Prescribed Rate Loans for Income Splitting: How They Work in Canada

If one spouse earns significantly more than the other — or if a family trust holds investments on behalf of lower-income family members — Canadian tax law offers a legitimate strategy to reduce the overall family tax bill: the prescribed rate loan. Used correctly, prescribed rate loan income splitting in Canada lets investment income flow to the hands of whoever is taxed at the lower rate, instead of piling onto the higher earner's return.

This article explains how the strategy works, what it actually requires (the rules are stricter than many people realize), and where a lawyer fits into the picture alongside your accountant.

What Is a Prescribed Rate Loan?

Canada's income tax rules contain what are called the attribution rules. In plain language, if a higher-income person simply transfers or gifts money to a lower-income spouse or minor child, the Canada Revenue Agency (CRA) will "attribute" the income earned on those funds back to the person who gave them. The gift doesn't work as a tax strategy — the higher earner still pays tax on the investment income.

A prescribed rate loan sidesteps this problem. Instead of giving money outright, the higher-income spouse lends money to the lower-income spouse (or to a family trust) at an interest rate set by the CRA — the "prescribed rate." When the loan is properly documented and the interest is actually paid each year, the attribution rules do not apply. The lower-income spouse or trust keeps the investment income, pays tax on it at their lower marginal rate, and the difference in tax becomes the family's saving.

The prescribed rate is set by CRA each quarter based on Government of Canada treasury bill yields. Check the CRA website for the current quarterly rate before setting up any loan — it changes, and locking in at the right moment matters enormously (more on that below).

Why Use a Prescribed Rate Loan Instead of a Gift?

An outright gift to a spouse sounds simpler, but the attribution rules undo the tax benefit entirely — any income or capital gain the recipient earns on gifted funds is taxed in the giver's hands. A prescribed rate loan avoids attribution because the Income Tax Act carves out an exception: when a loan is made at an interest rate equal to or greater than the CRA prescribed rate in effect at the time the loan is made, and that interest is paid within the required deadline each year, the income earned on the borrowed funds belongs to the borrower for tax purposes.

The spread between what the invested funds earn and the low prescribed rate is where the family's tax saving lives. If the prescribed rate is, say, one or two percent (as of writing — confirm with CRA or an accountant), and the investments return five or six percent, the additional return is taxed in the lower-income spouse's hands, often at a significantly lower marginal rate.

How to Set Up a Prescribed Rate Loan: Step by Step

1. Confirm the current CRA prescribed rate. Visit the CRA website or ask your accountant for the rate in effect for the current quarter. The rate you lock in at the time of the loan is the rate that applies for the life of the loan — even if CRA raises it in future quarters.

1. Decide on the loan recipient. You can lend directly to a lower-income spouse or common-law partner, or you can lend to a family trust that holds investments for the benefit of lower-income family members, including adult or minor children.

1. If using a family trust, establish it first. A family trust requires a trust deed prepared by a lawyer. The trust must be properly settled and have designated trustees and beneficiaries before the loan can be made to it. This is where Treadstone Law can assist.

1. Draft a promissory note. The loan must be evidenced by a formal, signed promissory note — a written promise to repay. It should set out the principal amount, the prescribed interest rate, and the repayment terms. Without this documentation, CRA may not accept the arrangement.

1. Transfer the funds. Move the loan proceeds from the higher-income spouse's account to the borrower (spouse or trust). Keep clear bank records showing the transfer.

1. Invest the funds. The borrower invests the proceeds. The income generated — interest, dividends, capital gains — is reported on the borrower's tax return, not the lender's.

1. Pay the annual interest by January 30. Every year, the borrower must pay the interest owing on the loan to the lender no later than January 30 of the following year. The lender reports this interest as income. The borrower may deduct it against their investment income.

1. Repeat annually — on time, every year. This is not optional. Missing the deadline even once triggers the attribution rules for that year and every year after, regardless of what happened previously.

The Annual Interest Payment Requirement

The January 30 deadline is the most operationally demanding part of a prescribed rate loan strategy. The interest must actually be paid in cash — a paper entry or a promise to pay later does not satisfy the rule. Set a calendar reminder well in advance. Your accountant should be tracking this as part of your annual return preparation, but the responsibility ultimately sits with you.

The lender — typically the higher-income spouse — must report the interest received as income each year. This is a real cost, though usually modest relative to the tax savings if the prescribed rate is low.

What Happens If You Miss an Interest Payment?

If the borrower fails to pay the interest by January 30, the attribution rules snap back — permanently for that loan. The investment income reverts to being taxed in the lender's hands for the year the payment was missed and every year going forward. There is no cure. The only way to reset the strategy at that point would be to repay the loan in full and establish a new one, which would be at whatever the current prescribed rate happens to be.

This is why discipline matters. The mechanics of the loan are straightforward; the annual follow-through is where arrangements break down.

Loans to a Family Trust vs. Directly to a Spouse

A loan made directly to a lower-income spouse is simpler to set up but has a narrower benefit — the income-splitting advantage runs only between two spouses. A loan to a family trust can distribute income among multiple lower-income beneficiaries: a stay-at-home spouse, adult children in lower tax brackets, or other family members named in the trust deed.

Family trusts also offer succession planning and asset protection advantages beyond income splitting. However, they come with additional compliance obligations — annual trust returns, trustee duties, and professional fees for the trust deed itself. The suitability of a trust depends heavily on the family's financial picture and long-term goals; this is a decision to make with both your accountant and your lawyer.

Documentation and CRA Scrutiny

CRA scrutinizes income-splitting arrangements, particularly where the tax savings are substantial. The agency looks for arrangements that are properly documented, commercially sensible, and actually carried out as described.

Key documentation requirements:

• A signed promissory note in place before any funds are transferred
• Bank records showing the actual transfer of loan proceeds
• Annual evidence of interest payment — a bank transfer or cheque, with corresponding records in both parties' accounts
• A trust deed (if lending to a family trust), executed before the loan is made

Keep all of this on file indefinitely. CRA can reassess prior years, and missing documentation years later is a real audit risk.

Is a Prescribed Rate Loan Right for You?

Prescribed rate loans work well when:

• There is a meaningful difference in marginal tax rates between spouses or between the lender and the trust beneficiaries
• The family has capital to lend — the strategy requires actual funds to be transferred, not just notional amounts
• The annual interest payment discipline is realistic for your household
• The investment returns are likely to meaningfully exceed the prescribed rate

They are less useful when the rate gap between spouses is small, when the prescribed rate itself is elevated relative to expected investment returns, or when the administrative overhead of a family trust outweighs the tax saving. Your accountant is best placed to run the numbers for your specific situation.