Q. I have loaned $500,000 to my wife at the Canada Revenue Agency’s (CRA) prescribed low interest rate of three per cent and she has been paying the required interest. I am gifting $100,000 by bank transfer to my adult son, who is 21 years old. He will transfer the same amount by bank transfer to his mother (my wife). My wife will then transfer the same amount to me by bank transfer to reduce the outstanding loan amount by $100,000. The gift deed will be signed by the donor (the son) and the donee (his mother)

mentioning gifting is voluntary . By doing several of these transfers, my wife will repay the entire loan amount and build up her own capital to invest, without having to worry about attributions on capital gains, interest, etc. At the time of transfers, none of us have any debts, owe creditors or CRA or have unsettled claims. Please give me your opinion on whether these gifts are considered legitimate? And could you confirm that attributions would not apply to her investment gains and losses, interest, etc.? Your response will be highly appreciated.

—Daniel in St. John’s FP Answers: Prescribed rate loans are a tool for families looking to split investment income and reduce their overall combined tax bill. The most common application is when you have family members with a big difference in their incomes who have lots of taxable investments.This strategy can save tax, but if done incorrectly, it can also trigger CRA scrutiny.

To avoid attribution of income from the loaned funds back to the lender, there are strict conditions. When it is between non-arm’s-length parties such as certain family members, the interest rate charged must be at least the prescribed rate at the time the loan is made. This rate is locked in for the life of the loan, regardless of future changes in interest rates.

Right now, the CRA prescribed rate is three per cent. A few years ago, it was only one per cent and the concept was understandably more popular. The interest must be paid annually within 30 days after the end of the calendar year in which it becomes payable. The interest is taxable to the lender and tax deductible by the borrower if they invest the borrowed funds in eligible income-producing assets. This must be properly documented with a written loan agreement and clear records of payments to stay compliant.

Repayments should come from the borrower’s resources. If the borrower uses funds that ultimately originated with the lender, whether directly or through gifts or other family members, there is a risk CRA may treat the arrangement as circular and apply attribution rules. This is where your approach

could raise red flags , Daniel. If the repayment is made indirectly, such as through your son in your example, CRA could challenge whether this repayment constitutes a genuine repayment or merely a continuation of the original loan. If the original loan is not truly repaid, because repayment comes from the lender, directly or indirectly, the attribution rules could continue to apply to income from your wife’s investments. This is sometimes referred to as the “novation” or refinancing risk.

So, routing repayments through your adult son introduces an element of risk. If funds move indirectly from lender to borrower, CRA could deny the prescribed rate loan exception if one of the main purposes of the transfers is to reduce tax. Circular arrangements can trigger attribution even if each individual step — the gifts, in this case — appear legal.

This is because even if all technical conditions are met, the General

Anti-Avoidance Rule (GAAR) can apply if a transaction lacks economic substance or is primarily tax motivated in a way that abuses the

Income Tax Act . GAAR gives CRA broad powers to question taxpayers and circular or paper-based arrangements without real change in economic position, and may therefore be challenged.

Prescribed rate loans can be a powerful income-splitting tool but only if the rules are followed carefully. Interest must be paid on time, repayments must come from independent sources and circular gifting can trigger attribution and anti-avoidance issues.

Your proposed strategy is creative, Daniel. It may have risks. There are formal ways to seek input from CRA on a proposed transaction by requesting an advance ruling from them, but this could invite future scrutiny. This is probably a situation where you would want to consult a qualified tax professional to avoid an unexpected surprise and understand the potential repercussions.

Andrew Dobson is a fee-only, advice-only certified financial planner (CFP) and chartered investment manager (CIM) at Objective Financial Partners Inc. in London, Ont. He does not sell any financial products whatsoever. He can be reached at adobson@objectivecfp.com.

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