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Spousal loans are a great way to implement income splitting between two spouses, where one spouse is in a higher tax bracket than the other spouse. Generally, spouses are not able to split income to reduce their tax bill unless specifically allowed under the Income Tax Act. For instance, there are specific rules which allow the splitting of pension income.
If one spouse has gifted money to the other to invest, the income earned on the investments will be attributed back to the spouse who made the gift, rather than the spouse who holds the investment. In order to meet the goals of having the income stay with the spouse who has legal title, it will be necessary to comply with the rules of the Income Tax Act.
It is possible for one spouse to make a loan to the other, and have the loan proceeds used to fund investments. However, interest must be paid to the lender spouse at the prescribed rate, which is currently 1%. If the loan is set up while the CRA prescribed rate is 1%, this rate will be used for the entire term of the loan. Interest rates are expected to rise in the near future, which will cause the prescribed rates to rise as well.
It is imperative that the interest be paid to the lender spouse by January 30 following the year it is accrued. If the interest is not paid, the entire loan goes off-side, and the income on the investments will always be attributed back to the lender spouse thereafter.
Let’s assume the following: A and B are spouses. A is in the highest tax bracket, while B does not have any income. A has $500,000 of funds earning interest income of 6%. A decides to sell the investment and issue a loan to B in the amount of $500,000. A must charge B interest at the CRA prescribed rate, which is currently 1%. B can now invest the funds and earn the 6% interest on the investment, and pay A 1% interest on the loan. The 2010 interest of $5,000 will have to be paid by B to A by January 30, 2011.
The result is that B will earn interest income of $30,000 per year, and interest expense of $5,000 per year. The net amount of $25,000 will be taxable income to B, and B will pay taxes at the lowest rate on this income. A will include the $5,000 interest from B as part of A’s income, and will remit taxes at the highest marginal rate on this amount. This is advantageous as $25,000 has been moved from the highest tax bracket to the lowest tax bracket.
There is sensitivity around dates of payments and ensuring the loans are properly set up, therefore it is advised that you seek the advice of professionals experienced in this area. In order to determine if this is a useful idea for your personal situation, this should be discussed with your income tax advisor and your investment advisor. If you wish to set up a spousal loan, the anticipated rise in interest rates suggests that this should be implemented in the near future, while it is still possible to lock in at 1% for the entire term of the loan.
For more information on splitting income between spouses, contact your local MNP advisor.
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