Tag: Spouse

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.

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.

Revoking a spouse beneficiary on separation

At issue    

The breakdown of a marriage is seldom a pleasant or simple process to work through.  One potentially problematic aspect of this is how to deal with the revocation of life insurance and RRSP/RRIF/pension beneficiary designations.  Despite expressed intentions and commitments in a separation agreement, additional positive steps may be necessary to give effect to a purported change.  

Here is a recent trial court decision where an ex-spouse remained on record as life insurance beneficiary, and a couple of appeal court decisions that provide further context.

Love v. Love, 2011 SKQB 176

The separation agreement made reference to the husband’s pension, but made no mention of the group life insurance on which the wife was the named beneficiary.  Following separation, the husband sent an email to his employer’s human resource department requesting the necessary paper work “to change the beneficiary on my pension etc. (from my former wife to my son).”  After his death, the incomplete form was found in his files.  

The court held that an email could suffice as a “declaration” to change a beneficiary under the Saskatchewan Insurance Act.  On the facts however, neither the reference to the policy (“etc.”) nor the new beneficiary were sufficiently clear, particularly as there were actually three sons.

Richardson Estate v. Mew, 2009 ONCA 403

The Ontario Court of Appeal provides a useful summary of cases involving the interaction of separation agreements and beneficiary designations, and enunciates some principles for analyzing the cases:

“A former spouse is entitled to proceeds of a life insurance policy if his or her designation as beneficiary has not changed. This result follows even where there is a separation agreement in which the parties exchange mutual releases and renounce all rights and claims in the other’s estate.  General expressions of the sort contained in releases do not deprive a beneficiary of rights under an insurance policy because loss of status as a beneficiary is accomplished only by compliance with the legislation. The general language used in waivers and releases does not amount to a declaration within the meaning of the Insurance Act.”

Martindale Estate v. Martindale, 1998 CanLII 4561 (BCCA)

The British Columbia Court of Appeal held that, on the facts in evidence, it would be a breach of the separation agreement for the ex-husband to claim insurance proceeds from the death of his ex-wife.  Instead, he received the proceeds only as trustee of a constructive trust for the benefit of the intended beneficiaries. 

In the words of the Court, “it would be against good conscience for the appellants to keep this money because Mr. Martindale had, by the separation agreement, surrendered any right he might have had to the property of the deceased.”

Practice points

  1. Separating spouses and their lawyers should be sure to direct their minds and their drafting to explicitly address life insurance and RRSP/RRIF/pension beneficiaries in the separation agreement.
  2. The Martindale result should be viewed as the exception to the general approach expressed in the Richardson case.  To achieve greater certainty, separated spouses should change beneficiaries using each respective institution’s forms and procedures.