Splitting a tax headache: Spousal loans, with 3% interest until March 31, allow income to be taxed at a lower rate

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Tad Peterson, 39, is a securities lawyer and partner at a downtown Toronto
law firm who pulls in a very healthy $400,000 a year. His wife, Julie, spends
most of her time looking after their four kids but recently began working part
time and expects to earn about $10,000 this year.

Since Tad is in the highest tax bracket for 2006 and pays tax at 46.41% on
any income over $118,285 while Julie pays tax at only 21% on her income over the
2006 basic personal exemption of about $9,000, the Petersons (not their real
name) make ideal candidates for income splitting.

So, what is income splitting? Income splitting can be defined as the
transferring of income (usually investment income) from a high-income family
member to a low, or in some cases, a no-income family member to reduce the
overall tax burden of the family.

Since our Canadian tax system has graduated tax brackets, 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, the overall tax burden of the family can be lightened.

Unfortunately, there is a myriad of onerous and complex rules throughout the
Income Tax Act that converge to block most attempts to split income among family

For example, one of the most obvious income splitting techniques that might
come to mind is the possibility of "gifting" your minor children money to invest
and thus have the investment income taxed in a minor child's hands, who,
consequently, may not pay any tax at all.

The Tax Act specifically prohibits this by attributing all income earned from
the child's investments back to you and forcing you to pay tax on that income at
your marginal tax rate. Interestingly, this rule does not apply to capital gains
and thus income splitting of capital gains with minor children is permitted and
is often accomplished through the use of informal trust accounts, known as
"in-trust" accounts or, Alternatively, if the money involved is significant,
formal family trusts may be established.

The tax rules, however, are much tighter when it comes to income splitting
between spouses or common-law partners (the two are equivalent for tax purposes)
in 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.

In other words, if Tad simply gives money to Julie to invest, any income
earned or capital gains realized upon the ultimate sale of these investments are
taxed back to Tad, even if the investments are legally registered solely in
Julie's name.

But what if Tad, instead of giving the money to Julie to invest, loaned it to
her? As long as interest is charged on the loan at the Canada Revenue Agency's
"prescribed rate," currently set at 3% until March 31, any investment return
generated above the 3% will be taxed to Julie, at her lower tax rate.

In addition, the interest paid on the loan to Tad is tax deductible on
Julie's return since it is being paid for the purpose of earning investment
income. Note that the interest must be paid by Julie to Tad by Jan. 30 following
each calendar year for this strategy to work.

If Tad loaned Julie $400,000, using an assumed rate of return of 6%, the
strategy will result in an income-splitting opportunity of $12,000 annually,
producing an annual tax savings of over $3,000. (see chart).

But time may be running out to take maximum advantage of this strategy. The
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 or so, the prescribed rate has ranged from a low of 2% to a high of
9% in 1995.

With recent rising interest rates, it's likely that the prescribed rate will
increase come April 1. Under the Tax Act, however, 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 3%
if you establish the loan by the end of March.

Finally, while it is not a technical 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 to see evidence of a bona fide loan.

David Nadler, a partner with Goodmans LLP, advises potential couples
interested in implementing this strategy not to fear the legal documentation.
Says Nadler: "A simple promissory note evidencing the loan and setting out the
principal amount, interest rate and repayment terms should be sufficient."

GRAPHIC: Black & White
Photo: Images.Com, Corbis; A promissory note detailing the terms of a spousal
loan is sufficient to document an income-splitting plan that could save families
a bundle on taxes.; Black & White