With the recent changes in tax legislation at the federal level, married or common-law couples may now find that there is a greater disparity in their marginal tax rates than ever before. As both members of the relationship must file their taxes separately it makes sense, where allowed, to place taxable investment income into the hands – and onto the tax return – of the lower income spouse.
Unfortunately, straightforward gifts of investment property, typically cash or securities in-kind, will not accomplish this objective, as they invoke the income attribution rules.
The attribution rules state, that if one spouse gifts to the other for the purpose of investing, then all of the income and capital gains earned by the recipient spouse will be taxed in the hands of the gifting spouse. Essentially the attribution rules would eliminate any tax benefit available from the gift.
This is where the spousal loan enters the tax planning landscape. The CRA states that a taxpayer may not gift to his/her spouse for investing without attribution, however, a taxpayer may loan to his/her spouse and avoid attribution, as long as the following conditions are met:
- The transfer must be made at fair market value. Capital gains will be realized by the lending spouse, if applicable.
- The rate of interest assigned to the loan must be at a minimum the prescribed rate of interest. This rate is set by CRA every quarter. Currently the CRA’s prescribed rate of interest is 1%. This interest paid is taxable to the lender and deductible by the borrower.
- There must be a real interest payment on the outstanding loan balance from the borrower to the lender by no later than 30 days after the loan year-end, typically December 31st. Proof of payment must be documented.
Following the aforementioned conditions will allow the resulting investment income to be taxed in the hands of the lower income spouse and thereby reduce the overall tax burden of the family unit.
Let’s consider an example to highlight the real-world benefits this tax planning strategy can have for you.
Jack and Jill are married and reside in Ontario. Jill realizes a cash windfall through employee incentive plans of $250,000. She plans to invest the money. The resulting investments will return 5% and the prescribed rate of interest is 1%. Jill’s annual employment income is $220,000. Jack’s employment income is $45,000 per year. This gives Jill a marginal tax rate of 53.53% and Jack 29.65%.
Scenario 1 – No loan, Jill invests the proceeds
Additional tax due to portfolio Jill $6,691 ($250,000 X 5% X 53.53%)
Additional tax due to portfolio Jack $0
Total tax due $6,691
Scenario 2 – Jill loans the $250,000 to Jack and he invests the proceeds
Additional tax due to portfolio Jill $1,338 ($250,000 X 1% X 53.53%)
Additional tax due to portfolio Jack $3,706 ($250,000 X (5% – 1%) X 29.65%)
Total tax due $5,044
Tax savings $1,647
The above noted tax savings will grow over time. As the market value of the portfolio increases, increasing the investment income, the amount of the loan remains static, keeping the resulting interest payments static. In addition, the prescribed rate of interest in force at the time of the loan also remains static. Thus, a loan made at 1% will remain at 1%, irrespective of subsequent moves in the CRA’s prescribed rate of interest.
When thinking about whether or not this strategy is right for you, consider the following:
- If transferring securities, you will need to determine how much tax is triggered from deemed capital gains at the time of transfer,if any, and how long will the annual tax savings take to make up for that upfront cost?
- Ensure your loan and payments are documented in the event of a CRA review or audit.
- Make the payments on time. If not, the loan would no longer be bona fide and the strategy ceases to work.
There may be a time when you want to repay the loan. The borrower can choose to repay or the lender may call the loan at any time. This type of loan is known as a demand loan and does not have a term. Though many demand loans are short-term in nature, they are not required to be.
An example of when a loan may be recalled and repaid would be when the CRA’s prescribed rate of interest is falling. After repaying the original loan, a new loan is made at the new lower rate. The borrowing spouse would be liable for any taxes due to realized capital gains this repayment transaction may cause.
This can be a very powerful long-term, tax saving strategy if set up and administered correctly. If this sounds like it would work for your financial situation, the time to take advantage of it may be now, as the CRA’s prescribed rate could rise at any time.
Wondering how else you might be able to minimize your income taxes? Contact me for a complimentary tax strategy consultation.
Matthew Ardrey is a dedicated provider of creative and comprehensive solutions for high-net-worth private clients. Specializing in financial planning, tax planning and investment management, his proactive approach and big-picture thinking are signature to his style. A strategic thinker and clear communicator, Matthew is often sought by major media sources for his financial expertise.
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