Low rates help families split income, save taxes
by Evelyn Jacks
“I should have . . .” Have you ever muttered this phrase
under your breath, in rueful recognition of a lost opportunity? Well,
if you are an investor looking for the next big win, you could be missing
out if you aren’t “tax astute” this summer. This is
especially true if you live with a lower-earning spouse and your goal
is to split investment income for tax purposes.
Check with your financial advisor about the benefits of loaning money
to your spouse for investment purposes and taking advantage of low prescribed
interest rates of 2%. Here’s what you need to know.
Step 1: Understanding Tax Terms. First, understand three key terms in
maximizing inter-spousal loan provisions:
The Attribution Rules. Why is an inter-spousal investment loan necessary
to equalize capital accumulations and split investment income earned between
It’s because of the “Attribution Rules,” a detailed
set of rules in the Income Tax Act that prevent taxpayers from splitting
income earned on the transfer of property from a high earner to a lower
earner in the family, the purpose of which is to get a lower combined
tax bill. The Attribution Rules apply to transfers of property between
spouses, including common-law and same-sex partners (defined below) and
related minor children.
The Attribution Rules can be avoided, in the following circumstances:
• When the sale or transfer of property is made to the spouse at
fair market value;
• The price is paid fully in cash, or in kind or by way of an indebtedness
(such as an inter-spousal loan) on which interest, at the time the indebtedness
occurred, is charged in an amount not less than the lesser of a) the prescribed
rate of interest, and b) the rate that would be agreed upon between arm’s-length
parties under similar circumstances.
In addition, the interest on the loan must be paid to the transferor
no later than 30 days after the end of each calendar year in which it
became payable – that’s January 30. The transferor must also
report any capital gain or loss on the property as at the date of transfer.
Definition of Spouse. A spouse, for tax purposes, is someone to whom
you are legally married, which includes persons of the same or opposite
sex who live in a conjugal relationship throughout a continuous 12-month
period, or who at the end of the tax year were the actual, or adoptive
parents of the same child.
The Attribution Rules will apply to property loaned or transferred to
a person who was a spouse or became a spouse after the transfer or loan
was made. They will not apply after the transferee is no longer the transferor’s
spouse, or during a period of time in which the spouses are living separately
due to the breakdown of their relationship (a joint election is required
not to have these provisions apply), or following the death of the transferor
or transferee. Living apart for at least 90 days is indicative of conjugal
The Prescribed Rate of Interest. This is an annual rate set by CRA to
determine the interest that will be charged on overdue taxes owed to and
by the CRA. It is also used to calculate the taxable benefits for employees
who receive low-interest or interest-free loans from their employers as
a perk, and to set the minimum rate that can be used on non-arm’s-length
loans, such as loans made to spouses for investment purposes.
The prescribed interest rate is adjusted quarterly by the CRA, to reflect
average yields of 90-day Treasury Bills for the first month of the preceding
quarter. In addition, the CRA will gross up the rate by 4% to increase
the penalty for late payment of taxes by the taxpayer or by 2% to compensate
for late refunds due to the taxpayer by the CRA.
Step 2: Concept and Action.
Now, let’s convert this information into a real-life scenario.
Thomas Smith is a vice-president of sales for a national distributor and
the main breadwinner of the family, earning six figures annually. His
spouse Johanna does not work outside the home and looks after the family’s
twin girls, 8. Thomas wants to transfer money he has accumulated to Johanna
so that resulting investment income is taxed at her low marginal tax rate.
If he does so without drawing up an inter-spousal loan, resulting income
from the property – interest, dividends, rental and royalties, as
well as capital gains or losses – will be taxed in his hands.
However, the investment earnings can be reported by Johanna if they draw
up a bona fide loan, using a demand note (see sample) or term sheet, with
interest paid by January 30, 2005, by Johanna to Thomas at the prescribed
rate in effect at the time the loan was drawn up.
This will likely result in little or no tax payable on the earnings,
depending on her income level. (Remember that in 2004, every taxpayer
under 65 can earn up to $8012, the Basic Personal Amount, tax-free). Thomas
will, of course, have to report the interest paid to him by Johanna on
his tax return for the year he received it.
The prescribed tax rate in effect at the time of the indebtedness –
2% in this case – can be set for the entire term of the loan, which
should mirror other commercial lending terms.
Step 3: Invest, Save Tax Dollars and Create Wealth.
It makes sense to increase the number of inter-spousal loans written
now, when prescribed rates are so low, if the goal is to transfer capital
used for investment purposes and minimize taxes payable within the family
unit over the longer term. Investors should seek the advice of their advisors
on this matter.
Financial advisors, meanwhile, may use this as an opportunity to contact
appropriate clients this summer in advance of the setting of the fourth
quarter rates – especially if they believe that interest rates will
continue to rise. Reinvestment strategies could be discussed in the context
of financial planning goals for the family as a whole.
Evelyn Jacks is the author of 30 best-selling books on the subject of personal income taxation, and the President of Knowledge Bureau, Inc., Canada’s leading professional education publisher in the tax and financial services industry, specializing in delivering courseware and information services to knowledge-based practices. For more information call toll free 1-866-953-4769 or visit www.knowledgebureau.com.
This article is written to be of a general nature and neither the author, her company, employees, subcontractors or others associated with The Knowledge Bureau can take responsibility for any results, positive or negative, taken by any persons. While the author received a fee to write this article, she is not in the business of providing advice on investment products and is not registered and licensed to do so, nor does the author have any compensatory relationship, or beneficial ownership
regarding the sale of investment products discussed herein