The Telecommunications Regulatory Authority set the interest rate to rise to 3% in the fourth quarter

Jimmy Golombek: Here’s what you should do in anticipation of a looming interest rate increase

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Interest rates continue to rise. As a result, the Treasury confirmed this week that the benchmark interest rate will be raised to three per cent for the fourth quarter of 2022. This rate increase will have diverse implications, both for taxpayers who owe money to the Canada Revenue Agency, and for those considering a loan-rate strategy. Specified for apportionment of investment income with spouse, common-law partner, children or grandchildren. Let’s review how the exact rate is determined, and then, what you should do in anticipation of this impending rate increase.

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What is the exact price?

The specific rate is set quarterly and is directly related to the yield on three-month Canadian Government Treasuries, with a delay. The calculation is based on a formula in the income tax regulations, which takes the simple average of three-month Treasuries for the first month of the previous quarter rounded to the next full percentage point (if not an integer).

To calculate the rate for the next quarter (October 1 to December 31, 2022), we look at the first month of the current quarter (July) and take the average three-month Treasury yield, which was 2.1962 percent (July 7, 2022) and 2.6959 percent (21 July 2022). That average is 2.44605 percent but when rounded up to the nearest full percentage point, we get three percent for the new rate set for the fourth quarter of 2022.

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This upcoming increase marks the second time the set price has risen since the previous historical low of 1 percent between July 1, 2020 and June 30, 2022.

However, in reality, there are three specific rates: the base rate, the rate paid for tax refunds, and the rate charged for taxes owed. The base rate, which rose to three percent on Oct. 1, applies to taxable benefits for employees and shareholders, low-interest loans and other related party transactions. The tax refund rate is two percentage points higher than the base rate, which means that if the CRA owes you money, you’ll start paying 5% interest on October 1. Not a bad deal! On the other hand, if you owe CRA money, this rate is four percentage points higher than the base rate. This puts the rate of interest that applies to all tax debts, penalties, inadequate premiums, unpaid income tax, Canada Pension Plan contributions and employment insurance premiums at a whopping 7 percent, starting October 1.

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tax debt

That looming 7 percent rate set by the telecom regulator is punitive, and to make matters worse, the interest charged on tax amounts owed is not tax deductible. For someone in a higher tax bracket of, say, 54 percent, that means you have to find an investment that earns a pre-tax guaranteed rate of return above 15 percent to be better off paying off your tax debt!

So, the advice is clear and simple – if you owe CRA money, make the payment ASAP. You must do this even if your tax amount is in dispute and you plan to do so officially And even, in the end, he took the matter to court. If you are ultimately successful, you are entitled to a refund (taxable) of five percent (effective October 1). And if you’re not, you’ll save at least hundreds, if not thousands, of dollars in non-deductible interest.

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Develop income-splitting strategies before October 1, 2022

The upcoming increase in the fixed base rate means that the window for securing an income-splitting loan at the current fixed rate of 2 percent is fast approaching its end. If you act now, however, and before September 30, 2022, you can take advantage of the current set rate of 2 percent to split income for the life of the loan, even after the rate is increased to three percent (or higher) in the future.

Here’s a quick summary of how the income-splitting strategy works, using the example of Harold, who pays tax at the highest marginal rate, and his wife, Marian, who pays tax at the lowest marginal rate. Harold Marian loans $500,000 at the current fixed rate of 2 percent, with a guarantee of a written bill of exchange. Marianne invests the money in a portfolio of dividend-paying Canadian stocks with a current yield of four percent.

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Each year, Marian gets $10,000 of the $20,000 dividend she receives to pay the interest on the loan to Harold. It makes sure to do this by January 30 of each year after the year after the loan is made, as required by tax rules.

The couple’s net tax savings would be to tax the dividends into the hands of Marianne at the lowest rate rather than Harold’s hand at the highest rate. The savings are offset a bit by earning $10,000 of interest on Harold’s taxable promissory note with the highest rate of interest income. However, this interest paid is tax-free to Marian at the lower tax rate as the interest was paid for the purpose of earning income, i.e., dividends.

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The rush to beat the September 30 deadline is that in order to avoid applying attribution rules to a spouse loan like this, you only need to pay interest at the exact rate in effect at the time the loan was originally extended. In other words, if you establish the loan during a quarter in which the set rate is 2%, as it currently is, you can use that rate for the life of the loan, even if the set rate rises in the future. Note that no end date is required for the loan, which can simply be repaid on demand.

If Harold deferred the implementation of the marital loan and delayed it until October 1 (or later), Marianne would have to pay $15,000 ($500,000 times 3 percent) to Harold to be taxed at the highest rate, instead of $10,000.

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This strategy can also be used to help fund children’s or grandchildren’s expenses, such as private school and extracurricular activities, by offering a set rate loan to a family credit. The fund then invests the money and pays the net investment income, after interest on the loan, to the children either directly or indirectly by paying for their expenses. If the children have zero or other meager income, this investment income can be earned tax-free.

Jamie.Golombek@cibc.com

Jamie Golumbeck, CPA, CA, CFP, CLU, TEP is the Managing Director of Tax and Estate Planning with CIBC Private Wealth in Toronto.

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