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: