Monday, June 15, 2015

Canadian Tax Primer 3: Graduated Rates for Individuals

Canada uses a graduated rate system for individuals.  This means that the rate of tax increases as the overall level of taxable income increases.  For example, assume that you reside in British Columbia and that you have $75,000 of total taxable income.  Tax applies at a 20% rate on the first $37,869 of this taxable income, at a 23% rate on the next $6,800 of taxable income and at 30% on the rest.  So your effective tax rate is a combination of these various rates on the different portions of your income.

Because of the graduated rate system, it is much better to have two spouses each earning $75,000 in taxable income rather than a single spouse earning $150,000 (two times $75,000) in taxable income.

Various rules in the Income Tax Act make it difficult (but not impossible) to split income between spouses.  If a high-income spouse simply gifts money to a low-income spouse and the low-income spouse invests the gifted money, income earned by the low-income spouse on the gifted money will still be taxed at the rate of the high-income spouse.  However, there are ways around this rule.

In 2014, the federal government introduced a family tax cut credit.  This allows a couple with a child under the age of 18 to transfer up to $50,000 of taxable income from a high-income spouse to a low-income spouse.  However, the maximum tax benefit from such a transfer is limited to $2,000 in any one year.

In many cases, it is better for the high-income spouse to lend funds to the low-income spouse with interest.  The interest rate has to be at least equal to the Canada Revenue Agency prescribed rate of interest at the time of the loan.  As of the second quarter of 2015, this prescribed rate of interest is only 1%.  If the low-income spouse invests the loaned funds and earns a 4% return, the low-income spouse pays tax on a 3% return (after deducting the 1% interest paid to the high-income spouse).  While the high-income spouse pays tax on the 1% interest received, the high-income spouse avoids paying tax on the other 3%.

The loan has to be carefully documented and the low-income spouse has to actually pay the interest to the high-income spouse within 30 days of the end of each calendar year.  With proper structuring of the loan, the current 1% interest rate can be locked in for a considerable period of time (up to 20 or 25 years).  Over time, the low-income spouse can build up a significant investment portfolio so that the couple can split income even after the children have reached the age of 18 and the family tax cut credit is no longer available.  Furthermore, the amount of annual income tax that can be saved with the loan method is not limited to $2,000.

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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.