The low interest rate environment has made the prescribed rate loan arrangement a very popular tool for income splitting with family members without generally running afoul of the tax on split income (TOSI) rules. However, if some of the family members are subject to US income tax, either because they are US citizens, US permanent residents (i.e. green card), or have substantial presence in the US, US tax issues will likely arise from the arrangement.
The Prescribed Rate Loan Strategy
As most individual Canadian taxpayers know, there is not a consolidated filing of tax return regime in Canada unlike that of the US. Due to the marginal tax bracket system, where there is significant income inequality between family members, there is a large incentive to “split” income between family members in order to utilize the lower marginal tax brackets of lower-income family members. There are numerous Canadian tax rules to police this type of income splitting, such as the TOSI rules to prevent splitting of income derived from the family business, and the “attribution rules” – described further below – to attribute income and capital gains back to the hands of the transferor of properties.
The “prescribed rate loan” strategy is a common tool to avoid the attribution rules. Generally speaking, there are four categories of attribution rules under the Canadian Income Tax Act (the “Act”) with respect to transfers between individuals or trusts in Canada:
- Section 74.1: Where a taxpayer transfers or lends property to a spouse, a common-law partner (“CLP”), or a minor who does not deal at arm’s length with the taxpayer, any income from the property is attributed back to the taxpayer. In effect, the transferor reports the future income from the property in his or her hands as if the property was never transferred or lent.
- Section 74.2: Where a taxpayer transfers or lends property to a spouse or CLP, any capital gain from the property is attributed back to the taxpayer.
- Section 74.3: Where a taxpayer transfers or lends property to a trust in which a spouse, CLP, or a minor who does not deal at arm’s length with the taxpayer is a beneficiary, the above attribution rules in sections 74.1 and 74.2 apply correspondingly.
- Subsection 56(4.1): Where a taxpayer makes a loan to any person or trust with whom it does not deal at arm’s length and one of the main reasons for making the loan was to reduce tax by causing future income to be reported in the hands of the transferee, any income from the loaned property or property that the loan enabled is attributed back to the taxpayer.
However, none of the above attribution rules above will apply if the taxpayer transfers cash or other properties to the spouse, CLP, non-arm’s length minor, or trust under a loan arrangement that charges at least the “prescribed” rate of interest. What is the prescribed rate of interest? It is an interest rate set by paragraph 4301(c) of the Canadian Income Tax Regulations, and it is based on the yield of the Government of Canada Treasury Bills. Due to the current low-rate environment, the prescribed rate of interest has returned to its historical low of 1% since July 1, 2020 (previously 2%).
To properly qualify for the prescribed rate loan exception, the loan arrangement needs to meet both of the following criteria:
- I) the loan must charge interest at a rate equal to or greater than the prescribed rate in effect at the time the loan was made (which is currently 1%), and
- II) that interest must be paid no later than 30 days after the end of each taxation year.
Since the interest on the loan can be locked in at today’s prescribed rate of interest of 1% irrespective of future increases in prescribed rate and still qualify for the prescribed rate loan exception for the entire period of the loan is outstanding, this is a very popular strategy right now for families to split income with low-income family members. There is also no requirement of any repayment terms on the loan, so it is potentially a permanent income splitting strategy. The prescribed rate loan may even be forgiven as a bequest in the lender’s Will without the application of the Canadian debt forgiveness rules. The net result is that all future income, except for the 1% interest, is taxed in the hands of the desired family members at their low marginal tax rates, while only that 1% interest is taxed in the hands of the lender family member.
It is very important that interest be actually paid by 30 days after the end of each taxation year. For individuals, the taxation year is always the calendar year. This means that on or before January 30th of each year, cash equal to the interest on the loan must be paid to the lender by the borrower and documentation should be kept to evidence this. If the January 30 payment deadline is missed even for one year, the prescribed loan arrangement fails in perpetuity and cannot be cured.
While this is a powerful and relatively straight forward strategy for families resident solely in Canada, what additional considerations are there if a family member involved in this planning is a person subject to US tax?
US Tax Issues That May Arise
In the United States, the most common form of “consolidated filing” of tax returns is the joint return available to married couples (MFJ). As with income splitting in Canada, MFJ returns generally provide the greatest benefit when one spouse earns substantially more than the other, allowing the couple to average out income and expenses between them. (MFJ is treated as an irrevocable election, which can only be severed through the innocent and injured spouse provisions under the Internal Revenue Code.) Because of the ability to file MFJ, US taxpayers typically do not employ income splitting or loan arrangements between spouses.
For Canadian taxpayers who deploy the “prescribed rate loan” strategy for Canadian tax purposes, this same strategy can create a raft of complications and unintended consequences for US reporting and compliance purposes. The following are just a few of the many issues that may arise in this context.
Related Party Issues
The Internal Revenue Service and state taxing authorities are highly skeptical of intrafamily transfers and related party transactions. Several provisions of the Internal Revenue Code address and circumscribe transactions between related parties. One pertinent example is section 267 of the Internal Revenue Code, which disallows any deduction for any loss from the sale or exchange of property, directly or indirectly, between “related parties,” which among other relationships generally includes most extended family members and most relationships created under a trust. IRC § 267(b), (c)(4).
Matching rules also apply under section 267 for deductions based on the payment to a foreign related person that will force the use of the cash method of accounting for any otherwise deductible amounts that are owed to a related foreign person. The amount must also be paid to the foreign person before the amount can be deducted. Treas. Reg. § 1.267(a)-3(b)(1). These matching provisions apply even if a US treaty sets a lower rate for the payment of income to the related foreign person (for example, the payment of royalties). Treas. Reg. § 1.267(a)-3(c)(3).
Another relevant related party limitation rule is under section 1239, which provides that the gain resulting from the sale or exchange of property, directly or indirectly, between related persons is treated as ordinary income (as opposed to capital) gain if the transferred property qualifies for depreciation in the hands of transferee. “Related person” under section 1239 differs from section 267 but includes a person (1) and all controlled entities by that person, (2) a taxpayer and any trust where the taxpayer or spouse is a beneficiary (unless the beneficiary’s interest is a remote contingent interest), or (3) an executor of an estate and a beneficiary of an estate (except for a sale or exchange in satisfaction of a pecuniary bequest). IRC § 1239(b).
Still another provision that can apply, while not necessarily a “related party” provision, concerns section 482, which allows the IRS to reallocate gross income, deductions, credits, and other allowances among commonly controlled trades or businesses.
Gratuitous Transfers (Gifts)
The IRS will consider a transfer a “gift” for gift tax purposes, if one transfers property or the use of property or income from the property to another without expecting to receive something of at least equal value in return. If the amount of the gift exceeds the annual exclusion amount, the gift is taxable and must be reported on Form 709. The amount reported on Form 709 reduces the donor’s unified tax credit. When the unified credit is exhausted, the individual will have no credit against the estate and gift tax at death.
Special rules apply for such transfers between spouses. For spouses who are both either US citizens or considered US permanent residents, US tax law allows an unlimited transfer between spouses without recognizing any gain or loss and the related party rules do not apply. IRC §§ 267(g); 1041(a)(1). Such transfers can also occur without gain or loss if “incident to divorce.” IRC § 1041(a)(2).
A related provision provides that any transfers under section 1041 are treated as a gift and the gift recipient’s basis in the property will be the same as the donor’s IRC § 1041(b). Spouses who are both US citizens are also able to gift an unlimited amount to each other without gift tax consequence if both individuals are married at the time of the gift. IRC § 2523. As a result, not dealing with your spouse in an arm’s length transaction has no tax effect and does not affect the basis of the property transferred if both spouses are US citizens.
These provisions have an exception that apply where the recipient is not a US person. Under section 1041(d) a US non-resident alien spouse who receives a transfer of property does not have the unlimited nonrecognition rule and the regular rules of gain and loss would apply, particularly those under section 267 discussed above. Moreover, the ability to gift an unlimited amount to a spouse does not apply when the recipient spouse is a non-US citizen. IRC § 2523(i). Instead, the non-US citizen spouse receives an increased annual exclusion, currently $159,000 USD for 2021. Rev. Proc. 2020-45 § 2.43(2).
A CLP would be recognized as a marriage under US tax law if the CLP is recognized as a valid marriage in Canada and in at least one US state or territory. Treas. Reg. § 301.7701-18(b)(2). See, also, Rev. Rul. 58-66; Rev. Rul. 13-17.
Gifts to non-spouses, including children, are covered by the annual gift exclusion amount, which for 2021 is $15,000 USD.
Accordingly, anyone who adopts a “prescribed rate loan” strategy should be mindful of the potential gift tax consequences such a strategy will have on the US side when property is transferred to another.
Income and Taxable Gifts Arising from “Gift Loans”
Interest free loans do not exist under US tax law. For such “interest free” loans, the Internal Revenue Code will generally impute interest to the loan based on the applicable federal rate (AFR), which is determined quarterly. A term loan must have an interest rate that equals the AFR in effect as of the day on which the loan was made, compounded semi-annually. IRC § 7872(f)(2)(A). Similar rules apply for demand loans but have other complications that are not relevant for this discussion. IRC § 7872(f)(2)(B).
Any below-market loan in which the foregoing of interest by the lender is “in the nature of a gift” will be deemed a “gift loan.” IRC § 7872(f)(3). More specifically, if the value of the property transferred exceeds the value of consideration received in a transaction that is not made in the ordinary course of business, a below-market loan will be treated as a gift loan. See, e.g., Frazee v. Commissioner, 98 T.C. 554 (1992) (promissory note bearing interest at 7% that was received by the transferors in exchange for real property transferred to transferors’ children held to be gift loan subject to section 7872 because note bore interest rate below applicable federal rate and transfer was not made in the ordinary course of business).
When a below market loan is a “gift loan” two transfers occur: First, a taxable gift from the lender to the borrower in the amount of the foregone interest; Second, a payment of interest from the borrower back to the lender. IRC § 7872(a). This would obviously have a much different result than the one intended.
A few very notable exceptions apply. A de minimus rule exception applies if the aggregate principal amount of all outstanding loans (whether or not involving foregone interest) between the lender and the borrower does not exceed $10,000 USD. IRC § 7872(c)(2). US tax law does not recognize loans between spouses for purposes of section 7872. IRC § 7872(f)(7). Such transfers would therefore be the same as a loan made to oneself and disregarded. Prop. Reg. § 1.7872-11(c). Section 7872 also generally does not apply to indebtedness issued by a buyer to a seller in a sale or exchange of property. 7872(f)(8); prop. Reg. 1.7872-2(a)(2)(ii). Loans made in the ordinary course of business (for example, loans made by financial institutions). Temp. Reg. § 1.7872-5T(b)(1). While not an exception, section 482, addressed above, also coordinates with section 7872 and can apply simultaneously.
To avoid “gift loan” treatment, any loan must use the appropriate AFR, be in writing, have clear and fixed terms for repayment. In addition, both parties should maintain the appropriate records indicating dates of payment. The loan should not by its own terms set forth a certain procedure for forgiveness. If all else fails, limit the aggregate loan amount to $10,000 USD to take advantage of the de minimus rules under section and 7872. AFR is published monthly, listing rates for short-term (three years or less), mid-term (between three and nine years), and long-term (in excess of nine years). As of May 2021, short-term is 0.13 percent, mid-term 1.07 percent, and long-term between 2.14 and 2.16 percent (depending on period for compounding). See, Rev. Rul. 2021-8.
The law of trusts in the US differs significantly with Canadian trust law. Among the many differences, grantor trusts in the US are generally disregarded as separate from the grantor while the grantor is still living. Transfers to a US grantor trust will not change the effective ownership of an asset from the original owner. Loans between a grantor and a US grantor trust would accordingly be disregarded. The US trust would need to be a nongrantor trust or irrevocable trust to allow for an arms length loan to be respected, subject to the related party rules discussed above. The use of trusts to facilitate a “prescribed rate loan” strategy could have drastically different results in the US
Estate Tax Concerns
To the extent that the “prescribed rate loan” strategy involves US real property transferred to a non-US person, besides potential gift tax issues, the recipient should also be aware of potential estate tax exposure. Any US situated property is includible in the gross estate upon death. For non-US citizens or residents, the threshold for estate tax is statutorily set at $60,000. (The US-Canada Tax Treaty generally applies a pro rata approach to estate tax.) The situs of debt obligations is determined by reference to the primary obligor under the instrument. Treas. Reg. § 20.2014-1(a)(3), (a)(5). Accordingly, a debt obligation will generally be considered property located in the United States if the primary obligor is a domestic US corporation or other US person. IRC § 2104(c).
As is evident from the above discussion, while using the “prescribed rate loan” strategy may be a simple means to reduce the tax exposure by “splitting” the income among several people for Canadian tax purposes, this usefulness creates a much larger potential complexity on the US side. Just a few of the potential differences concern related party rules, taxable gifts, “gift loan” rules, and estate tax exposure based on the situs of the underlying asset. Canadian individuals with US connections should carefully evaluate and work with US advisors to avoid unforeseen adverse effects of a Canadian “prescribed rate loan” strategy.