You might be wondering if you could save taxes by transferring assets into the name of your child. Such planning is commonly referred to as income splitting. Income splitting techniques seek to transfer income from an individual (e.g. a parent) who pays taxes at a high rate into the hands of an individual (e.g. the child of the parent) who is taxed at a lower rate. The Income Tax Act (the Act) contains rules intended to limit such planning opportunities, including the so-called “attribution” rules, which impose substantial limitations on available income splitting strategies where the child has not yet reached the age of 18 before the end of the tax year.
Generally, when they apply, the attribution rules tax investment income earned on investments transferred to a child by a parent at the parents’ (higher) tax rate (attribution of income and losses will cease at the beginning of the taxation year in which the child attains the age of 18). In the case of a minor, the attribution rules only apply to income from property, such as interest and dividends. Consequently, while some tax savings can be achieved, since there is no attribution of capital gains derived from increases in the value of investments transferred to a child, the savings may not be substantial depending on the type of investments.
The attribution rules can, however, be avoided by implementing a prescribed rate loan strategy. In particular, if instead of gifting investments to your child, you transfer the investments in exchange for a loan which bears interest at the “prescribed rate” (i.e. a “prescribed rate loan”), the attribution rules will generally not apply to income or gains earned on the transferred investments. In other words, the attribution rules are effectively turned-off if investments are transferred to a child in exchange for a prescribed rate loan. You will be required to include in your income interest earned on the prescribed rate loan, however, the prescribed rate, which fluctuates over time, is currently very low (at the time of writing, 1%). Consequently, substantial tax savings can be realized via the prescribed rate loan income splitting strategy since capital gains, interest, dividends or other income earned on the investments transferred in excess of the prescribed interest rate will be taxed in your child’s hands. The prescribed rate loan strategy can also be implemented using a family trust if you wish to maintain control over the investments.
The following examples illustrate the prescribed rate loan income splitting strategy. Note that a certain amount of income included in your child’s tax return will not be subject to no tax (i.e. up to the basic personal amount, which is approximately $13,000). Example 1:
In the 2020 taxation year, every additional dollar of income earned by Mr. and Mrs. Smith is taxed at a 40% combined federal/provincial rate. That is, they would pay $40 in additional tax on every $100 of additional income. The couple have an 8-year-old son, Tommy. With the intention of splitting income, the parents transfer a $50,000 bond to Tommy that pays interest at a rate of 5%. Tommy therefore receives $2,500 of interest income in the 2020 taxation year and has no other source of income. However, since the bond was gifted to Tommy, the interest income is attributed back to the parents who pay $1,000 in tax on the income ($2,500 × 40%).
Instead of gifting the bond to Tommy, Mr. and Mrs. Smith transfer the $50,000 bond to Tommy in exchange for a note that bears interest at a rate of 1% (the prescribed rate). Tommy pays $500 of interest to his parents at the end of the year, in respect of which $200 of tax is paid ($500 × 40%). However, Tommy does not pay any tax on his net investment income of $2,000 ($2,500 - $500). The chart below illustrates the tax savings of the prescribed rate loan income-splitting strategy:
Investments held Prescribed rate
directly by parent loan at 1%
Taxable investment income $5,000 $5,000
Tax payable by parents $1,000 $200 (tax on $500
Tax payable by Tommy — $Nil
Tax savings year 1 — $800
Tax savings over 10 years — $8,000
To transfer investment income to your child using this strategy, ownership of the income producing investment must actually be transferred (i.e. merely transferring entitlement to the investment income will not suffice). In Example 2 above, the parents were careful to transfer to Tommy ownership of the bond itself, and did not merely assign the interest income to Tommy in exchange for the loan. Furthermore, the $50,000 prescribed rate loan made to Tommy must be formally documented, and the annual interest on the loan note must be paid by January 30th of the following year in order to avoid the application of the attribution rules (i.e. to avoid the income being taxed in the hands of Tommy’s parents, it is critical that the interest on the prescribed rate loan actually be paid, and that the payment is made during the year or within 30 days after the end of the year). Tommy also files a tax return each year to report the interest income, even though he does not pay any tax on the income.
Although prescribed interest rates fluctuate each quarter, for the income splitting purposes described herein, the interest rate on the loan may be fixed at the applicable prescribed rate on the date the loan is made.
The prescribed rate loan strategy described above can also be utilized to split income between spouses or other family members. The strategy can generate significant tax savings over time.
For more information, please contact firstname.lastname@example.org or 1 844-GYTD-CPA