Tag: Spouse

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.

Valuing a book of business on marriage breakdown – Don’t forget the taxes

The breakdown of a marriage is difficult to work through.  Apart from parental concerns, the most contentious issues tend to revolve around valuing and dividing property.  This can be challenging enough when it’s about bricks and mortar, but can be especially problematic when the nature of the property is unclear.  

Take for example an investment advisor’s book of business.  Is it property?  Is it property that is subject to matrimonial division?  And if so, what value should be placed on it?

These are the key questions raised in LMJ v. RGJ (2015 SKQB 136), a recently reported case from the Saskatchewan Queen’s Bench Family Law Division.  While these issues are not entirely novel, the element of this case that caught my attention was the role that tax played – or arguably did not play – in the valuation.

Nature of a book of business

The definition of “family property” in the Saskatchewan Family Property Act is quite broad. This is not unlike its provincial counterparts, which are also expansively drafted.  

The judge in LMJ v. RGJ did not have to look back more than a handful of years to find a number of family cases in other provinces dealing with valuation of an investor’s book of business.  Consistently it was found that there was goodwill of significant value associated with the client contact, knowledge of investment objectives, and familiarity with historic investments.  

As to whether an advisor may not have the contractual right to take the clients, such a limitation may reduce value but does not detract from the fact that the goodwill is a marketable asset.  In support, a passage is quoted from a 2008 Supreme Court of Canada decision that refers to the “cultural reality” of the investment industry where advisors “frequently change employers”. 

RGJ led evidence from representatives of his dealership to the effect that he had no financial ownership in the book of business, did not own the list of clients and could not sell it.  Though the judge acknowledged the dealer’s regulations, no written contract was produced that explicitly prevented RGJ from taking the clients.  As well it was noted that RGJ’s Will refers to the “proceeds raised from the sale of my client accounts” being held for the benefit of his children, and that the dealer’s business succession plan (to which he was not yet subscribed) paid compensation based on a retiring advisor’s three most recent years of commissions.

Bottom line: the book of business was subject to matrimonial division.

Gross valuation 

RGJ took the position that there should be no value attributed to the book of business.

By contrast, LMJ offered an expert for determination of the value of the book.  The expert’s report considered the most recent three years of RGJ’s gross commissions, recommending a valuation range from $1.8M to $2.1M.  

The judge accepted the three-year approach of the expert, but began one year earlier than suggested, arriving at a value of $1.6M.  This contributed $800,000 towards the ultimately ordered equalization payment of $641,775 from RGJ to LMJ.  

And taxes?

RGJ’s counsel argued that the valuations in the LMJ expert report should be discounted for taxes (and other inconsistencies).  Unfortunately for RGJ, there was no evidence for the court to consider in order to make such a ruling.  

The judge referred to a case from the Saskatchewan Court of Appeal stating that it is not sufficient to merely raise an issue of potential tax liability.  Evidence is required to support a tax discount; in the context of determining capital gains, that would at least require the adjusted cost base and marginal tax rates.  In fact, the SKCA suggests that this evidence combined with the proposed calculation may be sufficient, without the need to bring forward an expert.

At the extreme assuming a nominal ACB on the $1.6M valuation on RGJ‘s book, that could have been a tax discount nearing $400,000.  Alternatively, depending on the nature of the dealer’s business succession program, it is possible that those future payments could be treated as regular income, meaning that close to half could be lost to taxes.  

And finally, consider that the book is not actually being sold presently, presenting a further challenge for RGJ to find the liquidity to fund the equalization payment.