Today’s Interest Rate Cut is Good News!

Evelyn Jacks

Canada’s inflation target is now back to 2%, resulting in a half a point cut to the Bank of Canada’s benchmark rate t to 3.7% from 4.25% this week.  That’s good news for those managing or acquiring debt, and for spouses wishing to do some investment income splitting in the new year. This is especially important now that each individual has a $250,000 threshold for claiming capital gains at a 50% inclusion rate.   Here’s how it works:

What are the prescribed interest rates?  Calculated quarterly, prescribed interest rates for these purposes are based on the average yield of three-month government treasury bills sold in the first month of the previous quarter.  The prescribed rates for the current quarter (October to December 2024) are as follows:

• 9% -  interest rate charged on overdue taxes, Canada Pension Plan contributions, and employment insurance premiums as well as insufficient quarterly tax instalment remittances.
• 7% - interest rate paid by CRA on non-corporate (individual) taxpayer overpayments.
• 5% - interest rate paid by CRA on corporate taxpayer overpayments, as well as taxable benefits for employees and shareholders from interest free and low-interest loans, including loans to spouses.

Setting up Inter-spousal loans.  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.   That makes Income splitting more difficult between spouses.

However, interspousal loans are an important exception to this rule, as long as they are set up correctly.  If so, 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, especially when we take into account the new capital gains inclusion rate rules, and the requirement to make quarterly instalment payments as well.

But to legitimize the transaction, here’s what needs to happen:

CHECKPOINT:  DRAWING UP A SPOUSAL INVESTMENT LOAN

• 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 5 percent).
• 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.
• The indebted 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 indebted spouse is required to pay back only the interest due; there is no requirement to repay the principal.

Bottom Line – While the annual prescribed interest rates used for inter-spousal loans is currently 5%; the prescribed rates may go down further given this week’s interest rate reductions from the Bank of Canada , which means that it might make more sense to wait and draw up new inter-spousal loans in 2025.  It’s a part of a year end tax planning discussion advisors and their clients should be having now.

Evelyn Jacks is President of Knowledge Bureau, multiple award winning business leader and author of 55 books on personal tax and wealth management.  Follow her on twitter and linked in!