Smart tax tips:

Income splitting loans

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  • Income splitting loans provide an excellent way to reduce a couple’s overall income tax liability. They are effective where one spouse is in a high tax bracket and the other spouse has either no sources of taxable income or is in a low tax bracket, as the plan involves transferring taxable investment income from the high tax bracket spouse to the other.

    The higher-income earning spouse loans funds to the other spouse to make an investment. The investment income earned by the lower-income spouse is taxed at a lower rate. But in order to avoid adverse tax consequences, the borrowing spouse must pay interest on the loan to the lending spouse at the CRA prescribed interest rate in effect at the time the loan is made. In addition, the loan should be made pursuant to a written agreement and interest payable on the loan for each year must be paid no later than January 30 after the year-end. As of August 2013, the prescribed rate is and has been 1% per year since the spring of 2009, and is the lowest the rate has ever been. If this plan is properly implemented now and if rates increase in the future, the 1% rate will continue to apply for as long as the loan is outstanding.

    Assume Mr. X, subject to the highest marginal rates of tax, loans $2 million to his spouse, who only has a marginal amount of taxable income, and follows all of the required steps as described above. Mrs. X invests in a five-year GIC at 2.5%. Mrs. X must pay $20,000 interest (1% of $2 million) each year to Mr. X, who will have to report the amount as income. Mrs. X’s net income (after deducting the interest) will be $30,000 ($50,000 - $20,000) and is taxed at the lowest marginal rate of tax. Assume that after five years the new five-year GIC rate is 6%. Mrs. X will still only have to pay $20,000 each year to Mr. X, but her net income after deducting the interest will increase to $100,000, all taxable at rates lower than what would have applied had the income been earned by Mr. X.

    It is increasingly likely that the prescribed rate will soon start to increase, perhaps as early as this fall. Therefore, now is the time to consider income splitting loans!

    August 14, 2013