Deadline January 30:  Interest on Spousal Loans

Did you set up an inter-spousal loan to do some investment income splitting last year?  You would have been wise to do it within the first two quarters of the calendar, when the prescribed interest rate was 1% – compared to 4% today. Also wise: The borrower must pay the lender the interest by January 30 – less than a week away – or the arrangement will be nullified. 

Inter-spousal loans allow couples to split capital gains and other investment income earned on "property”. The idea is the higher-income spouse lends money to the lower-income spouse, allowing the latter to purchase either real or financial assets. Then, the money earned on the property and the gains on the property's disposal will be taxed in the hands of the lower-income spouse, who presumably has a lower income tax rate.

Income splitting is a legitimate strategy, but only in certain instances because of what’s known as the Attribution Rules.   These rules prohibit the loan or transfer of funds from higher to lower earners in the family in order to reduce taxes, except in very specific instances.

In the case of inter-spousal loans, CRA requires the loan to be set up formally with commercial terms that include a repayment schedule that’s put in place at the time of the loan.  The annual interest rate charged can be no less than the prescribed rate of interest (this changes quarterly and is currently 4%).

If the spouse who is doing the borrowing does not stick to the repayment schedule, the CRA will not recognize it as a loan and as a result, will attribute the income earned back to the lending spouse. That of course defeats the whole purposes.

To legitimately bypass the Attribution Rules, it is necessary to maintain the structure of the loan.

The borrowing spouse, therefore, must pay the lending spouse the prescribed interest within 30 days of the end of each calendar year, that is, no later than Jan. 30.  That’s important – paying the interest by the end of the month, January 31, is too late.

The lending spouse is required to report the interest received on his or her income tax return as interest income. Assuming the loan was used to purchase income-producing stocks in a non-registered account, the borrowing spouse can deduct the interest paid on his or her tax return.  However, if the money was used to invest in a registered account – the spouse’s RRSP, TFSA or RESP, for example – there is no interest deductibility. 

Transfer of Assets

The transfer of the assets in the non-registered account will take place at the Adjusted Cost Base (ACB). That means future equity growth is taxed in the lower spouse’s hands as well.  However, it is possible to transfer assets at Fair Market Value (FMV) and either pay the tax on a resulting capital gain or use the opportunity to sop up capital losses.   In this latter instance, no inter-spouse loan is required as the spouse has received the assets at FMV, which becomes his/her cost base, and will report subsequent earnings as well.

It's also important to note the Attribution Rules do extend to children – adult or minor - as well.  In the case of adult children, income and capital gains earned on gifted or loaned amounts are taxed in the hands of the adult child, unless there are obvious tax avoidance indicators; that is if the key purpose of the loan was to reduce the higher income earner’s taxes payable.  

For minors, dividend and interest income will be attributed back and taxed in the hands the transferor until the child turns 18; capital gains, however, are taxed in the hands of the minor child.  (Note, where dividends are distributed to non-active members of a private corporation, at any age, top tax rates will be charged, unless certain exceptions are met).    

Bottom Line:  There are some good opportunities to get better after-tax results from investments by transferring assets from one spouse to another in order to do some income splitting down the line.  In fact, no wealth management plan is complete without a roadmap for family asset transfers.  Be sure to work with a DFA-Tax Services Specialist™ and an RWM™ (Real Wealth Manager™) to get the numbers – and the paperwork – right.

Additional Educational Resources:

RWM™ (Real Wealth Manager™) With the training, tools and processes, become an RWM™ that is highly trained to consider a client’s accountable financial outcomes with a consistently high standard of care. Over the long term, you’ll contribute not only as a knowledge specialist, but most importantly, as the primary advisor trained in the inter-advisory discipline of Real Wealth Management™. Specifically, the RWM™ possesses:

• Deep Knowledge in a field of specialization suitable to their clients’ needs:
• Investment Income Services
• Retirement Income Services
• Tax Planning Services
• Succession and Estate Planning Services
• A Strategy and Process for joint decision-making as illustrated below:

“Knowledge Bureau, with their first-class courses, offers a sustainable, long-term educational framework for industry professionals.

This is about implementing the Real Wealth Management process from an emotional intelligence, as well as a technical point of view, to guide clients in achieving their goals”

—Stefanie Keller, CFP, RWM™

DFA-Tax Services Specialist™ As a designated specialist, provide high level advice with deep knowledge and top skills in your field. Study time is flexible—take up to 18 months to finish.

Tuition includes these resources:

• Personal course selection consultation
 • Virtual campus orientation
 • Lesson and study plans
 • Personal instructor email support
 • Comprehensive Knowledge Journal
 • EverGreen Online Research Library
 • Knowledge Bureau calculators
 • Testing and certification
 • CE/CPD accreditation
 • Examination, certification and designation

“The content in each course at the Knowledge Bureau was superior to most courses I have taken at other institutions. Navigating the courses was easy and the online instruction, readings and exercises were geared towards real life, which made things easier to understand.”

-Melanie Adams, DFA - Tax Services Specialist™ and MFA™ - Business Services Specialist

Evelyn Jacks is Founder and President of Knowledge Bureau, holds the RWM™, MFA ™, MFA-P™ and DFA-Tax Services Specialist designations and is the best-selling author of 55 books on tax filing, planning and family wealth management.  Follow her on twitter @evelynjacks.

©Knowledge Bureau, Inc.  All rights Reserved