Prescribed Rates Going Up July 1:  Pay Taxes, Make Tax Efficient Spousal Loans Now

Evelyn Jacks

Prescribed interest rates are about to rise for July 1 to September 30. One interesting and potentially beneficial financial strategy to grow the family’s wealth is to draw up an interspousal loan.  The time to draw up the paperwork and lock in the current 1% prescribed rate is before the end of the month - June 30.  Taxpayers who owe money to CRA will want to pay up before then too.  Here are the details: 

Prescribed interest rates are currently very low (1%) but only until June 30.  Effective July 1 to September 30 the rates are going up, as follows, and those taxpayers who owe balances due to CRA should be particularly concerned with the new interest rate they will pay:

• 6% - For overdue taxes, CPP contributions, EI premiums due
• 4% - For non-corporate taxpayer overpayments owed by CRA
• 2% - For corporate taxpayer overpayments owed by CRA
• 2% - To calculate taxable benefits for employees and shareholders from interest-free and low-interest loans

That brings an immediate opportunity to draw up spousal loans before the end of the month.  Here’s how they work and some of the benefits:

The CRA frowns on the transfer of income or assets between family members.  Under the “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 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, here’s what needs to happen:

• 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 Canada Revenue Agency’s prescribed rate (currently 1%).
• The spouse receiving the loan must pay the interest owing to the lender every year within 30 days after year end (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:  If one spouse has a much higher income than the other, there are numerous benefits to setting up interspousal loans, especially when prescribed interest rates are low.  They are  locked in 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:  Check out the following Professional Certificate Course from Knowledge Bureau:  Investment Tax Strategies. While this course provides professional training, owner-managers may find this knowledge will help them have better conversations with their accountants, lawyers  and financial advisors and thereby make more tax-astute financial decisions.