Tag: Interest

Spousal loans still on 1% sale

For the 14th consecutive quarter, the prescribed rate on spousal loans is 1%. 

To put that in context, during the 25 years leading up to April 2009, the lowest rate was 2%, and it only occurred in three quarters during that interval.

So is it time for spouses to get on this bandwagon? 

A spousal loan recap

Our tax system is based on the individual as the taxable unit, as compared to some economies where spouses or a broader family unit is the taxable entity. 

That being the case, taxpayers have an incentive to split income – or at least attempt to do so – with household members who face lower tax rates on their marginal income.

In response, the Income Tax Act has a number of anti-avoidance rules that attribute income earned on transferred assets or sources back to a transferor. An exception to attribution is available on loans between spouses at the prescribed rate. 

A low-income spouse could be taxed on the investment income generated on borrowed money. Interest charges paid to the higher-income spouse would be deductible to the borrower spouse, and correspondingly taxable to the higher income lender spouse.

Be careful when servicing the loan

The lower the interest rate allowed on such loans, the more desirable the arrangement could be. This is particularly so because such loans have no mandatory horizon date, and the rate can be locked-in for life at the initial rate setting. 

Still, the decision to establish a loan cannot be dictated by tax considerations alone, even when the 1% rate is the lowest possible point (based on the rounding formula used in the regulations). 

As well, a significant disparity in spouses’ marginal tax rates may make this strategy appealing, but there are no guarantees. For example, had a loan been established back in 2009, the intervening interest payments would have been taxable income to the lending spouse, and yet the borrowing spouse may not have experienced much or any income or gains in that time period. 

Indeed, had the investments declined in value, the higher income spouse may have been able to make more effective use of resulting capital losses.

Thus, tax motivation must be tempered with investment risk and outlook. 

What’s more, the borrowing spouse must keep that loan in good standing every year. This means the interest must be paid during the year or within 30 days of its end, and those payments must be made from the borrowing spouse’s own resources. 

In particular, if some of the investment portfolio is sold or redeemed in order to make those interest payments, in effect the lending spouse is getting his or her own money back. The attribution rules would apply from that point forward, even if the loan is properly serviced in future years.

With all that in mind, the borrowing spouse should consider including income-generating components within the portfolio to cover the interest charges. To be even more tax-efficient, Canadian dividends may be particularly worthwhile, as the gross-up/credit treatment leads to a much lower effective tax rate at lower brackets.

Appealing penalties for unreported income

At issue

There is an inherent danger in a self-reporting tax system that an individual may fail to report income.  Checks and balances in the system expose such gaps and/or influence taxpayers to diligently report their income, for example the requirement for employers to report employee income directly to the Canada Revenue Agency.

In situations where income has been unreported, it may be possible for a taxpayer to rectify the situation and request that penalties be waived.  While courts may get involved, such a waiver remains in the discretion of the Minister of Revenue as represented by CRA.

Dunlop v. The Queen, 2009 TCC 177

Where there has been unreported income in any of the three preceding years, a penalty of 10% applies to any current year’s unreported amount.

Dunlop was a university student employed on a part-time basis with a supermarket franchise.  For 2005 tax reporting, he did not receive a T4 slip and did not report the income.  CRA received its copy of the T4 and reassessed Dunlop, and the tax was eventually paid.

For 2006, he again had not received his T4 by April 2007, and attended at the employer’s location to obtain it.  The franchisor lived in another city and did not deliver the T4 prior to April 30, so Dunlop estimated $5,250 as the income in filing his return.  He was reassessed in October 2007, about the same time as the T4 arrived in the mail.  The actual income was $5,526, and the penalty on the reassessment was $646.

The court allowed the taxpayer’s appeal based on his diligence in reporting the source and nature of his income, though obviously not the exact figure.  The penalty was reversed.

CRA 2010-0356361I7 (E) – Due Diligence Defence to a S. 163 Penalty

The taxpayer was reassessed for failure to report some interest income for the 2004 taxation year.  With respect to the 2005 taxation year, the taxpayer discovered an error late in 2006 and requested an adjustment to dividend income due to attribution from property transferred to his minor child.  On reassessment, a 10% penalty was added.

The taxpayer sent an email to CRA requesting that the penalty be vacated.  The request was granted, with the official citing that it would not be reasonable to assess such a penalty when it was the taxpayer who initiated the steps to rectify the omission.  

Spence v. Canada Revenue Agency, 2012 FCA 58

Spence had a small amount of unreported income in 2004.  A tax preparation firm prepared his 2006 return but failed to include a T4 slip, resulting in reporting income of $21,696 when it should have been $57,915.  Once source deductions had been accounted for, the reassessment reduced his tax refund by $123.98 to $2,419.10, but also assessed penalties and interest related to the unreported income in the amount of $7,623.85.

With the support of the tax preparation firm, the taxpayer made a request to the CRA fairness committee, but it was denied.  The taxpayer then applied for judicial review by the Federal Court, and an order was made in 2010 setting aside the committee’s decision and referring the matter to a different ministerial representative for redetermination.

On reconsideration, CRA again refused to exercise discretion to cancel the penalty.  An appeal to the Federal Court was dismissed, and this was upheld on appeal to the Federal Court of Appeal.  A factor in determining the reasonableness of the decision was the substantial discrepancy in the reported amount that Mr. Spence “ought to have noticed” before being detected by CRA.

Practice points

  1. Be sure that all T4 slips are in hand well prior to the tax filing deadline, so as not to be in the position of having to file an incomplete return.
  2. If unsatisfied, appeal may be made through CRA channels, and if unsuccessful then on to the court system.
  3. A court may only order the Minister of Revenue to reconsider exercising discretion to waive the penalty, so a clear record of one’s due diligence is important. 

RRSP mortgages and interest deductibility

At issue

Generally a mortgage secured against real estate in Canada is a qualified investment for an RRSP.  An annuitant may even choose to hold a mortgage on his or her own property, though the qualification criteria are more stringent in such situations.

Essentially, where annuitant and debtor are not at arm’s length, the Income Tax Act requires that the mortgage be administered by an approved lender and that it must carry mortgage insurance.  While there are costs associated with these requirements, in a high interest rate environment a RRSP mortgage may be preferable to making payments to a commercial lender, as the interest contributes to the RRSP’s investment return.

Of value to those with rental properties, in the right circumstances it is possible to also deduct interest charges on those mortgage payments made into one’s own RRSP.

CRA 1999-9926175E – Mortgage as a Qualified Investment

The CRA author provides a rundown of the principal sections in the Income Tax Regulations under which a mortgage may be a qualified investment for a RRSP.  Though the relevant sections have since been amended and consolidated, the substance remains effectively the same today.

Included is an admonition that an annuitant cannot benefit from the existence of the mortgage.  In support, the letter goes on to state that “the mortgage interest and other terms must reflect normal commercial practices.”  

In context, this reinforces the purpose of the lender and insurance rules, and should not be taken to suggest that there can be no other benefits whatsoever, such as for example potential interest deductibility where a rental property is involved. 

CRA 2011-0413761E5 – Interest

This CRA letter comments on a hypothetical scenario whereby a taxpayer’s RRSP uses a non-arm’s length mortgage to retire an original loan from an arm’s length bank used to purchase some rental properties.  It confirms that “as long as the rental properties continue to be held by the taxpayer for the purpose of earning income from a business or property”, interest on this second loan – now held by the RRSP – will indeed continue to be deductible.

Duxbury v. The Queen, 2006 TCC 688

To invest in a business, the taxpayer borrowed from a commercial lender by mortgaging his jointly-held home.  Some years later as part of a creditor protection exercise, his RRSP used a mortgage to retire the arm’s length mortgage.  At the same time, the house was transferred into his wife’s name alone.

In a subsequent year, the taxpayer sought to deduct the annual mortgage payment as an RRSP contribution for that year.  CRA denied this claimed deduction, and its position was upheld in this taxpayer appeal.

Given that the original borrowing had been for a business purpose, the interest would have originally been deductible.  Depending on how the RRSP acquired its mortgage from the commercial lender, some or all of that deductibility could potentially have carried through to the RRSP mortgage.  Unfortunately, there is no mention in the judgment of the interest component as distinct from the full mortgage payment, so it is not clear whether the taxpayer could not advance this argument based on the facts, or if the issue was simply not raised.

Practice points

  1. The cost of non-arm’s length RRSP mortgages becomes more palatable in higher interest rate environments.
  2. One is not precluded from deducting interest where a rental property or underlying business purpose can be shown.
  3. Good recordkeeping will assist in tracing the use of funds, particularly where a substitute loan is employed.