Canada has a progressive income tax system – the more income you earn the higher the rate of tax you are required to pay. Income splitting is a tax planning technique designed to shift income from a high rate taxpayer to a lower rate taxpayer such as a spouse or minor child.

One way of achieving this is to lend money to a family member in a lower tax bracket with that individual earning and reporting investment income earned on the loaned funds.

Unless interest is charged on the loan, the entire investment income is attributed to the person making the loan and taxed in his or her hands. An exception to the attribution of income exists where the person lending the funds charges interest and collects interest from the borrower which is then declared on the lender’s tax return.

In order to prevent abuses of the Income Tax Act, the Canada Revenue Agency establishes the minimum rate of interest that must be charged for loans of this type. This prescribed rate of interest for income tax purposes changes on a quarterly basis. For the second quarter of 2009, the rate will drop to 1%, the lowest it has ever been. This reduction provides an excellent opportunity for a high income tax rate individual to shift investment income to his or her spouse or minor child. By making loans to lower tax rate family members all income in excess of 1% will be taxed in the hands of such individuals. In this case not only is there no attribution of income earned back to you, but your spouse or child is entitled to an interest deduction on the interest paid to you.

Using these loans for investment purposes will allow for the income to be taxed at the lower income-earning family member’s tax rate indefinitely. Given that the rate of interest that must be paid is fixed at the time the loan is entered into, even if the prescribed rate increases in the future all loans made in the second quarter of 2009 will continue to bear interest at 1%.

If you have pre-existing inter-family loans where the prescribed rate was higher than 1%, consideration should now be given to renegotiating them at the current rate. This includes loans to family members, family trusts and certain loans from private companies. Furthermore, if you have excess cash for investment and are in a high tax bracket, consider making loans to family members in lower tax brackets to take advantage of this opportunity.

If you decide to proceed with this tax savings technique please ensure that you not neglect to make the interest payments. To avoid the attribution of income on loaned funds, the interest has to be payable, and actually be paid, by no later than January 30th of every year that the loan remains outstanding. Furthermore, it is highly advisable that loans be properly documented so that the obligation to repay the loan exists and that the lender is able to recover the amounts loaned.