Time is running out to take advantage of one of the easiest tax savings
strategies at the most tax advantageous time in more than 20 years. The strategy
involves loaning money to your spouse or partner (the two are equivalent for tax
purposes) to legally split investment income between couples.
Income splitting can be defined as the transferring of income, usually
investment income, from a high-income family member to a low, or ideally,
no-income family member to reduce the overall tax burden of the family. Because
Canada has a graduated tax system where the more income you make, the higher
your tax rate is on a marginal dollar of income, by having the income generated
from the investments taxed in the lower income earner's hands, taxes can be
minimized.
Unfortunately, there are onerous rules throughout the Income Tax Act to block
most attempts to split income among family members. There are some well-known
exceptions to the rules, the most common being the spousal RRSP, whereby one
spouse (usually the higher income one) can contribute to the other spouse's RRSP
and upon retirement, the money withdrawn can be taxed in the recipient spouse's
hands.
But what about income splitting of non-registered investment income between
spouses? The general rule is that both income as well as capital gains earned on
money transferred or gifted to a spouse is taxed back or "attributed" to the
transferor spouse. For example, if Jack, who is in the highest tax bracket,
gives money to his wife Jill, who is in the lowest bracket, to invest, any
earnings are taxed back to Jack, even if the investments are legally registered
solely in Jill's name.
There is, however, an exception to this rule. If instead of gifting the money
to Jill, Jack was to loan it to her and charge interest on the loan at the
"prescribed rate," any investment return generated above the prescribed rate is
taxed to Jill, at her lower rate. In addition, the interest paid on the loan is
tax deductible to Jill since it is being paid for the purpose of earning
investment income. Note that the interest must be paid by Jill to Jack by Jan.
30 after each calendar year for this strategy to work.
The prescribed interest rate until Sept. 30 is 2%. Last week, the Canada
Revenue Agency announced that beginning Oct. 1, the prescribed rate would be
increasing to 3% for the fourth quarter of 2004.
So, why the rush? Prescribed rates are set by the CRA quarterly and are tied
directly to the yield on Government of Canada 90-day Treasury Bills, albeit with
a lag. During the past decade alone, the prescribed rate has ranged from today's
low of 2% to a high of 9% in the summer of 1995.
To avoid the attribution rules from applying to a spousal loan, you need only
use the prescribed rate in effect at the time the loan was originally extended.
Even if the prescribed rate creeps up over the duration of the loan, you never
need to charge more than 2% if you establish the loan by the end of the month.
While it is not a requirement of the Tax Act to get a formal loan document
drawn up between you and your spouse, it's probably worth the legal fees
involved just in case the tax man comes knocking at your door one day asking you
to prove the existence of a bona fide loan.