Low interest rates continue to prevail in the current economy. The Canada Revenue Agency recently announced that the “prescribed interest rate” will remain at 1% for the fourth quarter of 2010. While low interest rates do nothing to bolster my savings account, they can give rise to excellent income-splitting opportunities.
Let’s say that Mary and Ron are married with 2 young children. Ron earns $150,000 a year and is taxed at the top marginal tax rate (about 44%). Mary is a stay at home mom (a roll that Ron acknowledges is far more challenging than his job) and earns no income. Ron and Mary want to build an investment portfolio for Mary. They think it is a good idea for Ron to simply give Mary money for her to build that investment portfolio. Unfortunately, that plan would not lead to any tax savings because Mary’s income would be taxed at Ron’s high tax rate.
A better plan is for Ron to lend money to Mary so that she can invest and earn her own income and they can reduce their overall taxation. To avoid income tax attribution rules, Ron must charge Mary interest on the loan. Here is where low interest rates are an advantage. The minimum amount of annual interest that Ron needs to charge Mary is based on the Canada Revenue Agency “prescribed rate of interest”, which is currently 1%.
Say that Ron lends $100,000 to Mary and she invests that money. Mary will have to pay Ron 1% interest ($1,000 per year). Ron will include that $1,000 in his income. Mary will deduct that $1,000 in computing her income. Any investment return in excess of 1% is taxed as Mary’s income, at her lower tax rate. Even a GIC would pay about 2% interest. Other investments – even in these tough economic times – can pay up to 5% and even more. Since Mary pays tax at a lower rate than Ron, the difference in their tax rates means an annual tax savings.
With proper documentation, that 1% rate can be locked in indefinitely. Assuming that the economy will eventually recover (which we all know that it will), a timely loan to a lower-income spouse can result in significant long-term tax savings.
This idea comes with one warning. The Income Tax Act is littered with provisions, commonly referred to as “attribution rules”. Attributions rules can derail the best laid plans. In this example, unless Mary pays Ron the minimum amount of annual interest ($1,000 per year), within 30 days of the end of each calendar year, Ron (not Mary) will have to pay the tax on any income or capital gains that Mary earns from the investments. Even though the investment income belongs to Mary, it is “attributed” to Ron for income tax purposes unless Mary pays Ron that minimum amount of annual interest.
The key aspects of this plan are as follows:
1. the spouse with the higher income lends to the spouse with the lower income;
2. the lower income spouse pays interest to the higher income spouse at the prescribed rate of interest (currently 1%); and
3. the lower income spouse gets to pocket – and pay tax on – any excess investment returns.
While it is not quite as simple as I’ve stated here and there are potential pitfalls, the tax savings can be significant.
The 1% rate will be with us until at least the end of this calendar year. Accordingly, it may be a good time to take advantage of these historically low interest rates to create ongoing tax savings that could last well into the next economic recovery. The foundation of good tax planning must to be laid early in order to reap the benefits down the road.
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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.
