Income Splitting – Prescribed Rate Loans
A common question that gets asked is, “Are there any ways of splitting income with my spouse?” This is especially popular when two spouses have significantly different levels of income, meaning that they are taxed at vastly different marginal tax rates. In the ideal scenario, the higher-income spouse would be able to shift some of their investment income to their spouse’s tax return in order to utilize the marginal rate tax system in Ontario and pay lower taxes overall. In Ontario, the lowest combined tax bracket is 20.05% which is the tax rate that an individual would pay on most income sources up to about $45,000 of taxable income. In Ontario, an individual starts to pay a 53.53% combined income tax rate on most sources of income when their taxable income exceeds $220,000. As shown, there are varying tax rates that are levied in Ontario which makes it desirable to income-split with your spouse, given the right circumstances.
One potential income-splitting strategy is to provide your spouse (or a family trust) with a prescribed rate loan. It is important to highlight the difference between “a gift” to a spouse (or a family trust) and a “prescribed rate loan” to a spouse (or a family trust). If funds are gifted to a spouse, then the income generated from that gift are subject to the attribution rules of the Income Tax Act and the income is reported on the gifting individual’s tax return resulting in no income-splitting benefit. This prescribed rate spousal loan strategy also avoids any negative implications of the Tax on Split Income (TOSI) rules. In order to avoid the attribution rules, the following criteria must be met:
- Interest must be charged on a loan at a rate equal to or greater than the prescribed rate that was in effect at the time the loan was made; and
- The amount of interest that was payable in respect of each year the loan is outstanding is paid no later than January 30 of the following year.
The current prescribed rate (as of July 1, 2020) is 1%, meaning that this strategy is as desirable as ever since the recipient of the loan only has to pay interest at 1% in order for this strategy to be effective. In addition, this strategy is only effective if the loaned funds are generating income at a rate that is higher than the prescribed rate, which is now more easily attainable since the prescribed rate is down to only 1% (previously 2%).
Please see downloadable table below for an comparative example of the tax savings calculation by effectively utilizing the prescribed rate spousal loan.
There are some additional steps that need to be undertaken in order to formalize the spousal loan and to be in accordance to Canada Revenue Agency’s (CRA) protocols:
- A promissory note should be drafted and signed by both parties to formalize the terms of the loan.
- The interest on the loan needs to be paid, preferably from an account solely in the payer’s name to an account solely in the recipient’s name, before January 30 annually. Documentation such as cancelled cheques or proof of transfer should be retained for CRA audit purposes.
Further considerations need to be explored if any US persons (US resident, US citizen or green card holder) are involved in this type of arrangement. These issues are beyond the scope of this article.
In closing, the prescribed rate spousal loan strategy can be an effective way to income-split with your spouse in the right circumstances. It is also important to ensure you are following all of Income Tax Act’s rules to ensure you are onside should CRA ever review the details of the loan arrangement. Contact one of our Taxation Professionals if you feel you may benefit from a prescribed rate spousal loan arrangement.