In the past, income splitting, which is defined as transferring income from a higher income-earning family member to a lower income-earning family member such as a spouse, was a regular part of tax planning undertaken by families. In recent years, the Canada Revenue Agency(CRA) has started to target such plans and has closed many of the loopholes previously available in the Income Tax Act.
One mechanism that is still available and can aid in income splitting is the use of prescribed rate loans.
A prescribed rate loan is a tax planning strategy that allows taxpayers to effectively transfer income from higher-income earners to lower-income family members, reducing total income taxes for the family; this strategy is commonly used between spouses and involves the higher income-earning spouse lending funds to the lower income-earning spouse at a “prescribed interest rate”. The borrowed funds can then be invested by the borrower, and income from these investments, less the amount of interest paid to the lender, is taxed at the “lower”income-earning spouse’s tax rate. It is important to note that prescribed rate loans need to be documented, and all interest needs to be paid annually beforeJanuary 30th. If a payment is missed, the prescribed rate loan arrangement can be tainted. The prescribed rates can be found on the CRA’s website and are updated on a quarterly basis.
Furthermore, this type of planning is also not subject to the tax on split income (TOSI) rules. The strategy is especially effective when the CRA prescribed interest rate is low, and the stock market decline is anticipated to reverse. The prescribed interest rate at the time the loan is established will remain in effect for the duration of the loan regardless of any future interest rate increases.
Generally, setting up a prescribed rate loan requires personally held cash. However, in a declining stock market environment, it could be an opportunity for the higher tax bracket individual who owns a reduced-value portfolio to do a loan“in-kind” of portfolio securities because their accrued capital gain on these stocks may be lower.
The primary benefit of the spousal loan strategy is its ability to maximize your family's after-tax investment income by reducing your family's overall tax liability.
Assume a couple in Toronto expect to earn $300,000and $50,000 in 2022, excluding investment income. Also assume the higher earning spouse has $400,000 of available cash to invest and is looking for aROI of 5%. If the higher earning spouse makes this investment, they would earn$20,000 of investment income and would owe approximately $9,000 of tax, netting them $11,000.
If the couple uses a prescribed rate loan arrangement, the higher income spouse can loan the investment cash to the lower income spouse, who can then make the same $20,000 of investment income; at a lower tax bracket, this would result in approximately $5,000 of tax, netting the couple $15,000 after tax.
Attribution is the main factor that prevents income splitting via gifts of income-producing properties to low-income family members, such as a spouse or minor children. If an individual simply gifts investments or cash that will be used to purchase investments, the income from that investment may be attributed back to the individual providing the gift, thus eliminates the benefit of income splitting.
The CRA 2022 Q1 quarterly prescribed interest rate is currently 1%, potentially making it a good time to implement the prescribed rate loan strategy through a loan to a spouse. It's certain that interest rates will rise eventually, but once a prescribed rate is established, it will not change.
Every year, it’s best to evaluate your tax savings with a professional and ensure that the plan remains effective. The purpose of the spousal loan method is to move investment income from non-registered assets to your spouse, who has a lower marginal tax rate, in order to save money for the family.
When calculating your spouse's investment return, you must take into account the required loan interest payment. You should also consider the taxes you owe on your spouse's interest payments when determining if the loan is suitable for you.
A spouse can generally deduct interest paid on a spousal loan if the proceeds are used for assets that generate income, such as investments.
You and your spouse may choose not to reinvest income earned on the portfolio but may choose to withdraw it for non-income producing purposes, such as personal expenses or travel. In this instance, the interest on the loan would still be deductible as long as the initial borrowings remain invested in income producing assets.
The cost of establishing the spousal loan may include legal fees involved in drafting the loan agreement and promissory note. In addition, you may need to pay legal fees to ensure that the loan remains valid.
It is important to consider these costs and fees when determining whether a spousal loan strategy makes sense for you.
There are attribution rules designed to prevent certain types of income splitting between you and your spouse. Consult with a qualified advisor to establish whether or not this strategy is feasible for you and your family.
The current low prescribed interest rate may be an ideal time to look into spousal loans as a way to reduce your family's overall tax bill.
Your lower income spouse will be able to use the borrowed funds to invest in their own portfolio. The spousal loan strategy will only be effective if the portfolio generates a higher return than the interest rate on the loan.
To pay interest, your spouse can either write you a check or transfer funds from their sole account to your sole account to show a payment has been made. You might find it difficult to use a joint account as your spouse would have to clearly demonstrate that they paid the interest from their own funds. It is also important that your spouse document that the payment is for interest for the relevant tax year.
You don't have to be a high-net-worth earner to take advantage of this strategy. It could be someone who received an inheritance or anyone sitting on investable capital who is earning income and paying high taxes. Prescribed rate loans are one of the ways to minimize taxes now and maximize the value of your estate.