How Investors Are Saving Thousands of Dollars In Future Taxes Using A Spousal Prescribed Rate Loan

By Mark Slater: Vice President, Portfolio Manager, Investment Advisor and head of the Slater Financial Group at CIBC Wood Gundy

With interest rates close to all time lows, astute investors are focusing on spousal prescribed rate loans as a way to reduce their taxes by income splitting. Income splitting is a strategy used to transfer income from a high-income spouse to a lower income spouse in order to reduce the overall tax burden of the family. Unfortunately, the “attribution rules” in the Tax Act make this difficult as it generally attributes any income or gains earned on money transferred or gifted to a spouse back to the original transferor spouse.
 
The Act does provide an exception to this rule if funds are loaned, rather than gifted, from one spouse to the other at the prescribed rate in effect at the time the loan was originated. The prescribed rate is set by Canada Revenue Agency every three months and is currently set at 1% (effective until next review on June 30, 2010). As it stands, you can currently loan money to your spouse at 1% for an indefinite period of time.

Below is an example of a couple who take advantage of a prescribed rate loan to income split over a 10 Year period. One spouse earns $150,000 per year so any investment income earned would normally be taxed at top marginal rates. The other spouse (at the time of the loan) had no earned income. The higher income spouse had an investment portfolio worth $200,000 that they liquidated before setting up the loan.

They set up a prescribed rate loan between them for $200,000. The money is invested in a balanced portfolio that generates 2% in interest income, 2% in dividend income, and 3% in realized capital gains per year, providing a total annual return of 7%. For illustration purposes, we will assume all taxes are paid yearly on income earned (no deferral). In addition, we assume the lower income spouse withdraws $2,000 per year from the investment portfolio to pay the interest owing on the prescribed rate loan. What’s left after the interest payment and taxes are re-invested back into the portfolio each year.

The results using the prescribed rate loan after 10 years are as follows:

• The low income earning spouse didn’t have to pay any taxes on the investment income earned over the 10 Year period as the income earned never reached a level that was taxable.
  
• As a result of the loan, the higher earning spouse did need to report an extra $2,000 in interest income each year which resulted in $928 per year or $9,280 over 10 years in taxes payable. The after tax value of the loan interest was $10,718.
  
• The original investment portfolio of $200,000 grew to $365,797 and if we included the after tax value of the loan interest mentioned above, the total value grew to $376,515.
  

In contrast, if the investments remained in the higher income earning spouse’s name they would have paid $53,834 in taxes on the growth of the portfolio and, as a result, the portfolio value would have only grown to $320,983.

In summary, at the end of the 10 years, the prescribed rate loan resulted in $44,552 less in taxes paid and an increased portfolio value of $55,532.
 
It should be noted that the effectiveness of this income splitting strategy depends on proper documentation as well as evidence of actual repayment within a reasonable period of time. Failure to meet the conditions, including missing or being late on a single interest payment, will invoke the attribution rules with all income and capital gains attributable to the lending spouse. Given the complexities involved with this income-splitting strategy, professional tax advice is recommended before any action is taken.

As shown in the above example though, it is worth the effort as spousal prescribed rate loans if implemented correctly can potentially save families thousands of dollars in taxes.

Mark Slater is a Vice President, Portfolio Manager and Investment Advisor and heads the Slater Financial Group at CIBC Wood Gundy. More information on Mark and his team can be found at: www.slaterfinancialgroup.com

CIBC Wood Gundy is a division of CIBC World Markets Inc., a subsidiary of CIBC and Member CIPF. Mark Slater is an Investment Advisor with CIBC Wood Gundy in Toronto. The views of Mark Slater do not necessarily reflect those of CIBC World Markets Inc. Clients are advised to seek advice regarding their particular circumstances from their personal tax and legal advisors