On October 1, 2013, the Canada Revenue Agency (“CRA”) increased the prescribed interest rate to 2%. This change clearly affects Canadians looking to use prescribed rate loans as a strategy for income splitting, but prescribed rate loans used for income splitting purposes can also affect US citizens, US residents and even green card holders (collectively referred to as “US persons”). Before we jump too far ahead, let us take a moment to understand the income splitting strategy as it is used here in Canada.
One of the many differences between the Canadian and US tax systems is that, in the US, spouses can file a joint tax return, but in Canada, spouses are forced to declare their own personal income by filing separate tax returns. The net result (putting tax rates aside) is that a married couple will pay more tax in Canada than they would in the US. A common solution to this problem is the strategy of income splitting, which attempts to allocate income from a spouse taxed in a high tax bracket to members of that spouse’s family who are taxed at lower marginal rates.
Conceptually, it seems simple enough to take advantage of this strategy. Assuming everyone is a Canadian citizen and resident, Spouse A, who is the higher income earner, would make a gift to Spouse B. Spouse B could then invest those assets and earn income at his or her lower marginal rate. Unfortunately, the CRA has a wide range of attribution rules which would attribute that income back to Spouse A, forcing tax to be paid at Spouse A’s higher marginal rate.
However, the Income Tax Act (the “Act”) says that attribution would not apply had Spouse A made a loan to Spouse B at the prescribed rate. This is the rule in its most basic form. There are exceptions and nuances that must be adhered to, but this is the general principal. If a loan was made at the prescribed rate, the interest earned by Spouse B could then be taxed at his or her lower marginal rate.
Using prescribed rate loans as a tax strategy is meant to achieve lower overall Canadian tax, but what if our example above incorporated a US person? The US has its own array of tax laws that can conflict with those here in Canada. This incongruency can result in the strategy being obsolete or even more detrimental to the taxpayer than if they hadn’t done anything at all.
The issues on the US side differ depending on what role the US person is playing in the strategy and whether the loan is being made to an individual or a trust (loans at the prescribed rate to a trust are usually used to allow income splitting between spouses and children). Based on certain assumptions below, let’s begin to analyze some issues and situations.
Spouse A, a Canadian citizen/Canadian resident and a non-US citizen, lends money at the prescribed rate to Spouse B, who is a US citizen/Canadian resident.
Canadians are typically not concerned about US estate tax. However, the Internal Revenue Service (“IRS”) can impose a tax on the value of a Canadian’s US situs assets on death. The definition of “US situs assets” as per the Internal Revenue Code (“IRC”) includes debt obligations of US persons. Therefore, the promissory note outlining the loan at the prescribed rate from Spouse A to Spouse B would be deemed a US situs asset to Spouse A, which could trigger a US estate tax upon death should the debt remain outstanding at the time of Spouse A’s death.
But what if the facts were slightly different and Spouse B was a US resident instead of a Canadian one? In this situation, interest payments made on the loan to Spouse A would be deemed US-sourced income under the IRC, as they would have been made by a US resident. This could cause the interest to be taxed by the US, and Spouse A could be faced with added filing requirements in the US. The only good news is that the Canada/US Tax Treaty would apply, which would essentially protect Spouse A from double taxation. Spouse A, then, would only be obligated to pay tax to the CRA, but he or she would have additional filing requirements for that year.
Spouse B, on the hand, has his or her own set of issues to deal with. If Spouse B is a US resident at the time of repayment, the IRS could impose an obligation to withhold some or all of the income to Spouse A (who is not a US resident). It is Spouse B’s responsibility to withhold income if necessary. The obligation to withhold will depend on the type of income. However, Spouse B could be obligated to remit this withholding directly to the IRS or have Spouse A sign form W-8BEN, which Spouse B would need to keep on file. Failure to do so could result in costly penalties. Spouse B must also submit form 1042-S to the IRS in order to notify them of source withholdings, provided the interest qualifies as portfolio interest.
Spouse B may also find that he or she cannot deduct the full interest being paid on the loan. The rules state that “investment income” is tax deductible, and interest paid on a prescribed rate loan would typically fall into this category. The problem is that the IRC limits the amount of investment interest that you can deduct to something called “net investment income,” which is investment income in excess of investment expenses. Therefore, if Spouse B pays $20,000 in interest to Spouse A but makes only $15,000 of income from the loan, Spouse B is limited to a deduction of only $15,000 and will carry forward the remaining $5,000. There are even further issues surrounding the ability of Spouse B to deduct the interest, so special care must be taken in this particular situation.
EXAMPLE 1: Spouse A, a US citizen/Canadian resident lends money at the prescribed rate to Spouse B, who is a Canadian citizen/Canadian resident and a non-US citizen.
US persons always need to be vigilant when it comes to filing taxes, especially persons who reside in Canada. This is due to a major difference between the US and Canadian tax systems: Canadian taxes are based on residency while US taxes are based on citizenship. This means that US persons living in Canada are subject to both tax regimes and must disclose assets and other personal information to the IRS even though they are Canadian residents.
In recent years, for example, US persons have become obligated to report certain foreign assets by way of IRS Form 8938. Under the IRC, the promissory note from Spouse B would be considered a foreign asset that requires reporting to the IRS. Thus, the promissory note creates a reporting obligation for Spouse A. And the IRS does not mess around when it comes to filing obligations: the penalty for failure to report assets on Form 8938 can be as high as $10,000.
There is another financial obligation to consider in this scenario as well. In order to fund universal healthcare, the US has passed new legislation; now, under the IRC, US citizens and residents are subject to an additional tax of 3.8%. Therefore, if Spouse A’s net investment income and modified adjusted gross income are high enough, he or she might end up paying an additional 3.8% on the interest received from Spouse B to the IRS. Making matters even worse, this additional 3.8% tax would not qualify for a foreign tax credit, possibly subjecting Spouse A to double taxation.
EXAMPLE 2: Spouse A is a Canadian citizen/Canadian resident and non-US citizen. Spouse B is a US citizen/Canadian resident. Spouse A loans to a Canadian discretionary trust at the prescribed rate. Spouse A is the trustee, and Spouses A and B are beneficiaries.
In this scenario, Spouse B needs to be aware of nasty throwback rules in the US. Any undistributed income that is later paid to Spouse B would be taxed at the highest marginal rate for the year in which it was made, not the year of distribution to Spouse B. The income distributed to Spouse B would then pay a penalty in the form of interest accruing from the date it was earned in the trust. If these rules are not carefully looked at, Spouse B could face taxes and penalties that outweigh the income received. As well, any distributions made to him or her must be declared to the IRS on Form 3520. And there is a heavy penalty of 35% for failure to file.
What if Spouse A loaned to a US trust instead of a Canadian discretionary trust? Similar to what was discussed above, the interest paid to Spouse A could be considered US-sourced income, creating additional filing and tax obligations for Spouse A. As well, for US estate tax purposes, Spouse A’s interest in the trust could cause tax liabilities upon his or her death. However, US trusts are not typically used in income splitting strategies, so these may be non-issues.
EXAMPLE 3: Spouse A is a US citizen/Canadian resident. Spouse B is a Canadian citizen/Canadian resident and non-US citizen. Spouse A loans to a Canadian discretionary trust at the prescribed rate. Spouse A is the trustee, and Spouse A and B are beneficiaries.
Once again, we have additional filing requirements for Spouse A, a US person. Since Spouse A is also the trustee, he or she is deemed to be the owner of the trust under the IRC and has an obligation to file Form 3520-A every year. Failing to do so can carry a penalty of 5% on the gross value of the assets held by the trust. Secondly, the IRC says that when a US person transfers money to a foreign trust, they have an obligation to notify the IRS by filing Form 3520. If you haven’t yet noticed the pattern, failure to do so comes with a hefty penalty of 35% on the gross value of the property transferred.
The final issue worth discussing is what happens if Spouse A loans to a grantor trust. In such a scenario, Spouse A would be taxed personally in the US on all the income generated, regardless of distribution, because the IRS ignores/disregards grantor trusts for tax purposes. Therefore, all tax liabilities fall to Spouse A personally on the US side.
The US’s treatment of grantor trusts causes the dreaded double taxation issue to arise. On the Canadian side, when the income splitting strategy is employed and Spouse B receives the income allocated to him or her, Spouse B must pay tax in Canada. However, Spouse A also has to pay tax in the US due to the rules surrounding grantor trusts. With different individuals paying on different sides of the border, there is no way to apply foreign tax credits, and Spouses A and B are left paying tax in different jurisdictions.
Although using the prescribed rate for income splitting purposes is a great tool to help Canadian families achieve an overall lower tax rate, you must consider all the issues and plan carefully before attempting this strategy with a US person.
Always consult a cross border specialist when using any Canadian approach that involves a US person to ensure that the above issues, among many other pitfalls, are not accidentally created.
The information contained herein is for informational purposes only, and is not legal advice or a substitute for legal counsel. It is not intended to be attorney advertising or solicitation. If you have a legal question, please consult with a licensed attorney.