Time to Lock in Spousal Loans

Drawing up inter-spousal investment loans are a legitimate way for the higher-income spouse to transfer taxable investment income to their lower-income spouse to reduce the family tax bill. For several years now, the prescribed rate for spousal loans has been set at 1% but that may be changing shortly.

Although not officially announced, the rate for the fourth quarter (October to December 2013) will be based on the average rate for three-month Government of Canada Treasury Bills for July 2013. For the first time in several years, that rate exceeded 1% and, per the Regulations, the prescribed rate for the quarter must be the T-Bill rate rounded to the next higher whole percentage. 

That means as of October 1, the prescribed rate will jump from 1% to 2%. This has implications for those who owe CRA—they’ll have to pay 6% on outstanding taxes and deficient instalments, but it will also impact the potential savings for those who intend to use spousal loans to split investment income. The good news is you can still lock in the old rate if you act before October 1.

Example:

Martin earns $200,000 annually and has a non-registered investment portfolio of $100,000. Martin’s wife Eve has never worked but has her own investment portfolio from capital inherited from her father. Eve’s taxable income is $20,000. The couple lives in New Brunswick.

Assume that Martin were to invest his $100,000 in Government of New Brunswick December ’32 strip bonds paying 4.544%. His annual earnings on the bonds would be $4,550 on which he’d pay $2,275 income tax leaving after-tax investment income of $2,275.

If Martin made a bona fide loan to Eve for $100,000 at the current prescribed rate of 1% and she made the investment instead, then Martin would have to include the $1,000 interest in his income (and pay $500 tax) and Eve would add the net $3,550 (interest earned minus interest paid on the loan) to her income and she would pay $844 tax. The net earnings for the family would be $4,550 earnings less $500 tax paid by Martin and $844 tax paid by Eve or $3,206. The net result is an increase in net family income of $931 per year.

However, if Martin waited until October to make the same arrangement, the interest on the loan would be $2,000 so his taxes on that interest would be $1,000 and Eve’s taxes on the net $2,550 interest would be $595. The net increase in family income would then be $680—a $251 reduction.

The prescribed rate is locked in for the life of the loan, so a loan set up at 1% this month will continue to shield against income attribution for as long as the loan is outstanding and interest is paid annually before the January 30 of the following year. The terms of the loan should mirror commercial terms to be audit-proof. See your MFA or DFA-Tax Services Specialist for help with this strategy.