How to Take Advantage of Income Splitting Using Intra-Family Loans

Solutions Magazine: Winter Edition 2010

Income splitting involves the transfer of income from a high- income earner to a family member in a lower tax bracket.The lower- income individual is taxed at a lower marginal tax rate, so the family pays less tax overall.

The problem is that the Canada Revenue Agency (CRA) restricts most forms of income splitting through the Income Tax Act’s attribution rules. An individual cannot simply give a spouse $100,000 to invest and have the spouse declare the investment income on his or her tax return so the money is taxed at a lower marginal tax rate. In such a situation, the investment income would be “attributed” back to the individual and taxed at his or her higher marginal rate.
There are, however, a few legitimate ways to split taxable income with a spouse or minor child. In a low interest rate environment, one of the most effective strategies is through an intra-family loan to a spouse or another family member.

WHAT ARE THE BENEFITS OF AN INTRA-FAMILY LOAN?
Provided the loan is properly structured, the recipients of an intra-family loan can invest the loan proceeds and any investment income they earn will be taxed at their lower marginal rates. Intra- family loans are most commonly made between spouses, either married or common-law, but this strategy can also be effective with minor children.
To ensure the income attribution rules do not apply to investment income earned by the loan proceeds, two loan conditions must be met:
• The loan must charge interest at a rate that is at least equal to the prescribed rate (updated quarterly) set by the CRA at the time the loan is made; if the commercial loan rate is lower than the prescribed rate at the time the loan is made, this lower commercial rate can be used
• The annual interest owing on the loan must be paid to the lender no later than 30 days after the end of each year

This means that one of the keys to a successful income splitting strategy is to ensure that investment returns are higher than the interest rate charged on the intra- family loan.

TAKE ADVANTAGE OF TODAY’S LOW INTEREST RATES

If you lend your spouse money for the purpose of income splitting, the prescribed rate (the rate of interest you charge your spouse) remains fixed for the term of the loan.

This is a considerable advantage in today’s low interest rate environment. For example, the prescribed rate in the fourth quarter of 2009 is one per cent.

ALREADY HAVE A PRESCRIBED RATE LOAN?

You can still take advantage of today’s lower interest rate. If you and your spouse implemented this strategy in the past, when the prescribed rate was higher, there is a way to take advantage of the current lower rate to increase your tax-saving opportunity.

First, your spouse must repay the existing loan – it’s not enough to just re-sign the loan agreement. To do this, your spouse may have to sell some investments and this may result in capital gains. However, any gains will be taxed in your spouse’s hands, and therefore less tax will be due than if you held the investment yourself. You can then enter into a new loan at the current lower prescribed rate and your spouse can purchase new investments.

Solutions Magazine: Winter Edition 2010