Tag: Investing

Spousal loans now even more compelling

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.

Transferring capital losses between spouses

Advantageous use of the superficial loss rules

Our tax system is based on each individual as a distinct taxpayer as opposed to taxing a pooled unit such as a couple or a family.

Even so, there is a built-in acknowledgement of these personal relationships in many ways; for example, the ability to transfer capital property between spouses at adjusted cost base (ACB). This defers recognition of any existing unrealized capital gains and associated taxes until there is a disposition by the recipient spouse.

But sometimes it may be preferable not to have that ACB rollover apply. One such occasion is when one spouse has capital losses and the other has capital gains. By strategically managing the superficial loss rules, the couple can transfer the loss so that it can be used by the spouse with the gain.

Superficial loss rules

A taxpayer’s capital losses in a year must first be applied against that year’s capital gains, with any remaining net capital loss allowed to be carried back up to three years or forward indefinitely. Where identical property is involved, the timing of those gains and losses is critical.

The superficial loss rules deem a capital loss to be nil if an individual purchases identical property 30 days before or after the disposition (a 61-day window) and still holds the property on the 31st day after the disposition. Concurrently, the ACB of the acquired property is increased by the amount of the denied loss, preserving the ability to claim the loss in future.

The rules also apply if certain related parties carry out a purchase, such as a trust of which that taxpayer is a major beneficiary, a controlled corporation or – perhaps most commonly and central for the purposes of this strategy – a spouse.

By strategically managing the series of transactions, the tax results can be split among taxpayers, enabling a couple to use the rules to transfer a capital loss between them.

Steps to transfer the loss

The strategy is most easily explained through an example. Let’s assume Eve has 300 XYZ Ltd. shares in in her non-registered account with an ACB of $30,000 and a fair market value (FMV) of $20,000. Her spouse Adam already has a realized capital gain of $10,000 this year. To maintain focus on the transfer of the capital loss, we’ll assume no market movements.

Step 1 – Eve sells her 300 XYZ shares on the exchange on day 0.

Step 2 – Within 30 days before or after Eve’s sale, Adam purchases 300 XYZ shares on the exchange.

Step 3 – No earlier than the 31st day after Eve’s sale, Adam sells his XYZ shares on the exchange.

As Adam’s purchase is within the 61-day window, Eve’s $10,000 loss is deemed to be nil. Adam would have spent $20,000 to acquire the XYZ shares, to which is added the $10,000 denied loss, giving him an ACB of $30,000. When Adam sells, he will incur a $10,000 capital loss.

For this to work, Adam must use his own funds for the purchase, or he could obtain (and service) a prescribed-rate spousal loan from Eve if the funds are in her hands. As well, bear in mind that if this is part of a broader series of transactions, the Canada Revenue Agency may seek to invoke the general anti-avoidance rule, or “GAAR.”

It is also possible to transfer the capital loss by transferring property between the spouses directly, for example, shares of a closely held corporation. In that case, the spouses must take the further step to elect out of the automatic ACB rollover that would otherwise apply. A detailed example of this procedure is included in our InfoPage titled “Capital loss planning.”

Mutual funds – Form matters

If the property in question is a mutual fund, remember that investment mandates are often available in trust and corporate forms. The two forms are not treated as identical property under the superficial loss rules.

This could work to a taxpayer’s benefit in trying to reduce his/her own capital gains. Let’s say that a mutual fund trust holding had lost value, but the taxpayer is confident that it is positioned well for the future. The holding could be sold and the corporate version acquired. The superficial loss rules will not apply, so the capital loss will be immediately usable by that taxpayer.

However, for the spousal capital loss transfer to succeed, the spouses actually want the superficial loss rules to apply. Hearkening back to our example, If Eve sells a mutual fund trust and Adam acquires a mutual fund corporation, Eve will have a capital loss that she has no present use for. For the capital loss to transfer, Adam must be sure to buy the same mutual fund trust as Eve held.

As a final note, be aware that a mutual fund company’s frequent trading rules could affect the timing of transactions and possibly their cost. It would be well-advised to vet the intended transactions with a tax professional to be sure that they carry out as intended.

Fee-based accounts on the horizon? – Regulatory initiatives and tax implications

In December 2012, the Canadian Securities Administrators (CSA) launched a consultation on mutual fund fees, with formal submissions due by April 2013.

This has focused media and public attention both on the cost of investing and on the nature of how such costs are charged. In turn, questions on fee deductibility have been coming in to our Tax & Estate InfoService with increased frequency in the past few months, and are a regular topic of conversation I myself am having with advisors in the field.

Accordingly, it’s an opportune time to revisit the conditions under which investment counsel fees may be deductible, and how fee-based accounts and mutual fund management expense ratios (MERs) compare for tax purposes.  

International initiatives in fee disclosure

For some added context on what’s possibly been influencing the CSA, it may be beneficial to look at what a number of jurisdictions are doing regarding investment fund fee structures. Many have reviewed them over the past few years, with varying degrees of change coming or proposed:

  • United Kingdom – Effective January 1, 2013, the Prudential Regulation Authority (PRA) requires that advisors set their own charges for their services in agreement with their clients. Specifically, they may no longer receive commissions set by product providers or otherwise embedded in the cost of the product
  • Australia – Effective July 1, 2013, Future of Financial Advice (FoFA) reforms will ban commissions that may allow product providers to influence advisor recommendations, such as sales commissions and trailing commissions. Advisors must negotiate fees for advice directly with retail clients and renew their advice agreements every two years if clients are paying ongoing fees
  • Europe – In the second quarter of 2013, the European Securities and Markets Authority (ESMA) is expected to publish new guidelines for investment firms. These are designed to ensure the consistent and improved implementation of existing conflicts of interest and conduct of business requirements concerning remuneration
  • United States – In 2010, the Securities and Exchange Commission (SEC) proposed Rule 12b-2, which would cap charges for certain distribution activities (including trailing commissions) at 0.25%. Fees above this amount would be allowed, but would have to be explicitly disclosed as an “ongoing sales charge” subject to a cumulative limit calculated with reference to front-end sales charges. The rule has not yet been finalized

On the international stage, clearly there is both direction and momentum toward fee-based advisor compensation. Whether and just how far Canadian regulators may go in this regard, we’ll have to wait and see. In the meanwhile, it’s worthwhile for Canadian advisors to understand the business and tax implications of fee-based billing practices.

Deductibility – The base case

An investor is entitled to deduct investment counsel fees for advice regarding the purchase or sale of specific shares or securities, or for services relating to the administration or management of shares or securities. Furthermore, the fees must be paid to an individual or firm whose principal business is to advise or provide service in such investment matters. As per the Canada Revenue Agency (CRA), “principal business” is satisfied where 50% of either time or gross revenue is spent on the activity. Understandably, the amount of fees must be reasonable in the circumstances.

Fee deductibility does not necessarily extend to all aspects of the business offerings provided by an advisor. Specifically, it does not apply to general financial counselling or planning, nor does it apply when associated with generating tax-exempt income, which includes registered accounts, such as RRSPs, RRIFs and TFSAs.

Fee-based versus MERs: Differing deductibility?

Inevitably the question arises whether a move to a fee-based model – by choice or requirement – will change the tax implications for the investor.

In this regard, a persistent myth exists that deductibility may only be available for fees directly charged to an investor, but not for fees charged internal to a mutual fund. In an article last year (Fundamentals, January 2012), I used a line-by-line comparison to show the effect of earning fully taxable income, such as interest or foreign dividends. The result is the same whether a full MER is charged within the fund or a lower F-series MER in the fund is combined with the advisor charging the difference as a direct fee.

However, where income is not fully taxable, a fee-based account may have an advantage. Take the example of a mutual fund that has only preferred income, such as Canadian dividends, capital gains and unrealized capital gains. An internally charged MER reduces this preferred income, but if some of that fee is directly charged to the investor by the advisor, it can reduce other fully taxable income.*

Aligning advisor and investor interests

Obviously, regulators are operating within their consumer-protection role in exploring investment fee structures, whether that is in pursuit of avoiding conflicts of interest, having greater transparency or encouraging optimal investment choices.

Whatever the impetus, direct-fee-billing practices may become more common as a result, and, in turn, this will affect advisor-investor relationships.

Considering the tax front on its own, investors holding all or most of their investments in registered accounts will have nothing to gain by moving to directly charged fees. For those with significant non-registered investments, however, a move to fee-based could yield a net positive result, even if overall costs remain the same.

* Note: For Quebec provincial taxes, deductions can only be taken against investment income earned. For more details, see our InfoPage titled “Deductibility of investment fees.”