Jack and Jill fall for income splitting

National Post

2008-07-05


Now's the time to take out a spousal loan

Calls for income splitting for Canadian couples are rising once again, following University of Calgary professor Jack Mintz's recent pro-splitting study and the Green Party's carbon tax plan, which includes full income splitting among spouses.

Don't hold your breath, though, as the current government hasn't endorsed income splitting beyond the splitting of pension income.

Meantime, couples who wish to split their investment income have a new window of opportunity by taking advantage of the recently reduced quarterly prescribed interest rate on spousal loans, which dropped to 3% this week.

Income splitting is the transferring of income from a high-income family member to a lower-earning spouse or, in some cases, a "no-income" family member, to reduce the overall tax burden of the family.

Since our tax system has graduated tax brackets, by having the income taxed in the lower income-earner's hands, the overall tax burden of the couple can be reduced.

Unfortunately, complex rules in the Income Tax Act block attempts to split income between spouses or partners by requiring any income, as well as capital gains earned on money transferred or gifted to a spouse, to be "attributed" or taxed back to the "transferor" spouse.

In other words, if high-income earner Jill gives money to her lower-income earning husband, Jack, to invest, any income earned or capital gains realized upon the sale of these investments are taxed back to Jill -- even if the investments are legally registered in Jack's name.

But what if, instead of giving the money to Jack to invest, Jill loaned it to him using the spousal-loan strategy?

As long as interest is charged on the loan at the Canada Revenue Agency's prescribed rate, which was set July 1 at 3% and will remain there until at least Sept. 30, any investment return generated above the 3% can be taxed in Jack's hands, at his lower tax rate.

As well, the interest paid on the loan by Jack to Jill is tax-deductible on Jack's return since it is being paid for the purpose of earning investment income.

Note that the interest must be paid by Jack by Jan. 30 following each calendar year for this strategy to work. A recent CRA commentary, which created some concern in the tax community last month, says that even if interest on the spousal loan is payable on the anniversary date of the loan, the accrued interest owing for the first year must still be paid by Jan. 30 of the subsequent year or the strategy fails, not only for the first year but in all future years.

Keep in mind that even though the prescribed rate varies by quarter and could ultimately rise, you need only use the prescribed rate in effect at the time the loan was originally extended.