New top bracket emphasizes the tax spread
It appears that the prescribed interest rate for spousal loans will remain at its rock bottom level of 1% as we move into the second quarter of 2016.
At the risk of being labelled the boy who cried wolf, this is once again a call to high-income/low-income spouses to consider establishing spousal loans. Yes, it may seem like déjà vu: except for the fourth quarter of 2013 when it edged up to 2%, we’ve seen this 1% level for 7 years running since April 2009.
But what is different now is that top-end tax rates have risen. A new top federal rate of 33% for income over $200,000 could be the tipping point to motivate spouses to take action.
Spousal loan mechanics
Our personal income tax system is based on the individual as the taxable unit, even where a mutual economic relationship exists. In the case of property gifted from one spouse to the other, attribution rules cause the transferor spouse to bear the tax liability on investment income.
However, where the transaction is structured as a loan, those attribution rules can be circumvented, allowing the borrowing spouse to record the income:
- Interest payments must actually be made from borrower to lender, paid during the calendar year or no later than 30 days after year-end (January 30th);
- The source of the interest must be the borrowing spouse’s own funds, and therefore cannot be simply capitalized to the loan or be part of a revolving loan arrangement; and
- The rate must be commercially reasonable, and be no less than the rate prescribed by the income tax regulations.
Paraphrasing Income Tax Regulation 4301(c), the prescribed rate is calculated as the average yield of Government of Canada 3-month T-Bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage. Those auction rates were under half a percentage point this January, leaving the prescribed rate at 1% for the April-June quarter.
So long as the loan is properly serviced, it may remain outstanding indefinitely at the rate established at the outset.
Illustrating the benefits
For a particularly stark illustration, let’s consider $1 million loaned at 1% between spouses in the province of Alberta. Ignoring current market rates, assume it will earn 4% interest income.
The new 2016 top federal bracket rate has increased from 29% to 33% for income over $200,000. The top provincial rate went from 10% to 15% on income over $300,000, taking the top combined rate from 39% to 48% from last year to this. Our borrowing spouse has an income of $50,000, thus benefiting from the 1.5% ‘middle class tax cut’, for a combined rate of 30.5%.
Absent the loan, the higher income spouse would pay $19,200 tax on $40,000 interest income.
By using the loan, the borrower deducts the $10,000 spousal loan interest, arriving at $30,000 net income and a $9,150 tax bill. The lender owes $4,800 on the spousal loan interest, for total tax of $13,950 between them. That is a $5,250 tax savings.
This simple interest illustration generates an annual after-tax saving of about 0.5%. As it is unlikely that this arrangement would be set up for interest investing alone, actual savings will of course vary with the rates and types of return experienced.
Before leaving the topic, you may wonder why I didn’t use an example with the lower income spouse at zero income. That could be misleading, since income earned by that lower income spouse will reduce or eliminate the ability of the higher income spouse to claim the spouse credit. As well, if interest must be paid but the investment is only generating unrealized capital gains, where does the interest payment come from? Finally, in the case of professionals or other business owners (prime candidates for spousal loans), dividend sprinkling is often used for income splitting, so a spousal loan could layer upon that.