Parents may think twice about offering an interest-free loan to their offspring to fund a house purchase or renovation from January 2022, following a move in the recent Finance Bill.
The proposal means that loans within a family on which no interest is charged will be treated as a greater taxable benefit; this benefit will also become more complex to calculate. In addition, the amendment may affect families that already have such arrangements in place.
Given the negligible return on deposits over the past number of years, many parents have looked to put their savings to use by offering their children interest-free loans; the children benefit from borrowing for considerably less than the rates available in the mortgage market, and may be able to use their loan, alongside a mortgage, to fund a more expensive home than they otherwise could afford.
"Parents are trying to help their children in the best way they can," says Maireád Harbron, director of private client services at PwC.
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Where a child receives a loan from a parent for which they pay nothing, or where they pay interest at a rate less than the open-market interest rate, the annual value of the loan may be treated as a taxable gift
Although tax law does not require family members to charge one another a specific interest rate, the value of the interest that the parent forgoes by lending the money rather than saving it is a taxable benefit. “Where a child receives a loan from a parent for which they pay nothing” – which is to say as an interest-free loan – “or where they pay interest at a rate less than the open-market interest rate, the annual value of the loan to the child may be treated as a taxable gift in each year that the loan is in place,” says a Revenue spokeswoman.
This cost to the parent, which is to say the savings interest they lose out on, is currently calculated by using the best deposit rate available from an Irish financial institution at the end of each year for which the loan is outstanding. Over the past few years this rate has trended to zero, which means only a nominal taxable benefit has arisen, so providing for almost “free” lending from parent to child.
The Government is unlikely to have intended for this to be the case: it is the result of current low interest rates rather than of a policy decision.
The recent Finance Bill looked to change this by proposing that the value of the gift should instead be determined by the best interest rate at which the child could have borrowed the money from a financial institution.
That would bring it into line with the way in which the free use of a house or other property is treated: the benefit is calculated in terms of its value to the person receiving the gift rather than its cost to the person making the gift.
This will give rise to a bigger taxable benefit, as borrowing rates are considerably higher than deposit rates. Consider borrowing €100,000 at 3 per cent interest. Over 10 years this would give rise to a total interest payment of €15,872; over 20 years the interest would amount to €33,103. This considerable benefit would be subject to capital acquisitions tax at a rate of 33 per cent.
Of the annual value of the free loan is less than €3,000, the gift each year is exempt from gift tax under the small-gifts exemption, provided the child has received no other gifts in the same year from the same parent
This tax can often be avoided, at least in part. According to a Revenue spokeswoman, if the annual value of the free loan is less than €3,000, the gift each year is exempt from gift tax under the small-gifts exemption, provided the child has received no other gifts in the same year from the same parent.
If the annual value of the free loan exceeds €3,000, only the excess amount each year is treated as a taxable gift – and this can also be avoided by using part of the lifetime allowance, currently set at €335,000, that a child is allowed to receive from a parent free of capital acquisitions tax.
But, as Harbron notes, eating into an allowance in this way means that when the time comes for the family home to be passed on, it may not be possible to do so without paying tax.
And for children borrowing more, the costs will start to bite. Triple that €100,000, for example, and the numbers jump substantially: borrowing €300,000 over 20 years would give rise to an interest bill of almost €100,000 – or about €5,000 a year – based on a 3 per cent borrowing rate.
In addition to dealing with the tax burden, parents will also be faced with the challenge of calculating the benefit. Until now this has been easy to do – a quick search on bonkers.ie or an equivalent quickly shows the best deposit rates available. "In terms of the burden of proof, it's a really low burden," Harbron says of the current situation.
But finding the appropriate borrowing rate is not as straightforward. The best rates in the mortgage market, for example, are for people borrowing less than 60 per cent of the value of the home. Should this rate apply? Or should it be the rate that applies to people borrowing more than 90 per cent?
The difficulty of the proposed provision is that it's bringing in uncertainty and also a compliance burden on people to gather backup documentation
Or what about the borrower’s creditworthiness – should this also be taken into consideration when determining a rate? And should a loan for a renovation come at a higher cost, given higher rates in the personal-loan market? Borrowing €100,000 at a rate of 7 per cent over 10 years will give rise to an interest bill of almost €40,000, for example.
“It’s a good bit more subjective,” says Harbron, adding that a further challenge arises for parents who are lending their children money to help them start a business. What rate of interest should then apply?
“The difficulty of the proposed provision is that it’s bringing in uncertainty and also a compliance burden on people to gather together that backup documentation,” she says, adding that clear guidance from Revenue in terms of what it will accept as backup documentation will help. “It will take some of the uncertainty away.”
Revenue says it will issue updated guidance as soon as possible after the Bill is enacted (likely at the end of 2021); uncertainty will remain until then.
The change will also apply, from this point onwards, to parents who already have such loan arrangements in place. “Maybe it was a decision [the parents] wouldn’t have made in the same way if they’d known a higher rate would be applied,” says Harbron.
And it might even hit this year. Typically, if no commencement date is indicated in an Act – as yet, none has been for this amendment – the amendment would apply for the whole of 2021.
Revenue says this may not be the case; the spokeswoman notes that, “as an administrative convenience”, it will continue to accept the pre-amendment rules until the end of 2021.
