The Honeymoon is Over for Canadian Couples – Part Deux: CRA Expected to Announce Prescribed Rate Increase
The last time I wrote about this subject it was 2013, fast forward to present day and here I am three kids later, and having survived a global pandemic…so much has changed but the window of opportunity to income split remains the same.
Since July 1, 2020, high net worth families have been able to take advantage of one of the greatest tax saving opportunities: the 1% prescribed rate spousal loan. Canadians are permitted to make a loan to a spouse at a rate of 1% per year, with the rate being “locked-in” for the life of the loan. These rates are calculated by taking the average yield of Government of Canada 90-day Treasury Bills rounded to the next highest percentage point and are announced quarterly by the Canada Revenue Agency (“CRA”).
Based on April data released by the Bank of Canada, it is expected that the CRA will announce that they will be doubling the prescribed rate to 2%, effective as of July 1, 2022. With only weeks before the rate increase, you should consider if a spousal loan can bring you significant tax savings, and if so, you must act quickly.
Spousal loans are simple in concept. Where there is a higher-earning spouse (including a common-law partner) in or near the top tax bracket, he/she can attribute capital to the lower-earning spouse through a loan that the lower-earning spouse must invest (documentation is required). This tax strategy potentially could yield tax savings amounting to thousands each year.
Consequently, the borrowing spouse is generally taxed (at a lower rate) on the investment income generated from the borrowed funds. By January 30th of the subsequent year, the borrower must pay back the 1% interest, an expense that is deductible for the borrowing spouse but taxable to the lending spouse. Investment earnings in excess of the prescribed rate will effectively be shifted and taxed in the hands of the lower-income spouse. The net effect is that the overall taxes for the family are reduced. This strategy may be most effective after the higher-earning spouse has already maxed out his/her RRSPs and TFSAs, and is looking for non-registered investment vehicles to tax-efficiently grow wealth.
Example
Let us illustrate by way of an example where the wife (e.g., Elana) is in the top tax bracket and the husband (e.g., Andre) has very little income. Elana lends her husband $1M which is currently earning a 6% return. The money is loaned at 1%, or $10,000. Andre would report income of $60,000 on his return with a deduction for the interest of $10,000 leaving $50,000 of taxable income. On the flip side, Elana would report the $10,000 of interest income versus the $60,000 reported in previous years. Effectively, this shifts $50,000 of income (or 5%) from Elana’s return to Andre’s return – where it is now taxed at lower marginal rates.
As can be seen by this example, entering into an income-splitting loan arrangement with your spouse can provide significant long-term tax benefits to your family, with the more money that is lent, the greater the benefit. With the prescribed rate at its lowest possible level, and its forecasted hike on July 1, 2022, now is an optimal time to enter into such an income-splitting strategy.
It should also be noted that Prescribed Rate Loan Planning to a Discretionary Family Trust can similarly serve as a very powerful planning tool to help fund family expenses – such as paying for private school, summer camp, extra-curricular activities, etc.
Takeaway
Since the rate of the loan can be “locked in” indefinitely, eligible Canadians have until June 30, 2022 to lock-in the 1% rate. For this reason, all lending agreements must be finalized before this time. This should include consulting a tax professional who will review your agreements to prevent adverse tax consequences as a result of a poorly structured plan or implementation.
Time is running out on the 1% spousal loan strategy. Act before the prescribed rate rises and take advantage of the income-splitting tax benefits, which are still available. Do not wait until it is too late and the honeymoon is over.
