Canadian Taxation
Making Loans
The attribution rules generally do not apply to money that is loaned when interest is charged at a rate prescribed by the Canada Revenue Agency (CRA) and paid within 30 days after the year-end. When an investment can be expected to generate earnings in excess of the prescribed rate, it might be worthwhile for a higher-income family member to loan funds to a lower-income family member. The lower-income family member can use the loan to purchase the investment, allowing the excess of the investment earnings over the interest charged to be effectively transferred to the person in the lower tax bracket.
Of course, the interest charged must be added to the income of the higher-income family member.
Key Points
- The attribution rules do not apply if the interest rate charged on the loan is at least the rate prescribed by the CRA and the interest is paid within 30 days after year-end.
- An investment expected to generate earnings in excess of the prescribed rate makes this strategy beneficial.
- This arrangement allows for an effective transfer of investment earnings to a lower-income family member, potentially optimizing overall family tax efficiency.
- The higher-income family member must include the interest received from the loan in their taxable income.
Frequently Asked Questions (FAQs)
Q: What is the prescribed rate set by the CRA?
A: The prescribed rate is determined each quarter by the CRA and is based on the average yield of Government of Canada short-term Treasury bills. It can change over time, so it’s important to check the current rate before making a loan.
Q: What are the attribution rules related to family loans?
A: The attribution rules are designed to prevent income splitting between family members in different tax brackets. However, if a loan is given with an interest rate at or above the CRA-prescribed rate and the interest is paid within 30 days after the end of each year, the rules do not apply.
Q: How should interest be reported for tax purposes?
A: The individual providing the loan (higher-income family member) must report the interest received as part of their taxable income. The individual receiving the loan (lower-income family member) can use the interest expense as a deduction against the income generated through the investment.
Glossary
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Attribution Rules: Tax laws that prevent high-income individuals from shifting income to family members in lower tax brackets to reduce the overall family’s tax liability. Specific conditions must be met to apply these rules.
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Prescribed Rate: The interest rate set by the Canada Revenue Agency for various tax purposes, such as determining the minimum interest rate for family loans.
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Income Splitting: A strategy to reduce the tax burden on a family by redistributing income among family members, usually through loans or gifts, taking advantage of different tax brackets.
The actual benefit of making a loan can be expressed as:
$$
ext{Net Benefit} = (R_i - R_{p}) imes L
$$
- ( R_i ) = Rate of return on the investment
- ( R_p ) = Prescribed rate set by CRA
- ( L ) = Amount loaned
Diagrams
pie title Interest Rate Breakdown
"Investment Rate of Return": 75
"Prescribed Rate": 25
This pie chart demonstrates that the investment’s rate of return can significantly exceed the prescribed rate, leading to a beneficial transfer for tax-saving purposes.
Key Takeaways
- Making a loan within a family can be an effective way to maximize income and limit tax liability when done according to CRA guidelines.
- Understanding and complying with the attribution rules and prescribed rate is essential for this strategy to work effectively.
- Reporting the interest appropriately ensures fairness and transparency according to the rules set by the CRA.
📚✨ Quiz Time! ✨📚
## When do the attribution rules not apply to loans made between family members?
- [ ] When no interest is charged
- [ ] When repayment occurs within 365 days
- [x] When interest is charged at a CRA-prescribed rate and paid within 30 days after the year-end
- [ ] When the loan amount is below $10,000
> **Explanation:** The attribution rules do not apply when interest is charged at a rate prescribed by CRA and paid within 30 days after the end of the year.
## What happens if a higher-income family member loans funds to a lower-income family member at the prescribed interest rate?
- [ ] The attribution rules apply irrespective of the interest charged
- [x] The excess investment earnings over the interest charged are transferred to the person in the lower tax bracket
- [ ] The entire investment earnings are attributed back to the higher-income family member
- [ ] The attribution rules do not apply, but the loan is taxed
> **Explanation:** The excess of the investment earnings over the interest charged is effectively transferred to the person in the lower tax bracket.
## How does the higher-income family member report the interest charged on a loan to a lower-income family member?
- [ ] It is exempt from income reporting
- [x] It must be added to the higher-income family member's income
- [ ] It can be reported by either family member
- [ ] It only needs to be reported in alternate years
> **Explanation:** The interest charged must be added to the income of the higher-income family member.
## Which rate should be used to charge interest on a loan to ensure the attribution rules do not apply?
- [x] CRA-prescribed rate
- [ ] Prime rate
- [ ] Family-agreed rate
- [ ] Investment return rate
> **Explanation:** Interest must be charged at a rate prescribed by CRA to avoid attribution rules.
## What is required for the interest on a loan to be considered properly charged under the attribution rules?
- [ ] It must be compounded annually
- [ ] It must match market returns
- [ ] It must be charged within 30 days after the loan is issued
- [x] It must be paid within 30 days after the year-end
> **Explanation:** The interest must be paid within 30 days after the year-end.
## What scenario would typically justify a higher-income family member loaning funds to a lower-income family member?
- [ ] When the lower-income member needs financial help
- [x] When the investment earnings are expected to exceed the prescribed interest rate
- [ ] When no other investment options are available
- [ ] When the prescribed interest rate is higher than usual
> **Explanation:** It's worthwhile if the investment is expected to generate earnings in excess of the prescribed rate.
## How frequently must the interest on a family loan be paid to comply with CRA rules?
- [ ] Monthly
- [ ] Quarterly
- [ ] Annually
- [x] Within 30 days after the year-end
> **Explanation:** The CRA requires interest to be paid within 30 days after the end of the year.
## Which family member benefits from the excess investment earnings over the interest charged on a CRA-compliant loan?
- [x] The lower-income family member
- [ ] The higher-income family member
- [ ] Both family members equally
- [ ] Neither family member benefits
> **Explanation:** The excess of investment earnings over the interest charged is effectively transferred to the lower-income family member.
## What must the higher-income family member do with the interest charged on a prescriptive rate loan?
- [ ] Reinvest it
- [x] Report it as income
- [ ] Ignore it
- [ ] Share it with the lower-income family member
> **Explanation:** The interest charged must be added to the income of the higher-income family member.
## Which of the following best describes the purpose of making loans under the CRA-prescribed rate rules?
- [ ] To avoid paying any taxes
- [ ] To evade reporting income
- [ ] To equalize income in a family
- [x] To transfer investment earnings to a lower tax bracket
> **Explanation:** This strategy transfers the excess investment earnings over the interest charged to the person in the lower tax bracket.