Some people in life are private. It is hard to believe this statement when we look at the number of social media posts that take a revealing look at people’s lives, their feelings and their relationships – good and bad.
Privacy is valued and sacred to many. Individuals may choose to be closed about their financial assets and matters surrounding their families and businesses. So, when the discussion turns to estate matters, efforts to ensure privacy continue to be of upmost priority.
The determination of what financial and estate planning tools should be considered, usually have us turn to will substitutes such as trusts, beneficiary designations, etc.
Beneficiary designations allows clients to consider the potential for:
- Bypassing the estate
- Avoiding probate (estate administration tax)
- Having beneficiaries receive funds directly
- Avoiding delays in settling the estate
However, when not coordinated in an overall plan and not taking into consideration family dynamics, it perhaps is not surprising that litigation can arise out of beneficiary designations. The desire for privacy is lost when disputes over who is entitled to receive the proceeds can escalate when it reaches the courtroom.
In Simard v. Simard Estate 2021 BCSC 1836, the loss of privacy plays out when Verna Simard (the matriarch) passed away leaving only one of her children, Julie, as the beneficiary of various registered accounts and joint bank account holder (for the purposes of this article, the other assets in dispute will not be addressed). Verna’s other children did not agree with their mother’s testamentary decision and took Julie to court. The use of the beneficiary designations may have seemed as a simple way for the proceeds to bypass the estate. However, based on court documents, the how and why this family ended up in the courtroom is a history of estrangement, tragedy, and other family dynamics that Verna probably never wanted disclosed.
The Result: The court applied the presumption of resulting trust from Supreme Court of Canada Pecore v. Pecore,  S.C.R. 795 (“Pecore”) to Verna’s joint account, but also to some RRIF accounts of which Verna designated Julie as beneficiary.
The Concern: The application of Pecore again has lead practitioners to consider the impact of this and other similar cases where the named beneficiaries of plans, funds and life insurance policies are not the same residuary beneficiaries of an estate.
At this point, what should we be doing:
Review our beneficiary designations
Take a whole view of the assets and beneficiaries we have in our lives
Compile a Net Worth Statement – what assets are being held jointly
Are our Executors prepared – Access to professionals and Executor Checklists
Does the estate have liquidity to address the estate debt?
Make it a point in your practice to review beneficiary designations
Encourage ourselves and our clients to compile a Net Worth Statement – what assets are being held jointly, etc.
Provide Executor Checklists
Consideration of the use of insurance trusts, contingent beneficiaries, will substitutes, etc.
Provide a comprehensive review of testamentary documents and do they match the beneficiary designations made.
The commentary in this article is meant to be general in nature and should not be considered legal or tax advice to any party. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation.
Jos Herman, BComm, CPA, CA, CFP, TEP Director, Wealth, Tax & Estate Planning
Planning for all of life’s events is not always possible. The same can be said for the transfer of a life insurance policy to a new owner, whether an individual or corporation. While it’s best to avoid the need to transfer life insurance entirely – and the accompanying tax consequences, which can be complex and onerous - it’s not always possible to foresee every future circumstance, and so sometimes, it just needs to be done.
For example, you may own a policy personally and want to transfer it to your corporation. Or, your operating company owns the policy and now the business is to be sold. So, what should you consider before contacting the insurance company to make a transfer?
One of the key considerations is what the deemed ‘value’ will be of the transfer and whether that will result in a taxable gain of any kind. The rule is that the ‘deemed proceeds of disposition’ will be the greatest of the fair market value (FMV) of the consideration received (if any), the cash surrender value (CSV) and the adjusted cost basis (ACB) of the policy. A gain will arise when the deemed proceeds exceeds the ACB – and this gain is not a capital gain so is fully taxable as income! In addition, there are no tax-deferred rollovers for the transfer of life insurance to or from a corporation.
What happens if you need to transfer ownership of a life insurance policy in the following situations… and remember to keep in mind the following terms related to valuing the policy for tax purposes: FMV means fair market value, CSV is the cash surrender value, and ACB is the adjusted cost basis (or the cost for tax purposes)
You transfer a life insurance policy to your corporation - you will have a gain for the deemed proceeds in excess of the ACB; however, there is no requirement that you receive FMV consideration on the transfer. Therefore, you could limit the proceeds to the greater of the CSV and the ACB. If the ACB of the policy is greater than the CSV, no gain will arise. If CSV is greater than ACB, a gain will arise equal to the difference.
Your corporation is being sold and you need to transfer the life insurance to yourself - if the consideration you receive is limited to the greater of CSV and ACB, this will limit the amount of the gain to your corporation, which seems like great planning; however, a shareholder benefit will result equal to the excess of FMV over that consideration! This is not a good result since your corporation would not get a deduction for the amount of the benefit – double tax results! If you instead pay FMV for the policy, the corporation will now have a taxable gain equal to the FMV less the ACB of the policy.
The operating corporation transfers a life insurance policy to your holding corporation - although the same shareholder benefit issues exist as noted above, the benefit can be eliminated by paying a dividend to the holding corporation that is equal to the FMV of the insurance policy and is paid by transferring the policy as payment of the dividend. The gain to the operating corporation is limited to the excess of the policy’s CSV and ACB. The dividend should be tax-free to the holding corporation if certain conditions are met.
You want to wind up your corporation - this might seem like the easiest solution to get the insurance policy into your hands but special rules apply that will result in a disposition of the life insurance policy at FMV, with potentially significant income tax consequences to you and your corporation.
You want to donate a life insurance policy to a charity - the same rules apply to determine the amount of the proceeds but there is no consideration received so proceeds would be limited to the greater of CSV and ACB. Your charitable donation receipt would be at FMV, which is a great result as the donation could be used to offset other income.
You want to transfer your life insurance policy to a family member – again, the same rules apply to determine the proceeds of disposition; however, there are rollover rules available in certain circumstances (between spouses and from a parent to a child for a policy on a child’s life).
Needless to say, there are lots of things to consider when transferring a policy using any of the methods outlined above. Always touch base with your tax accountant or lawyer before initiating a policy transfer to ensure you understand any resulting tax consequences.
by Riley Moynes
Everyone says you’ve got to get ready to retire financially. Of course you do…but what they don’t tell you is that you’ve also got to get ready psychologically!
Why is it so important to prepare psychologically? First, because 10,000 North Americans will retire today and every day for the next 10 to 15 years; it’s like a retirement tsunami!
And when they crash onto the beach, they’ll feel like fish out of water without a clue as to what to expect.
Second, it’s important because there’s a very good chance that you will live about a third of your life in retirement. So it’s critical that you have a “heads up” to the fact that there will be significant psychological changes and challenges that come with it.
I thought I had a pretty good idea what success looked like in a working career, but when it came to retirement, it was “fuzzier” for me. So I decided to dig deeper, and what I found was that most everything emphasized
financial and estate matters… important stuff for sure, but not what I was looking for.
So I interviewed dozens of retirees and asked the question, “What are the elements of a successful retirement?” Then I synthesized the information, looking for patterns.
And I discovered that there is a pattern or framework that can help make sense of it all…and that’s what I want to share with you.
Phase One is the vacation phase and that’s just what it’s like.…you wake up when you want, and do what you want all day. And the best part? There’s no set routine.
For most people, Phase One represents their view of an ideal retirement…relaxing, enjoying a fun holiday, Freedom 55.
Typically this Phase lasts about a year or two and then strangely, it begins to lose its luster.
We begin to find ourselves feeling a bit bored. We actually begin to miss our routine…something in us seems to need one. And we ask ourselves, “Is that all there is to retirement?”
When these thoughts and feelings start bubbling up, you know you’ve entered Phase Two.
Phase Two is when we feel loss and we feel lost.
It’s when we suffer five significant losses in retirement.
We don’t see these losses coming, and since we lose all five at the same time, it’s traumatic!
You see, before we achieve some of the positive results possible in Phases Three and Four, we are going to experience feelings of fear, anxiety and even depression. That’s just the way it is!
But luckily, at some point most of us say, “Hey, I can’t go on like this. I don’t want to spend a third of my life…perhaps 30 years…feeling this way.”
And when that happens, we’ve turned a corner into Phase Three.
Phase Three is a time of trial and error.
The critical question we ask ourselves in Phase Three is, “What can I do to make my life meaningful and productive again? How can I contribute?
The answer? Do things you enjoy and things you do well.
But understand this: It’ll often involve disappointment, failure and false starts.
I know this sounds bad…but we have to persist in exploring possibilities that’ll make us want to get up in the morning again, because if we don’t, there’s the real chance of slipping back into Phase Two, feeling like we’ve been hit by a bus …and that’s not a happy prospect.
Now, not everyone breaks through and reaches Phase Four, but those who do are some of the happiest people I have ever known.
Phase Four is when we reinvent and rewire.
The critical questions here are, “What’s my mission here, my purpose?” “How can I squeeze all the juice out of retirement?”
You see, we need to find activities we find meaningful, that give us a sense of purpose. And what I’ve found is that it almost always involves service to others.
Maybe it’s helping a charity we care about. Maybe it’s mentoring young people. Maybe it’s delivering Meals on Wheels.
Or maybe it’s doing what I did:
In November, 2019, I was part of a nine-person mission to Honduras sponsored by Water Ambassadors Canada (waterambassadorscanada.org). Our goal was to repair eight wells there, most of which had been broken and inoperative for years. During that week, we were fortunate to be able to repair seven of them thus providing clean water to 2260 people, and also offered hygiene training to 320 mothers and children in the villages we visited. It was exhausting, emotional work, but it was exhilarating!
That’s what’s possible in Phase Four!
So now you know the Four Phases of Retirement.
If you’re retired, you know which Phase you’re in.
If you’re not retired, I hope you have a better idea of what to expect when you do.
I just wish I knew then what you know now about The Four Phases of Retirement.
We know we should enjoy our vacation in Phase One. We know we need to adjust to the losses in Phase Two…and test some options in Phase Three.
But we need to keep our eyes on the prize! So let’s make it our goal to get to Phase Four.
Everyone says you’ve got to get ready financially. Of course you do… but you’ve also got to get ready psychologically.
[Dr. Riley Moynes is a ‘rewired’ (not retired) educator, author, financial advisor, TEDx speaker, and podcaster. He writes reader-friendly publications on topics of public interest. The Four Phases of Retirement is a Canadian best-seller. Visit thefourphases.com.]
By Patrick J. McCormick, JD, LLM
A growing number of nonresidents (those who, for U.S. tax purposes, are classified neither as citizens nor U.S. residents) are seeking ownership of American-based assets since the United States is an appealing jurisdiction for investment by foreign taxpayers. A consideration of American tax consequences, however, must be part of their investment exploration. The tax results for nonresidents can be stark when compared to U.S. taxpayers. Critically, differences in transfer tax exemptions for nonresidents make estate planning vital.
The Tax Cuts and Jobs Act doubled the lifetime gratuitous transfer exclusion for U.S. taxpayers (to $11.58 million in 2020). The need for tax-focused estate planning for domestic individuals may have been eroded, but for nonresidents, the need for transfer tax planning has grown. A stagnant, miniscule exemption of $60,000 for estate tax and no specific nonresident exemption for gift tax makes effective planning a necessity.
Nonresident aliens are taxed by the United States on income effectively connected with the conduct of a U.S. trade or business and non-U.S. trade or business income sourced to the United States (commonly referenced as “FDAP income” – fixed or determinable annual or periodic income). Critically, default rules applicable to nonresidents are subject to significant modification for qualified residents of countries with which the United States maintains an income tax treaty.
A relevant subset of the effectively connected income (ECI) rules is provided in Section 897 and pertain to foreign investment in U.S. real property. A nonresident disposing of a U.S. real property interest (USRPI) is subject to tax on gains associated with the interest, with these gains automatically classified as income effectively connected with a U.S. trade or business.1 Withholding rules are applicable: a transferee of a USRPI must withhold from the transfer at a rate of 15% of the amount realized (the sum of cash paid/property received and any liabilities assumed) on the transaction if the transferor is a foreign party.2
A major focus among nonresident clients typically is the potential for transfer tax liability – tax amounts owed to the United States for U.S.-sitused gifts and bequests. While nonresidents are subject to estate and gift tax on a much more limited scope of assets than U.S. citizens/residents, they are provided only a fraction of the exemption amounts available to U.S. taxpayers. Exposures can exist in unanticipated ways. For example, an intrafamily transfer of a U.S. vacation home can create transfer tax consequences. High tax rates result in enormous tax consequences from these (innocuous) transfers, with tax amounts typically avoidable if ownership of the asset is properly structured.
For nonresidents, estate tax is assessable on all property – tangible or intangible – located within the United States and owned individually at death, subject to listed exceptions.3 The exceptions are for bank accounts not used in connection with a U.S. trade or business (importantly, this exception does not extend to accounts not held with banking institutions - brokerage accounts are subject to estate tax, even if holding only cash), securities generating portfolio interest, and insurance proceeds. Where these exceptions do not apply, asset situs rules determine whether an asset is subject to American transfer tax. Real property and tangible personal property is sitused in accordance to where the assets are physically located; shares of a corporation are sitused to the country in which the corporation is formed.4 For partnership interests, the IRS has taken the position that the situs of a partnership interest is determined by where the partnership conducts business.5
Nonresidents receive a $60,000 estate tax exclusion, with a maximum 40% rate of tax applicable once a nonresident’s U.S. assets reach $1 million. Referencing the aforementioned intrafamily U.S. real estate transfer, say a testamentary transfer of a U.S. property worth $5 million occurs and the transferring decedent is an individual nonresident. The first $60,000 of value is exempted from tax; tax is then imposed so that the first $1 million of value is taxed at $345,800 and additional amounts are taxed at a flat 40%. In the example, if a $5 million real estate asset is transferred, the resulting U.S. estate tax is $1,921,800. The effective rate of tax (roughly 38.5%) is enormous, and is imposed against a U.S.-sitused asset – one which is ripe for IRS enforcement if required.
U.S. gift tax is assessed on lifetime gratuitous transfers of real property and tangible property within the United States by nonresident aliens. Importantly, intangible property (such as an interest in a U.S.-based corporation) is not subject to gift tax for nonresident donors. Nonresident aliens receive no specific lifetime exclusion, though they are permitted to use the annual gift exclusions of $15,000 per donee (an exception also available for U.S. taxpayers).6
Transfer taxes – both estate and gift – can be modified by estate and gift tax treaties, though transfer tax treaties are typically limited in scope and availability than income tax treaties.
Nonresident aliens investing in the United States maintain a number of options for investment ownership. Generally, the party directly taxable for a U.S. asset will be an individual, a corporation, or a nongrantor trust, with flow-through entities and grantor trusts amongst the structures functionally “looked through” until one of the three types of aforementioned taxpayers are found (but which are often beneficial for nontax purposes – such as liability protection). Nonresidents contemplating U.S. investments seek to minimize U.S. tax exposure (whether income tax or transfer tax), but are also motivated to minimize disclosures to the United States and, where possible, maintain a simplified ownership structure.
The most basic structure (ownership directly by the investing individual) offers simplicity, but it also poses clear issues. The most glaring are estate and gift tax exposures: if held individually, common assets like real estate and corporate interests will be subject to estate tax (and, in the case of the former, gift tax as well). Income is subject to tax based on the aforementioned ECI and FDAP rules; the former usually requires the filing of a U.S. tax return. The filing requirement requires exposure of the individual’s identity to the IRS; in the minds of some nonresidents, this risks additional inquiry into the individual’s financial affairs. A significant benefit to individual ownership for non-ECI assets is the exemption of capital gains from U.S. tax, particularly appealing where the investor resides in a country where foreign-sourced capital gains are not subject to tax. A detriment, however, is that ordinary income tax rates apply to income earned by the investment’s operations.
Ownership through a structure using a foreign corporation offers protection from U.S. transfer tax, but it requires income tax tradeoffs. Specifically, a foreign corporation holding U.S. income-producing assets is taxed at corporate rates, irrespective of the underlying character of income. But it is subject to the branch profits tax, with the underlying owner of the foreign corporation (i.e., the investing individual) required to be disclosed if the foreign corporation has U.S. business profits. Incorporating a domestic corporation into this ownership structure (i.e., having a U.S.-based investment owned by a domestic corporation, with the aforementioned foreign corporation now owning the domestic corporation rather than the actual U.S. investment target) removes branch profits exposure and investor disclosure (as the foreign corporation – now owning only a passive interest in a U.S. corporation – no longer has U.S. business profits). This structure precludes use of the exemption from capital gains for non-ECI assets. This consequence can be minimal, based on the targeted type of investment. U.S. real property interests, which are automatically classified as ECI and subject to U.S. tax, are a common example.
Foreign nongrantor trusts provide an appealing option for many, but one with critical caveats. As a foreign-sitused taxpayer, the trust is subject to U.S. tax only on U.S.-sourced income. Long-term capital gains rates also apply to qualifying taxable income items, a benefit when compared to corporate ownership (though a benefit which has been reduced with the Tax Cuts and Jobs Act reduction in corporate tax rates). Detriments exist where beneficiaries are U.S. taxpayers – or (often importantly) where beneficiaries could become U.S. taxpayers in the future. Tax rates on ordinary income are also a drawback, at least when compared to corporate structures – nongrantor trusts can be taxed at rates up to 37%, with corporate income taxed at a non-graduated 21% rate.
This article is from our December 10th speaker Doug Chandler and co-authored by Bonnie-Jeanne MacDonald
Published in The Globe and Mail
Defined benefit pension plan members facing pandemic-related permanent layoffswill have to make an important financial decision: take the lump sum now or the future pension later.
Canadian pension plans must give terminating employees who are not eligible to start drawing their pensions yet the option of portability. That means giving up their lifetime monthly retirement pension for a lump sum settlement, known as the commuted value.
Although the coronavirus pandemic might cause some delays, the commuted value option is still on the table.
The commuted value of a pension is the sum of the future monthly pension payments, adjusted for interest from now until the monthly payments are scheduled to be paid. With today’s rock-bottom interest rates, lump sum settlements are bigger than ever. But before you go that route, take a moment to consider why they’re so big.
A bond normally pays a positive return to the buyer because the sum of all interest and maturity payments from the issuer exceeds the purchase price. If the bond is resold at a higher price, then the new owner will get a smaller return on their investment. Bond prices have been rising, so the return to buyers has been going down.
At the end of July, the price of a government of Canada real return bond maturing in 2044 rose to $142 for every $100 of face value – even though the government will only pay out $137 in today’s dollars between now and when the bond matures. In other words, the real (inflation-adjusted) return on this bond will be negative. The prices of non-indexed government of Canada bonds are also trading at record-high prices, with returns (in nominal dollars) very near zero.
If you’re a member of an employer-sponsored pension plan, those high government of Canada bond prices are used to calculate the lump sum settlement offer included with your pension option statement, making the offer eye-popping. But should you take it?
Here’s the catch: Guarantees are expensive. What we’re seeing in bond prices is the going price for guaranteed future income. The rise in commuted values is driven by the decisions of professional fund managers who are choosing to pay record-high prices for government bonds instead of investing in riskier assets with the potential for greater returns.
And just as the price of guaranteed bond payments is high, so is the price of your guaranteed future pension. The goal of a commuted value calculation is to strike a fair balance between the interests of the individual who is giving up their pension, and the interests of their employer and the other plan members.
The commuted value represents the economic value of expected future pension payments, with no add-on for the risk that the individual might live longer than normal, or inflation might be higher than expected. There are also no adjustments for fees, or the risks and rewards associated with managing investments.
That means, as high as the commuted value may be, it’s not high enough. If you try to buy the same pension income in the retail market by purchasing an annuity, then you will have to settle for fixed annual increases, rather than true inflation protection linked to CPI increases. And the fixed rate of increases you can buy is very low – much lower than the Bank of Canada’s 2-per-cent inflation target.
Taxes are another consideration. The commuted values are transferred to a locked-in account, but these large values will almost certainly exceed the maximum tax limit. Unless it is used to buy a “copycat” annuity – a life annuity from an insurance company that copies what the pension would have paid – the excess is taken as cash and will be hit with a significant tax bill.
Choosing a lump sum over a lifetime pension payable at a future retirement date should come down to individual circumstances, not investment prospects. The key consideration is whether you need that pension to cover your regular monthly expenses.
Just like professional fund managers, your choice depends on your investment objectives, evaluated against the prices and risks of each alternative. If you value the inflation and investment protection of a lifetime pension, then you should seriously consider whether the risks in the stock market outweigh the possibility of better returns.
It’s hard to imagine, but your retirement could span 30 years or more. Over time, your health and personal care expenses are likely to increase, along with your need for secure income with less risk.
Retirement planning requires a long-term perspective – and the simplicity of secure monthly income is a precious gift you can give to your future older, more vulnerable self.
Doug Chandler is an independent research actuary based in Calgary. Bonnie-Jeanne MacDonald, PhD, is the director of financial security research at the National Institute on Ageing at Ryerson University and resident scholar at Eckler Ltd. Both are fellows of the Society of Actuaries and fellows of the Canadian Institute of Actuaries.
On November 26, 2020, the Estate Planning Council of Canada invited Cindy Boury (Portfolio & Branch Manager) at Raymond James in Abbotsford, BC to speak on this important topic. Cindy is very passionate about protecting senior clients and gave several examples to the audience, who are primarily financial planners, lawyers accountants, insurance advisors, trust officers and gift planners. Cindy explained that there are four main steps to protect clients:
Furthermore, Cindy provided contacts for where to go for help (in B.C.).
Link to handout
On behalf of the EPCC, thank you to our audience, speaker and volunteers for yet another successful Estate Planning event.
The Estate Planning Council of Canada is pleased to share our latest podcast with members of the Health Community and Advisors in the Planning Community.
As Canada faces a second was of COVID-19 cases, we chat with Kelly Yee – Founder of Avatara Yoga, to explore healthy aging and what we can do to improve how we feel and our outlook on life in these difficult times.
Learn more about small steps you can take for yourself and your family. Advisors want to take care of their health – and that gives them something in common with their clients.
Feel free to click on link below or search “Healthy Aging with Kelly Yee” on the following podcast stations:
Please feel free to share the podcast with your community.
Estate Planning Council of Canada
1. How are visits with residents facilitated/managed during the Covid-19 pandemic?
2. Were you greeted by the staff in a warm and friendly manner?
3. Were you able to speak with residents? Can someone vouch for warm and friendly interactions between staff and residents?
4. Do you like the outward appearance of the residence and is the interior clean, attractive and free of questionable odors?
5. Did you discuss the person’s needs and do you believe the staff can provide the appropriate support for your family member, including in an emergency?
6. Do staff only work at one facility at a time?
7. Were the financial requirements, contracts, and costs clearly explained?
8. Is it clear to you, under what circumstances a resident might be discharged?
9. When may a contract be terminated and what are the refund policies?
10. Can different levels of care be accommodated at the facility?
11. Are there RNs or Caregivers on the premises to provide for care needs? These needs may include: assistance with dressing, hygiene and grooming, transferring and mobility, bathing, toileting and incontinence, meals, medication and treatments, using the telephone, shopping, laundry, housekeeping, transportation to doctors or hairdressers. Do you feel satisfied that the staff providing these services have sufficient training and are compassionate and responsive to residents’ needs?
12. Do you know what information, documents and tests are required by the residence prior to a move?
13. Do you have a choice about using the residence’s furniture or bringing the resident’s familiar belongings?
14. Does the residence offer concierge services?
15. Are the rooms private or semi-private? Does each room have a private bathroom, if appropriate?
16. Ask about telephone services, cable and Internet. How is billing handled?
17. What are policies about meals and healthy choices? Can the kitchen provide special diets as needed?
18. What is the pet policy?
19. Did you see the activity calendar? Are the activities of interest? Are there activities and outings away from the residence?
20. Would you feel comfortable as a visitor or resident there?
Jamie Golombek: An upcoming drop to the Canada Revenue Agency's Prescribed Rate coming into effect next month could be potentially lucrative.
Canadian interest rates have fallen to record lows in recent weeks, so the upcoming drop to the Canada Revenue Agency’s prescribed rate, set to come into effect next month, opens up a potentially lucrative opportunity for some couples and families to execute an income-splitting strategy. Here’s what you need to know.
What is the prescribed rate?
The Canada Revenue Agency sets the prescribed rates quarterly and they are directly tied to the yield on Government of Canada three-month Treasury Bills, albeit with a lag. The calculation is based on a formula in the Income Tax Regulations, which takes the simple average of three-month Treasury Bills for the first month of the preceding quarter, rounded up to the next highest whole percentage point. As a result, one per cent is the lowest possible prescribed rate.
To calculate the rate for the upcoming third quarter (July through September), we look at the first month of the second quarter (April 2020) and take the average of that month’s T-Bill yields, which were 0.24 per cent (April 7), 0.30 per cent (April 14), 0.27 per cent (April 21) and 0.27 per cent (April 28). The average is 0.27 per cent, but rounded up to the nearest whole percentage point, the new prescribed rate for the third quarter of 2020 becomes one per cent. This marks the first time that the prescribed rate has dropped since it increased to the present rate of two per cent back in April 2018.
What is income splitting?
The drop in the prescribed rate may provide some taxpayers with a significant opportunity to split income with a spouse or common-law partner, (grand)children or other family members, by either making a loan directly to family members or, where minors are involved, using a family trust.
Income splitting transfers income from a high-income family member to a lower-income family member. Since our tax system has graduated tax brackets, the overall tax paid by the family may be reduced if the income is taxed in the lower-income earner’s hands.
The “attribution rules” in the Income Tax Act prevent some types of income splitting by generally attributing income or gains earned on money transferred or gifted to a family member back to the original transferor. There is an exception to this rule if the funds are loaned, rather than gifted, provided the rate on the loan is set (as a minimum) at the prescribed rate in effect at the time the loan was originated and the interest on the loan is paid annually by Jan. 30 of the following year.
If the loan is made at the prescribed rate of one per cent in July 2020, the net effect will generally have any investment return generated above one per cent taxed in the hands of the lower-income family member. Note that even though the prescribed rate varies by quarter and may ultimately rise, you need only use the prescribed rate in effect at the time the loan was originally extended. In other words, if you establish the loan between July 1, 2020, and the end of September 2020 (and possibly longer, if the prescribed rate remains unchanged), the one-per-cent rate would be locked in for the duration of the loan without being affected by any future rate increases.
How does a prescribed loan work?
Let’s say Johnny is in the highest tax bracket and his wife, Moira, is in the lowest bracket. On July 1, Johnny loans Moira $500,000 at the new prescribed rate of one per cent secured by a written promissory note. Moira invests the money in a portfolio of Canadian dividend-paying stocks, with a current yield of five per cent. Each year, Moira takes $5,000 of the $25,000 in annual dividends she receives to pay the one-per-cent interest on the loan to Johnny. She makes sure to do this by Jan. 30, as required under the Income Tax Act.
The benefit to the couple is having the dividends taxed in Moira’s hands at the lowest rate, instead of in Johnny’s hands at the highest rate. The savings are slightly offset by having the $5,000 in interest on the promissory note taxable to Johnny at the highest rate for interest income. This interest paid, however, is tax deductible to Moira at her low tax rate, since the interest was paid for the purpose of earning income, namely the dividends.
Prescribed rate loans can also be used to help fund minor children’s expenses, such as paying for private school and extracurricular activities, by making a prescribed rate loan to a family trust with the kids as beneficiaries. For example, Johnny could loan $500,000 to a properly established family trust for the benefit of his two children, David and Alexis. The trust then invests the money and pays the net investment income, after paying the interest on the loan, to the children, either directly, or indirectly by paying their expenses. If David and Alexis have no, or little, other income, this investment income can be received entirely tax-free. For example, if both children are in Ontario and have no other income, each could receive up to $53,228 in eligible Canadian dividends in 2020 free of tax, owing to the basic personal amount and the dividend tax credit.
How to refinance a previous prescribed rate loan
Finally, what if you entered into a prescribed rate loan with your family member when the rate was two per cent (or higher) and the family member invested the proceeds?
To take advantage of the upcoming lower prescribed rate, the family member should sell the investments (which could trigger capital gains tax, depending on the market value of the investments compared to their tax cost), and repay the loan to you. You can then enter into a completely new loan agreement using the new one-per-cent prescribed rate. The CRA has stated that simply repaying a higher prescribed rate loan with a lower rate loan could trigger the attribution rules on the investment income.
Jamie.Golombek@cibc.com / Financial Post June 19, 2020
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