By Winnie J Luk
Using a prescribed rate loan to split investment income with a spouse, common-law partner or even your kids is one of the most recommended tax planning strategies available to families.
Income splitting involves shifting income from the hands of a family member in a higher tax bracket to those of a one in a lower bracket so that the same income is taxed at a lower rate — or not at all. The tax rules prevent many forms of income splitting but some opportunities remain.
For example, a business owner can lend his or her spouse money (directly or via a family trust) to invest so that any investment income is taxed at the spouse’s lower rate. You must have a written agreement specifying the terms of repayment and an interest rate at least equal to the Canada Revenue Agency’s prescribed rate at the time. Currently the CRA’s prescribed rate is 1% and will increase to 2% effective October 1, 2013. (Update: the CRA reduced the prescribed rate to 1% effective January 2014.) Your spouse must pay you interest on the loan each year by January 30 of the following year. If the interest is not paid, the investment income resulting from the loan will be taxed in your hands.
Here’s how it works: You lend your spouse $100,000. Under a written agreement (such as a promissory note or loan agreement), your spouse agrees to pay you interest at 1% a year payable by January 20 each year.
She or he then invests the money and earns a 3% return of $3,000 (ie 3% * $100,000) in 2013. Your spouse must pay you 1% interest on the loan, or $1,000 (ie 1% of $100,000), by Jan. 30, 2014, which will be taxed in your hands. The difference of $2,000 will be taxed in your spouse’s hands in 2013. If you are paying tax at a top marginal rate of about 45% and your spouse is paying about 25%, you’ll save 20% in tax; $400 in this example.
Another similar tax plan involves a higher income spouse loaning funds to a family trust for the benefit of a lower income spouse, children and/or grandchildren. The family trust invests the funds in securities and income earned in the family trust is strategically allocated to lower income family members to minimize overall taxes paid.
The prescribed rate loan is an effective income splitting strategy available today.
Landmark Law Professional Corporation may assist in your estate planning matters.
Disclaimer: This article does not contain legal advice and only provides general information. It is not intended to replace advice from a qualified legal professional and should not be relied upon to make decisions. In all cases, contact your legal professional for advice on any matter referenced in this article before making decisions. Use of this article does not establish a lawyer-client relationship.