January 30:  Pay Interest on Spousal Loans

Evelyn Jacks

At rising prescribed interest rates, interspousal investment loans have not been as lucrative  for income splitting purposes as in years past.  Nonetheless if you have one, beware that the borrower must pay the lender the interest due on the loan by January 30 or the arrangement will be nullified.  You may wish to refresh on the rules:

Income splitting is a legitimate strategy, but only in certain instances because of 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.

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.

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 6%).

Worse, 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 purpose. 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.

Make a Big Difference.  CRA has very specific rules and lots of tax traps to avoid when it comes to its Attribution Rules and inter-spousal loans in particular.  Remember, 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. 

Evelyn Jacks is the President of Knowledge Bureau and best-selling author of 55 tax and financial books.  She tweets @evelynjacks.

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