Inter-Spousal Loan Planning: Prescribed Interest Rates Stay at 1%

Beth Graddon with excerpts from EverGreen Explanatory Notes

Prescribed interest rates have remained unchanged throughout the pandemic and will remain at 1% for the fourth quarter of 2021.  It’s a good idea to discuss this opportunity with clients well before year-end, while CRA’s prescribed interest rate for interspousal loans is still at this low level. It’s a tax planning ritual not-to-be-missed, especially with high net worth clients.

Under normal attribution rules, any money transferred from one spouse, typically the higher-income spouse, to another is deemed to be taxable in the hands of the transferor, at that person’s higher marginal tax rate.  Income splitting opportunities are therefore thwarted.

However, interspousal loans are an important exception to this rule, as long as they are set up and adhered to correctly. With such a loan, any investment income earned from the money transferred to the lower-income spouse will be taxed at that person’s lower tax rate. This can lead to significant savings on the couple’s total tax bill. But to legitimize the transaction, certain tax rules must be followed:

• The loan must be documented properly in writing, for example with a promissory note, including repayment terms, following normal commercial lending rules.
• The lending spouse must charge the other spouse interest at least equal to CRA’s prescribed rate (currently 1 percent).
• The spouse receiving the loan must pay the interest owing to the lender every year within 30 days after year end (note, that is by January 30). Failure to meet this condition will result in the normal attribution rules kicking in, meaning that income earned from the loaned money will be taxed in the hands of the higher-income spouse in that year and all future years.
• The lending spouse is required to report the interest received as income on his or her income tax return.
• Conversely, the borrowing spouse can deduct the interest paid on his or her tax return, as long as the loan was used to purchase income-producing assets with the potential of earning passive investment income (interest, dividends, rents or royalties), within in a non-registered account.
• The spouse receiving the loan is required to pay back only the interest due; there is no requirement to repay the principal.

Bottom Line:  Tax and financial advisors can calculate the tax advantages; setting up interspousal loans now at the 1% prescribed rate locks in the rate for the life of the loan.  That’s important with the real possibility of more interest rate hikes increasing as time goes on and Canada’s economy starts to recover.

Additional Educational Resources:  This article includes excerpts from EverGreen Explanatory Notes, your go-to tax research library. Subscribe today!

Or check out the Investment Tax Strategies Certificate Course, part of the MFA™-Pension & Estate Services Specialist Program.