Save on your tax bill using spousal loans

Does a spousal loan sound complicated?  It really isn’t.  Most importantly, it is a perfectly acceptable strategy for couples to income split.  The purpose of all income-splitting strategies is to transfer income from the higher income spouse to the lower-income spouse, and it is most effective when one spouse earns significantly more than the other spouse.

An absolute minimum is to be in different marginal tax brackets.  However, the greater the difference in income levels the more advantageous the strategy is from a tax savings standpoint.

Another factor in determining whether a spousal loan makes sense is the prescribed rate that Canada Revenue Agency allows loans to be issued at.  Every three months the Canada Revenue Agency sets the prescribed interest rate for loans.  It is posted quarterly and is calculated based on the average yield of 90-day treasury-bills sold during the first month of the previous quarter.  Currently the rate is a historic low of only one per cent, and is guaranteed to stay at that level until December 31, 2009.

If only one spouse is working and earning a significant income, for example $150,000, then over a series of years, the only working spouse will accumulate all of the savings, say $250,000.  Unfortunately, you cannot simply gift funds to your spouse, who has no other income, to buy investments.   Wouldn’t it be ideal to put the $250,000 in non-registered GICs earning four per cent, or $10,000 a year, in the name of the spouse with no employment income?  After all, the $10,000 in income would be below the basic exemption and not subject to any tax at all.

The Income Tax Act has rules that prevent these types of transactions to take place.  These are referred to as the “attribution rules”.  In the above case, the $10,000 income would be attributed back to spouse who earned the income.  The way around the attribution rules is to lend funds to your spouse at the prescribed rate, currently at one per cent.

Here’s an example:

Mr. Walker has annual employment earnings of $130,000 and over time has accumulated $250,000 in savings.  His conservative portfolio is invested in interest bearing investments with a rate of return of four per cent.  Every year he has been reporting 100 per cent of the T5 interest income (this year the T5 was $10,000) on top of his employment earnings.  As Mr. Walker’s marginal tax bracket is 43.7 per cent, he will pay $4,370 in taxes on this $10,000 of interest income.  Mrs. Walker has been busy raising three children and has no income at all.   In total, Mr. Walker has an estimated income tax liability of $42,450 for the year.

A strategy we recommended to the Walkers is a spousal loan.  Mr. Walker could loan $250,000 to Mrs. Walker at the rate of one per cent.  Mrs. Walker could then invest the $250,000.  Using a four per cent rate of return, Mrs. Walker would earn $10,000 a year and have a schedule 4 (part IV) interest deduction of $2,500.  Her net income will be $7,500 and below the basic exemption.  Mrs. Walker will pay no tax.

Mr. Walker on the other hand will avoid the $10,000 in T5 interest income from direct investments but will have to report the $2,500 received from Mrs. Walker on the spousal loan.  Mr. Walker’s income will be reduced by $7,500 and his estimated income tax liability will be $39,173 (instead of $42,450).  We estimate an annual tax savings for the Walker household of $3,277.

To ensure the funds are considered loaned, instead of gifted, the interest must be paid by January 30 of the following year.  If Mrs. Walker does not pay the interest of $2,500 then the total income of $10,000 will be attributed back to Mr. Walker.

It is important to document the terms of the loan, generally through a promissory note.  Although this is not a requirement under the Income Tax Act, we feel it is prudent and provides appropriate evidence of the terms of the loan.  This is especially important now that the rate is currently at one per cent.  A properly executed loan document will provide clarity for specific terms, such as interest payment dates.

The prescribed rate is subject to change.  As the rate is currently at one per cent we are not expecting the rate to go any lower.  This is the perfect time to act if the strategy is suitable for your situation.  The loan terms you set can be for an indefinite, or for a specific term such as five or ten years.  Even if rates increase after you have set up the loan, the rate will remain at one per cent and stay at one per cent for the entire term of the loan.

The Walker situation above is a perfect example of the benefits of a spousal loan.  Mr. Walker is in the highest marginal tax bracket and Mrs. Walker has income below the basic exemption.  If your situation is not so clear we recommend you speak with your financial advisor and accountant to determine if a spousal loan is right for you.