Business Adviser

Historically low interest rate creates tax advantage

By Deb MacPherson
Partner, KPMG Enterprise, Calgary

It costs a small fortune to raise a child to adulthood; I have seen estimates of $150,000 to $180,000 per child until age of 18. Of course, that cutoff doesn’t include the costs of post-secondary education and support, or room and board if they resist leaving the nest. For a business owner with capital available in the business and dependent children, there are tax-efficient — and legal — ways for their offspring to help earn their keep.

Since 2009, the Canada Revenue Agency has set the prescribed interest rate for family income-splitting loans at a historic low of 1%. As a result, until December 31, 2011 and possibly longer, any inter-family loan may carry an interest rate of only 1% for as long as the loan is outstanding. This gives more scope for investment gains that can be taxed in the hands of a lower-income family member such as a dependent child. Making a family loan arrangement now will set you up to realize income-splitting tax benefits in the future as the economy recovers and interest rates and investment returns rebound. To give some idea of how advantageous the 1% rate is, it has ranged from 2% - 6% over the last 10 years.

Here is a simple illustration of how it works: A $500,000 loan would earn $15,000 a year if interest were 3%, while the recipient — a trust or a spouse — would pay 1% interest on the loan. (This interest payment is due on Jan. 30 of the following year, rather than the traditional tax deadline, and is taxed in the lender’s hands). Should this loan be made to a spouse, he or she may be liable for tax on these investment earnings, depending on his or her other income for the year.

Now consider the same $500,000 loan from a business owner made to three minor children using a family trust: $15,000 of total income split amongst three children would easily be covered by their respective personal annual tax credits. (The 2011 federal personal credit amount is $10,527). The income would stay in the trust and be used to pay the children’s expenses, or be earmarked as payable to them. It would have to be given to the children at some point, but the business owner gets to take advantage of their current zero or near-zero tax earnings status. Stacked up against the top marginal tax rate of 46.4% in Ontario, for example, this strategy translates into annual savings of about $4,600 on the income from the $500,000 loan. If instead your trust is able to earn a higher rate of return, say 6%, the annual tax savings would be about $12,000.

Just as locking in low rates for intra-family loans as a way of saving tax takes some getting used to, so does the thinking behind the size of the loans. Not only should entrepreneurs seriously look at the tax benefits of making loans to their children to lock in the 1% rate, they should also consider just how few other opportunities exist to split income with minor children since the income attribution rules and the special “income splitting tax” (the “kiddie tax”) on certain types of income block most income splitting arrangements with minor children.

For business owners who already have a trust in place — it allows them to multiply the capital gains exemption in the event of selling the business, or to pay tax-effective dividends to adult children or a spouse — a 1% loan to the trust is an added benefit.

When business owners are wondering, “How much should I make the loan for?” they should ask, “How much investment income can we earn tax-free?” Working backward from your expected rate of return allows you to determine the amount of the loan.

Few people worry about the actual cost of children. However, there is a current opportunity to set up a tax-efficient way to have them “pay” their way in the future.

Business Adviser is published by KPMG Enterprise™ specifically for owners and executives of private companies. KPMG Enterprise is devoted exclusively to helping business owners and entrepreneurs build thriving enterprises. For further information about how KPMG Enterprise can help private companies, visit kpmg.ca/enterprise.