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Spousal loan strategy can reduce tax bill

Tax increases from current regimes in Canada may have sapped some of the energy from a few of us, but like a Monty Python character, tax planning is not dead yet, and never will be.
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Tax increases from current regimes in Canada may have sapped some of the energy from a few of us, but like a Monty Python character, tax planning is not dead yet, and never will be.

The spousal loan strategy, a well-established technique, shifts future investment income from the high-income/higher-taxed spouse to the lower-income/lower taxed.

In order for this to be useful, a fairly rare set of circumstances has to arise, like the story below.

Meet Bill and Patty:

Business owner, Bill Logdodger earns $215,000 per year, substantially more than his wife, Patty, who makes $50,000 as bookkeeper for the family business.

Bill recently sold an investment property he owned solely, resulting in a fortuitous $1,000,000 after-tax mid-life bonus.

His business/employment income had already put Bill in the highest tax bracket, at nearly 50 per cent, before any taxable income arising from income on the recent windfall, if he were to invest it directly.

Patty's low income keeps her in a lower tax bracket, presently around 28 per cent, nearly 22 per cent lower than Bill's.

If Bill gives the money to Patty, and she invests it, the Canada Revenue Agency (CRA) will claw her investment income back to him, using an anti-avoidance regulation called "attribution."

So now what?

The concept

Instead of investing it himself, or giving it to his wife, Bill lends the $1,000,000 to Patty. That's right, he must make an actual loan, complete with formal documentation.

Bill must charge Patty interest of at least the "prescribed rate" set out by CRA. In our low interest rate environment, this means his interest income from Patty will be very modest, presently two per cent. Bill's income on the $1,000,000 will be $20,000.

Patty then invests the $1,000,000 in her own name, and hopefully earns much more than the loan interest over time.

Any interest income, capital gains or dividend income from this portfolio will be taxed in her name alone, at her much lower marginal rate. She then claims this income, less the loan carrying costs, the $20,000 annual interest.

Crucially, Patty must pay the loan interest to Bill each year by Jan. 30. If the interest payment is late by even one day, those pesky attribution rules will apply for that year, and all subsequent years, sucking the income and related taxes back to Bill.

The CRA-prescribed rate in effect at the time the loan is made is locked-in for as long as the loan is outstanding, regardless of subsequent changes to the rate.

The lower this rate, the greater the tax saving opportunities for Bill and Patty.

Implementing

the strategy

As noted above, this strategy only works in a narrow set of circumstances.

The couple needs, a) wide income differential, b) a large non-registered account in Bill's name, and c) an accountant and lawyer to bless the idea.

Of course, the bigger the numbers, the more it's likely to make sense.

If the assets are not already in cash form, Bill should consider the tax cost of cashing out, which may trigger capital gains (or losses).

Bill could also review his Notice of Assessment to determine if he has capital losses carried forward that could be used to offset any new capital gains realized.

Patty's loan is backed by a promissory note and a formal written agreement setting out its terms.

She (they) should ideally consult a qualified legal advisor first, although it need not be a complex agreement.

The loan papers should be filed away as safely as an arm's-length loan documentation - or even more safely.

Bill should lend money from an account solely in his name to an account solely in Patty's name, rather than muddle the paper trail with joint accounts.

Keep it squeaky clean, so it will survive an audit. It's not like the CRA is our friendly neighbourhood tax coach.

Next, Patty builds a portfolio with the proceeds

Generally, the spousal loan strategy will only be effective if the annual income generated from the portfolio is greater than the interest rate on the loan.

If Bill sells some of his investments at a loss before lending the cash to Patty, they must be mindful of the superficial loss rules.

Patty must wait at least 30 days before acquiring the identical securities which triggered Bill's losses, or the capital loss Bill triggered will drift away in the gust of eastward Ottawa-bound wind. An easy work-around is to replace the loss positions with highly-correlated positions.

Patty can make the interest payments by writing a cheque to Bill or by transferring the funds from her solely-owned account to Bill's solely-owned account. She should clearly document that the payment is for interest owed on the loan.

Benefits of

the strategy

The main benefit here is lowering your family's overall tax bill by shifting some income from Bill's 50 per cent tax rate to Patty's 28 per cent rate. While it might not add up to much in a year, over time it will, if you find yourselves among those lucky enough to qualify.

And if you do, you've already won a lottery of sorts, but there's still no point in paying more tax than you are required to.

Mark Ryan is an investment advisor with RBC Dominion Securities Inc. (Member - Canadian Investor Protection Fund), and these are his views, and not those of RBC Dominion Securities. This article is for information purposes only. Please consult with a professional advisor before taking any action based on information in this article.