The one per cent solution for couples
Use the prescribed rate drop to your advantage
In just over two weeks, the government's prescribed interest rate will drop to an all-time low of 1%, providing couples a significant income-splitting opportunity.
The prescribed rate is based on the average yield of 90-day T-bills sold during the first month of the previous quarter. On April 1, based on January, 2009, T-bill yields, the rate will be set at 1%.
Income splitting is the practice of transferring income from a high-income spouse to a lower-income spouse to reduce the overall tax burden of the family. Having the income taxed in the lower income-earner's hands is a strategy prompted by our system of graduated tax brackets.
Unfortunately, "attribution rules" in the Tax Act make this strategy difficult by attributing any income or gains earned on money transferred or gifted to a spouse back to the original high-earner spouse.
Fortunately, the Act does provide an exception to this rule if funds are loaned, rather than gifted, at the prescribed government rate and the interest paid annually by Jan. 30 of the following year.
So, if the loan is made on or after April 1, any investment returns above the 1% prescribed rate can be taxed in the hands of the lower-income spouse. Note that even though the prescribed rate varies quarterly, you need only use the rate in effect at the time the loan was originally extended.
And, what if you entered into a loan with your spouse last year, when the prescribed rate was 3% or 4%?
Ideally, the borrowing spouse would sell his or her investments, repay the loan and then enter into a new loan agreement using the 1% prescribed rate.
But what if this triggers unnecessary brokerage fees or unwanted tax consequences? Furthermore, what if the fair market value of the investments is insufficient to pay off the original loan?
In these cases, while you may be tempted to either adjust the rate on the loan or refinance it at 1%, both may put you offside.
In 2002, the CRA stated that repaying a 5% prescribed rate loan with a new 2% loan could trigger the attribution rules.
One potential solution, courtesy of Ernst & Young, may be to consider borrowing from a bank (using the original investments as collateral) to repay the loan with the high prescribed rate. Then, a new prescribed loan, ideally using a different source of funds, could be structured between spouses at 1% and the proceeds used to pay off the bank loan.
"You want the two loans to be as different as possible," cautions Ernst & Young's Gena Katz, so that CRA doesn't view them as the same loan, in which case the attribution rules could apply.