I started an argument at home this week. After working out, I left my sweaty socks on the floor in the bedroom. Few things in life drive Carolyn crazy – but this is one of them. After she shared a few choice words, I said: “I just want to remind you that you owe me $50,000, and you need to pay me $500 by Jan. 30,” so be kind.
It was a low blow. But it’s true. A few years ago, we set up a spousal loan where Carolyn borrowed money from me and I’m charging her 1 per cent annually. This was a common strategy when the prescribed interest rate under our tax law was just 1 per cent. It was a great income-splitting tactic and, as interest rates come down, there could be an opportunity to make similar loans in the future. Let me explain.
Consider the strategy
The attribution rules in our tax law generally kick in to stop you from giving money to your spouse or minor children to have income on those assets taxed in their hands rather than yours. There are some exceptions (most notably, capital gains earned in the hands of minors can be taxed in their hands), but the most common way of escaping these rules is to lend money to your spouse, or a family trust, and charge the prescribed rate of interest in effect at the time.
This rate is set quarterly and is based on the average of three-month treasury bills for the first month of the preceding quarter, rounded to the next highest percentage point. For the first quarter of 2025, the prescribed rate is 4 per cent, but it was as low as 1 per cent as recently as the second quarter of 2022.
The prescribed rate applies for the duration of the loan, even if rates increase later. The borrower must pay the interest on or before Jan. 30 each year for the prior year’s interest charge. If the borrower fails to pay, the attribution rules will apply every year going forward – there’s no fixing it without repaying the loan then taking out a new loan at the current prescribed rate.
The borrower is entitled to a tax deduction for the interest paid, and the lender will have to report the interest as income, but if the borrower is earning more than the prescribed rate on the invested loan proceeds, and is in a lower tax bracket, there will be tax savings for the family.
However, when interest rates decline, you can’t simply adjust an existing loan to the lower rate. You have to actually pay off the loan, then establish a new loan at the lower rate. If you made a loan in the last two years at a higher rate than today’s 4 per cent, you could have the borrower pay off the loan and take out a new loan at today’s lower rate. But I’d wait a bit longer. The Bank of Canada could announce another cut in its policy interest rate on Jan. 29, in which case the prescribed rate could fall to 3 per cent in the second quarter of this year.
We may never see a 1-per-cent prescribed rate again, but a 3-per-cent rate can make a loan to a spouse or family trust worthwhile.
Consider an example
Take the story of Jack and Jill. Jack is in the highest tax bracket in Ontario, and his wife Jill is in a lower bracket. Jack is thinking about lending Jill $100,000 if the prescribed rate drops to 3 per cent.
If we assume that Jill can earn 6 per cent on the money, she’ll earn $6,000 annually. If Jack were to pay tax on this income, he’d pay $3,212 at his marginal tax rate of 53.53 per cent. If Jill is able to report that income, she’ll pay tax of just $1,203 at her marginal tax rate of just 20.05 per cent. The couple will save $2,009 annually.
But let’s not forget that Jack will pay tax on the $3,000 of interest Jill will pay him annually, and she’ll get a deduction for the interest. He’ll pay $1,606 in tax on this interest, and she’ll save $602, for a net tax cost of $1,004. This will reduce the net benefit to $1,005 ($2,009 less $1,004) annually. It’s not a huge savings, but better in their hands than the taxman’s. As the prescribed rate comes down, or the amount of the loan goes up, or the annual earnings increase, the total tax dollars saved increases.
So, don’t forget to pay your interest on or before Jan. 30 for existing loans, and watch for a declining prescribed rate for new loans.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.
