Income SplittingNov 01, 2018
People often consider tax saving strategies on an individual basis but overlook family strategies that can save significant tax dollars. The use of intra-family loans to split income and save taxes is a good example.
Income splitting involves the transfer of income from a high-income earner to a family member in a lower tax bracket. The lower income individual is taxed at a lower marginal tax rate, and the family pays less tax overall. Intra-family investment loans most commonly involve a loan between spouses, either married or common-law, but this strategy can also be effective with minor children.
The problem is that CRA restricts most forms of income splitting through the Income Tax Acts attribution rules. An individual cannot simply give their spouse $100,000 to invest and have the spouse declare the investment income on their tax return at their lower tax rate. In such a situation, the investment income would be “attributed” back to the original individual and taxed at their higher marginal tax rate.
There are, however a few legitimate and effective ways to split taxable income with a spouse or minor child. One of the most effective strategies, in a low interest rate environment, is through a loan to a spouse or other family members.Provided the loan is properly structured, the loan proceeds can be invested by the recipient, with the income taxed at their lower margin rate. Keep in mind, one of the keys to a successful income splitting strategy, is to ensure that the investment returns are higher than the interest rate charged on the loan.
To ensure the income attribution rules do not apply to the investment income earned by the loan proceeds, two loan conditions must be met:*The loan must carry interest at a rate that is equal to the prescribed rate (updated quarterly) as set by CRA at the time the loan is made. *The annual interest owing on the loan must be paid to the lender no later than 30 days after the end of each year. Although rates have moved up, the current CRA prescribed rate is 2% for the fourth quarter of 2018. CRA raised the prescribed rate in April 2018 from 1%. Taking advantage of today’s low interest rates, if you loan your spouse money for the purpose of income splitting, the prescribed rate remains fixed for the term of the loan. This is of considerable advantage in today’s low interest rate environment. Income splitting through loans is best suited for those: • With a pool of non-registered capital, you are wanting to invest. • Have a spouse or minor children in a lower marginal tax rate. Keeping in mind however: • Select an investment with expected returns that are higher than the current prescribed interest rate. • Formalize the spouse-to-spouse loan through a promissory note, which can be completed without the added expense of a lawyer. If you already have a prescribed rate loan, you can still take advantage of todays lower interest rate. If you and your spouse have implemented this strategy, in the past when the prescribed rate was higher, you could consider taking advantage of the current lower rate to increase the tax savings opportunities. First, your spouse will need to repay the existing loan, it’s not enough to just re-sign the loan agreement. To repay the existing loan, investments may have to be sold which may result in a capital gain. However, any gains would be taxed to your spouse and therefore the tax would be less than if you held the investment yourself. Then, you may enter into a new loan agreement, at the current lower interest rate.
You can view the current prescribed rate by going to the CRA site by clicking here.
Sr. Investment Advisor at Savanti Wealth
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