Interest Rates to Drop, Planning Opportunities Emerge

Evelyn Jacks

The Bank of Canada has reduced its target for the overnight rate by 25 basis points to 2.5%, with the Bank Rate at 2.75% and the deposit rate at 2.45%.  This is the first interest rate cut by the Bank since March.  It comes in the wake of higher unemployment, a reduction of 1.5% in Canada’s GDP in the second quarter and indicators that global economic growth is slowing.  With lower inflation risk, the cut was deemed appropriate to “better balance the risks.”  From a planning point of view, this may indicate an emerging income splitting opportunity.

Planning Interspousal Loans.  One interesting and potentially beneficial financial strategy to grow the family’s wealth is to draw up an interspousal loan to split income subject to tax in the future. 

With interest rates set to come down again, the plan may have more appeal than it has over previous higher interest rate periods.

Managing Attribution Rules. The CRA frowns on the transfer of income or assets between family members.  Attribution rules extend to spouses and minor children as well, although there are some variations for children. Let’s focus on interspousal transfers.

Under the “attribution rules”, any money transferred from one spouse, typically the higher-income spouse, to another is deemed to be taxable in the hands of the transferor, at that person’s higher marginal tax rate.  Income splitting opportunities are therefore thwarted. 

However, interspousal loans are an important exception to this rule, as long as they are set up correctly.

With such a loan, any investment income earned from the money transferred to the lower-income spouse will be taxed at that person’s lower tax rate. This can lead to significant savings on the couple’s total tax bill. But to legitimize the transaction, here’s what needs to happen:

Checkpoint:  Drawing Up A Spousal Investment Loan

• The loan must be documented properly in writing, for example with a promissory note, including repayment terms, following normal commercial lending rules.
• The lending spouse must charge the other spouse interest at least equal to Canada Revenue Agency’s prescribed rate (currently 4 percent – but possibly dropping for the next quarter?).
• The spouse receiving the loan must pay the interest owing to the lender every year within 30 days after year end (by January 30). Failure to meet this condition will result in the normal attribution rules kicking in, meaning that income earned from the loaned money will be taxed in the hands of the higher-income spouse in that year and all future years.
• The lending spouse is required to report the interest received as income on his or her income tax return.
• On the other hand, the borrowing spouse can deduct the interest paid on his or her tax return, as long as the loan was used to purchase income-producing assets with the potential of earning passive investment income (interest, dividends, rents or royalties), within in a non-registered account.
• The spouse receiving the loan is required to pay back only the interest due; there is no requirement to repay the principal.

In a declining interest rate environment, setting up an interspousal loan before the end of the year could create income splitting advantages for higher income clients.  Typically a demand loan is made with the lower earning spouse, backed by a loan agreement that sets out the terms of the loan, which should be commercially comparable.

Bottom Line:  If one spouse has a much higher income than the other, there are numerous benefits to setting up interspousal loans, especially when prescribed interest rates are low.  They are locked in for the life of the loan. 

That’s important should future interest rate hikes occur when Canada’s economy starts to recover from the current shocks.

Additional Educational Resources:  Check out the DMA – Tax Services Specialist Program

With this online course under their belt, both advisors and owner-managers will have better conversations about recent tax changes to make more tax-astute financial decisions.