Spousal loans can work great in certain tax situations to shift investment income from a higher taxed spouse to a lower taxed one while also avoiding triggering the infamous “attribution rules” in the Income Tax Act. This can result in significant tax savings that compound from year to year.
Attribution rules
So what is the big deal with the attribution rules? Well, simply put, these rules are triggered whenever you attempt to split income with a family member such as a spouse or child by giving them money and then trying to report the income generated by that money on their tax return. In such cases these rules will apply and the income that you may think is now being earned by your spouse or your children will still belong to you and you may be re-assessed as such by CRA, defeating the whole purpose of the exercise.
The Solution
When you make a loan to a family member that is on commercial terms, then the attribution rules will not apply. That is, if you loan money to your spouse as if they were an arms length third party, and charge them interest, and collect it each year, there is no attribution of the income your spouse now earns from the borrowed money.
The Income Tax Act mandates that a certain minimum rate of interest must apply to prove the commercial nature of the loan, a rate which is set by the CRA on a quarterly basis.
The reason spousal loans have again become a popular planning tool is because this “prescribed rate” is now at a historically low 1% rate of annual interest (subject to review after September 30, 2011). As a result you need only charge your spouse 1% interest, which must be paid each year on the outstanding balance, no later than January 30. Another great feature is that the rate can apply indefinitely into the future, it is not a floating rate, so even if the prescribed rate rises in the future, you do not have to collect more interest, as long as you establish your loan before the rate increases. You must charge at least the prescribed rate in effect on the date the loan is advanced.
In addition, this amount must be reported by the lending spouse as interest income, but is deducted by the borrowing spouse as a carrying charge of their investments.
Therefore, all investment income currently earned, above 1%, is now going to be taxed at the lower income spouses marginal rate. This can mean significant tax savings that will be generated every year the loan remains in effect.
Make sure such loans are properly documented with a promissory note or other loan agreement and that a cheque is used to transfer the funds to your spouse. It is also critical that a cheque changes hands every year to pay the interest to your spouse. This is important because you need to evidence that you are treating the loan as if you had made it with an unrelated party.
Of course, a loan is a legal agreement, and other considerations may apply in your situation, particularly if you are in a second marriage situation, so ensuring any loan agreement is properly structured may require the use of legal advice.
A family trust may also be an alternative to achieve similar splitting goals.
I have seen this strategy save thousands of dollars for families, particularly in cases where a higher income spouse has received a significant inheritance and invested the proceeds.
Talk to your tax advisor if you think this strategy may benefit you.