Tag: Prescribed rate loan

Easing spousal loans – A CRA commentary offers repayment flexibility

Prescribed rate loans are a mainstay of spousal income splitting. A high-income spouse lends to a low-income spouse to invest in a non-registered portfolio, allowing investment income and associated tax to shift from the former to the latter.

So long as interest on the loan is paid according to the rules, it may remain outstanding indefinitely. As the portfolio grows, spouses may also be motivated to keep a loan going for another reason: If the whole portfolio must be sold to retire the loan, there may be an unwelcome realization of large capital gains.

But does the whole portfolio really have to be sold? Recent comments from the Canada Revenue Agency (CRA) suggest that loan retirement is more flexible and tax-friendly than may have been feared.

Recapping the rationale

Our progressive rate income tax system is based on the individual as the taxed unit. If you as a high bracket taxpayer try to work around this by making a gift to someone close to you, like a spouse, investment income on that gifted property will be attributed back to you. However, if this is done through a loan charging interest no less than the prescribed rate according to tax regulations, there is no attribution.

The prescribed rate is set quarterly, 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. It is presently at 1%, its lowest possible rate, and will continue that way until at least March 2021.

The borrowing spouse is taxed on the investment income less interest paid, and in turn the interest is taxable to the lending spouse. The interest must be paid during the year, or no later than 30 days after year-end. As well, there must be an actual payment, meaning that it can’t just be a bookkeeping entry or further gift or loan from the lender.

Failure to comply with the rules at any point will taint the arrangement, such that attribution will apply for that year and on into the future.

Paying down or replacing loans

While the loan may remain outstanding indefinitely, there may be situations where it would be desirable to pay it off. For example, the borrower may inherit or otherwise come into a substantial sum.  Arguably that money could be invested alongside the existing arrangement, but depending on what else is going on in their lives at the time, the couple may decide it’s best to retire the loan.

Another scenario is where there is an existing loan that was established while the prescribed rate was higher than at present. A lower interest rate would both increase the borrower’s net return and decrease the income inclusion for the lender. As the rules do not allow the couple to simply change the rate by stroke of a pen, the past loan must be closed-out before a new one can be advanced.

Assuming there’s no other money in reserve, the source to pay off the existing loan would have to be that same investment portfolio. Playing devil’s advocate (without casting aspersions on our tax authority), with anything short of full disposition, could it be argued that the borrower is still investing and earning off the original borrowed money? If so, would that then taint the second loan from the beginning?

Favourable CRA view on refinancing

At the Canadian Tax Foundation conference in October 2020, the CRA was given the scenario of an original $100,000 prescribed rate loan at 2% that had grown through investment to $200,000. It was asked about the implications if the borrower sold half the investments to retire the loan, followed by a new $100,000 loan at 1%, also to be invested.

With respect to potential attribution on the continuing investment from the original loan, the CRA official quoted a section from IT-511R that allows exemption from attribution once “the loan is repaid” – Nothing more was said on the point. With respect to investment of the second loan proceeds, it was acknowledged that it could similarly qualify for the exemption from attribution, as long as all other conditions are satisfied.

Helpfully, CRA further mentions the attribution rule where a new loan is used to pay an existing loan. The response expressly notes that this rule “would not technically apply in this situation as the proceeds from Loan 2 are not used to repay Loan 1.”

This is good news for spouses looking to refinance a loan at a lower rate while keeping from triggering excessive capital gains on appreciated investments. As CRA itself highlighted, form and process matter here, so the couple should take care to execute the steps in the approved order, and document accordingly.

Spousal loans, real estate, RRSP earned income – Connections and opportunities

As we head into the second quarter of 2012, the unprecedented run of historically low prescribed interest rates on spousal loans continues.  Based on the relevant t-bill auction in January, the 1% rate will be available until at least mid-year.

For spouses who remain on the precipice of establishing such a loan, it occurred to me that a closer look at RRSP earned income could push them over that edge.  Specifically, what further benefits might the couple gain where the borrowing spouse deploys the invested money into rental real estate? 

Spousal loans

The spousal income attribution rules cause passive income on gifted funds between spouses to be attributed to the benefactor spouse.  The rules apply only to the initial income, which is to say that income-on-income or ‘second generation income’ is that of the receiving spouse. 

Attribution will not apply at all however where the receiving spouse has provided fair market value assets for the subject funds or where the spouses have entered into a bona fides loan arrangement.  

If a loan is used, the interest rate must be no less than the prescribed rate, and must be paid from the borrower’s own resources no later than January 30 following each calendar year the loan is outstanding.  The interest payment is income to the lender and a deduction for the borrower.

So how might a spousal loan assist a spouse’s RRSP?

Spouse’s RRSP

To be clear, I am not referring to a contribution (and deduction) by a high income earner into a spousal RRSP.  No doubt that avenue will have been canvassed and employed as a first step in tax-managing the couple’s wealth.  Rather, this is a subtler approach that attempts to bolster the tax efficiency of the receiving spouse’s contribution to the household wealth.  

Despite being a lower income spouse in a relative sense, that characterization does not mean that he or she is at the lowest bracket level.  Accordingly, the receiving spouse may him/herself still wish to make use of RRSP contributions as a means of reducing current income in anticipation of being in a lower bracket in future retirement years.

Connection to ‘earned income’

Most people would consider their entitlement to RRSP room to be inextricably tied to their employment income.  Principally that would be true for a large part of the population, but the definition of earned income (upon which the room is based) is much broader than that, including: 

  • Royalties from authorship or invention 
  • Net research grants
  • Unemployment benefit plan payments
  • Wage loss replacement plan benefits
  • Proprietor/partner active business income 
  • Qualifying support payments received
  • CPP/QPP disability pensions
  • Net rental income from real estate

Thus, borrowed money that is devoted to rental real estate investment can serve the dual purpose of generating income taxable to the receiving spouse, and increasing that person’s RRSP contribution room.  While a similar effect may be achieved where borrowed funds are placed in an active business, that obviously requires someone of an entrepreneurial bent to carry out.

Back to our real estate application, it is critical that the loan be properly documented and conscientiously serviced.  Should the loan fail to qualify in a future year, not only will that income be attributed to the lending spouse, but also the related entitlement to RRSP room.  Given that presumably the higher income spouse will already be maxing RRSP contributions, the couple will then lose out in both respects.

Income splitting in the TFSA era

The practice of income splitting has been around for decades.  Essentially it is the process of shifting income recognition from a high tax bracket individual to a low bracket individual, most often carried out between spouses.

With the implementation of the tax-free savings account (TFSA) in 2009, another legal avenue has opened up for those seeking to reduce household tax costs, both on its own and potentially in coordination with existing strategies.

Existing splitting strategies

Tax authorities will often seek to impugn aggressive splitting practices by attributing income apparently earned by a low bracket spouse back to a high bracket spouse. Still, there are many common strategies that are allowed and indeed encouraged by our income tax laws.

Second-generation income – Once income has been earned and recognized, the income on that income is taxable to the receiver spouse.  For this reason, one may choose to turn over such a portfolio more often in order to move more quickly into next generation income. 

Spousal loans – Income earned on money loaned from a high bracket spouse to a low bracket spouse will be taxed in the latter’s hands so long as required interest is paid.  Ironically, the recent economic downturn carried with it a positive twist for such loans as the prescribed rate has been at its lowest calculated point of 1% for the last year.

Fair market value exchanges – If a low bracket spouse provides assets of fair market value equal to money provided by the high bracket spouse, income earned on that money will be taxed to the receiving spouse.

Pension income splitting – Since 2008, one may elect to have up to 50% of certain pension type income sources allocated and taxed to a spouse.

Spousal RRSP – Contributions to a spousal RRSP may be withdrawn by that spouse and taxed to him or her in the 3rd calendar year after last contribution.  While taking care not to imperil later retirement needs, some such withdrawals could be timed to coincide with a spouse’s temporary low income period, such as a sabbatical or maternity leave. 

CPP pension sharing – Spouses may pool and then split their pension credits in order to shift some of the entitlement and taxation to the low income spouse.

TFSA strategies

One may provide money for a spouse’s TFSA, and the growth in value of the TFSA will belong to that spouse.  Essentially there is no income to be attributed.  That’s a $5,000 non-attributable deposit generating tax-sheltered income each year, with that figure indexed to inflation every 3 or 4 years.

To put the value of TFSA contribution room in perspective, remember that TFSA deposits are after-tax.  For a rough estimate of how that compares to pre-tax RRSP room, one divides by “1 minus marginal tax rate”.  For two spouses operating under a single income in a 45% bracket, their combined TFSA room equates to about $18,000 as a pre-tax figure – almost doubling the $21,000 tax sheltering room available under the RRSP alone in 2010.

If desired, that receiving low bracket spouse could pledge the TFSA as collateral to a lender in order to leverage invested assets.  As legal owner of the TFSA, all associated income would be that of the low income spouse, and of course the interest charges should be deductible. 

Arguably, the receiving spouse could employ the earnings from this leveraged strategy to assist in existing splitting strategies, for example to facilitate the eventual retirement of outstanding prescribed rate loans.  Care must be taken however to assure that the particular steps do not cross one over into the TFSA advantage rules and/or fall within the purview of the GAAR.  For these reasons, qualified tax advice should be sought before undertaking any more elaborate steps beyond plain vanilla spousal TFSA contributions.

Whether wealthy or not, the TFSA rules offer one further advantage to spouses, which is the ability to name a spouse as successor account holder.  At death, the account may roll to the survivor spouse, while having no effect on his or her TFSA room.  Be aware though that any unused TFSA room of the deceased spouse is forever lost.  

Accordingly, in situations where a serious illness has thrust upon the couple the need for terminal estate planning, it may be prudent to fund-up a TFSA before death, using a loan if necessary.  The loan could be retired after account transfer following death, thus preserving as much tax sheltering as possible for the widowed spouse.