canadian tax perspective because the return on the investment is taxed in his hands rather than attributed back to the wife due to the attribution exemption described above.
However, if the interest rate charged on the loan is below the CRA prescribed rate, the attribution rules will apply. As a result, no tax saving would be achieved. In addition, although using a prescribed rate loan can be an effective way to split income among family members, an analysis of the tax on split income (TOSI) rules must be undertaken if the borrowed funds are used to invest in a family business. The TOSI rules limit the tax benefits of income splitting where the related family member receiving the income has not made significant contributions to the family business.
To implement a prescribed rate loan, the prescribed interest rate must be the one in effect during the quarter in which the loan is made. Even if the prescribed rate increases in a future quarter, the original prescribed interest rate on the loan remains locked-in. Thus, taxpayers who wish to implement an income splitting strategy should consider implementing a prescribed rate loan when the prescribed rate is 1 per cent.
Modifying an existing intra-family loan
For situations where a previous loan was made at a higher prescribed rate, a taxpayer may consider refinancing the existing loan when the prescribed rate goes down to 1 per cent. However, the interest rate on the existing loan cannot simply be reduced as the attribution rules apply if the new interest rate is lower than the prescribed rate in effect when the loan was originally advanced. Rather, the borrower may need to liquidate the investments acquired and then use the proceeds to repay the existing loan. A new loan at the lower prescribed interest rate can then be advanced. While a lower interest rate improves the income splitting results going forward, the costs of selling the existing investments, including any income tax resulting from any realized gains, need to be considered.
If a shareholder borrows funds from her company, a taxable benefit may result. However, if certain conditions and exceptions are properly navigated, a loan may be a quick, easy – and now, relatively cheap - way to temporarily extract funds from a corporation.
As described in this article, certain loans made by a corporation to a shareholder, are included in the shareholder’s income in the year in which the loan was made, unless certain exceptions are satisfied. In the case of loans made to non-resident shareholders, when these shareholder loan rules apply, debt financing provided by a Canadian corporation to non-resident shareholders can be deemed a dividend paid to the non-residents subject to Canadian withholding tax. To avoid this result, a “pertinent loan or indebtedness” election (PLOI election) can be made to instead subject the creditor to interest imputation at the PLOI prescribed rate, which is about 4 per cent higher than the general CRA prescribed interest rate. In other words, by filing a PLOI election, instead of paying a one-time withholding tax on a deemed dividend under the shareholder loan rules, the Canadian creditor will pay annual income tax on the imputed PLOI interest.
Further, generally a no or low-interest loan from a corporation to a shareholder (other than a corporation resident in Canada), can result in the shareholder being deemed to have received a taxable interest benefit. Effectively, if the no or low-interest loan was extended by virtue of such shareholding, a benefit is deemed to be received by the debtor. The benefit is equal to the amount of interest computed at the prescribed rate in effect during the period less interest actually paid.
Therefore, the tax cost of making certain domestic and cross-border shareholder loans can decrease as the CRA prescribed rate decreases.
A decreasing prescribed rate can be advantageous in making employee loans as well. If an employee receives an interest-free or low-interest loan from his / her employer in his or her capacity as an employee, a taxable benefit may arise. The amount of the benefit will generally be the difference between the interest calculated at the prescribed rate, and the actual interest charged by the employer and any interest paid by the employee in respect of the loan. Therefore, if at least the prescribed rate of interest is charged on an employee loan, an employee should be able to borrow amounts from his or her employer relatively cheaply.
BEING A SAVVY BORROWER
Beyond the basic strategy of borrowing amounts at low rates to hopefully profit from a spread on a higher return, if carefully managed, debt can confer certain Canadian tax advantages when rates are low. Taxpayers may want to consider different borrowing options, which not only provide liquid funds but also help reduce their tax liabilities.