Dentists who own investments personally, (outside of their corporation), and who are at the top tax bracket, which starts at $132,406, pay 46.42 per cent on their interest income. Where the dentist has poor children, regardless of age, significant taxes can be saved by deflecting income which would have otherwise been taxed at the top tax rate into poor children’s hands.

Did you also involve your minor kids (<18) in your tax savings plan?

The tax department sets and publishes the prescribed interest rate every quarter.  The prescribed rate has been at one per cent since 2009.  What is the importance of this rate? If you (not via your PC/T/HSC) lend money to your minor children (under 18) through a discretionary family trust and charge interest at the prescribed rate, you are taxed on the interest income at one per cent of the loan but any income generated from the loan is taxed in your minor children’s hands.  This is how you split income (reduce family’s tax bill) with your minor children and avoid the attribution rule (i.e., ways the tax department prevent you from income splitting with your minor children).  Without this loan strategy, if you lend money to your minor children, all income, including interest and dividends (except capital gains) earned from the loan will be taxed in your hands.

Where children 18 and older are involved no attribution applies, i.e., you could lend money to them without charging interest or gift them the money and they can report all income earned therefrom. Hence for children 18 and older, you don’t have to do the extra steps outlined in the paragraph above, and will still realize the tax savings. Here is an example:

Example 1: 

Dr. David has a taxable income of more than $200,000, which is in the top personal tax bracket (46.42 per cent).

Dr. David has one minor child (Sara).  On March 1, 2012, he lends $300,000 at one per cent to a discretionary family trust in which Sara is a beneficiary.  The trust invests in a three per cent GIC.  Trust pays $2,500 ($300,000 x one per cent x 10/12) interest to Dr. David which he reports and pays tax in his 2012 personal tax return.  The interest must be paid to Dr. David by the trust on or prior to January 30, 2013.  The trust on the other hand will have net earnings of $5,000 ($7,500 minus $2,500) which is paid to Sara for her schooling or summer camp.  No taxes are payable by Sara.

In the case above, you have saved $2,321 ($5,000 x 46.42 per cent) of taxes if you are at the top tax bracket.

Example 2:

Dr. David personally owns stocks of publicly traded companies and bonds including RIM, BCE, etc. The current value of these stocks and bonds is the same as his cost. Dr. David sells the stocks and bonds to the discretionary family trust whose beneficiaries include children under 18 and who earn no income. Since the current value is the same as the cost, no gain or loss is reported on Dr. David’s personal tax return. The trust has no money to pay Dr. David. Therefore, the trust signs a loan agreement bearing interest at one per cent. All dividends, interest and capital gains will be taxed in the hands of the beneficiaries/kids.

Hence, taxable income which would otherwise have been taxed at the top tax bracket of 46.42 per cent will be tax free up to $10,822 (2012) per child. Having poor children saves taxes.

The key ingredients of this strategy are:

  • Create a discretionary family trust with help of your lawyer
  • Prepare proper documentation on the loan with interest at current prescribed interest rate (currently one per cent)
  • Pay interest based on prescribed interest rate on or prior to January 30 of the following year to lender
  • Pay net earnings from trust to minor children for their expenses or deposit to their own bank account
  • File trust return
  • All steps are carefully executed and documented

If you transfer existing investments, for example, stocks or bonds to the trust, you will have to report any capital gains, dividend or interest in your own tax return as you are deemed to have sold these at fair market value.  In 2012, one could earn up to $10,822 of interest without paying any tax, assuming they have no other income. The one per cent interest will at least be valid till March 31, 2012.  The second quarter prescribed interest will be announced towards end of March, 2012.