Are you looking into income splitting using a spousal loan? Canada has a graduated tax rate system which means individuals pay progressively higher taxes as their incomes increase.
If one spouse is in a higher income tax bracket than the other, then it may make sense for the higher income earner to split income with the lower-income earner to take advantage of the lower tax bracket.
This type of arrangement is called income splitting and there are several methods to achieve this such as spousal RRSP, pension income splitting or making a loan to the family trust.
Thanks to the low-interest rate prescribed by the Canada Revenue Agency (CRA) during the pandemic, the most helpful method at this moment is probably making a spousal loan at the CRA’s prescribed interest rate.
How to use a prescribed rate loan
The Income Tax Act (ITA) is filled with anti-avoidance rules and one of them is the attribution rules which prevent taxpayers from reducing taxes by shifting investment income to family members such as a spouse or children. The attribution will generally deem all income or loss and capital gain or loss to be the transferor’s income.
Therefore, you cannot simply transfer assets or money to the lower-income earning spouse because the attribution rules will treat that as your income.
However, one exception is when a loan is made between spouses at a rate that is not lower than the CRA’s prescribed interest rate.
Income Splitting using a Spousal Loan
There are two conditions that must be met for the Spousal Loan:
– The interest rate charged on the loan is at least as high as the CRA’s prescribed interest rate at the time the loan is made. The term “prescribed interest rate” is the interest rate set by the CRA each quarter and is tied to the yield on the government’s 90-day Treasury Bill;
– The interest is paid no later than 30 days after the taxation year (For example, if you made a loan to your spouse in 2020, then the interest must be paid before January 30, 2021).
To better illustrate the strategy, let’s consider the following example:
– Jason is a high-income earner who’s in the highest tax bracket and wants to use the spousal loan method for income splitting purpose. Suppose Jason loans $100,000 at the prescribed interest of 1% to his spouse Cathy who’s in a lower bracket. Cathy then uses the loan to invest in a portfolio that generates an annual return of 5% which is $5,000. Cathy then pays $1,000 (1% x $100,000) for annual interest to Jason.
As is illustrated above, under this scenario Jason is able to shift $4,000 of income to Cathy.
Attribution rules and children
As for children, if a parent gifts funds to an adult child, the income or capital gain earned on the fund transferred will not attribute back to the parent. However, a gift means the parent will no longer have control and access to the fund so most parents may want to transfer the fund as a loan.
Unfortunately, the attribution rules will apply unless it’s made at a prescribed interest rate.
Key points to consider before implementing the strategy…
The strategy may not always result in better tax treatments and taxpayers should consider the following factors before going down this route:
– The transferee must have the capacity to pay the lender each year that is no later than 30 days after the taxation year. If it’s missed by even one day, the attribution rule will kick in;
– This strategy only works if the investment return is equal to or greater than the prescribed interest rate at the time the loan is made;
– There must be formal documents that show a loan has been made and the transferor must report the interest earned each year. It is generally recommended to go to an experienced tax expert to make sure everything is formalized;
– If either spouse is not a Canadian resident, there may be adverse consequences.
Income Splitting using a Spousal Loan Conclusion
The CRA’s current 1% prescribed interest rate offers a good opportunity for couples to consider income splitting by making spousal prescribed rate loans. However, you should always consult with an experienced Canadian tax lawyer so that you understand all the traps and costs to maintain this method.
Jack Wang
Counsel at Barrett Tax Law.
Phone: (416) 907-8429 ext. 220
I found this content really helpful. I find the CRA to be a bit of a bully in Canada. They just send you random assessments, and they don’t explain their work. Didn’t they take Math 10? You have to show your work. I’m not going to write a check for a random amount to the government.