Since April 2009, there has been a tremendous opportunity available for tax strategies that involve loans between family members for investment purposes. The great deal is these parties could avoid attribution of taxable income when loaning money to each other at the bargain-basement rate of one per cent.
This one per cent rate is the "prescribed rate" published quarterly by the Canada Revenue Agency. Loans between spouses at this rate are essentially considered market-rate loans instead of gifts, exempting the investment income earned on the loaned capital from tax attribution to the loaner.
We will explain more about the strategies in a moment, but the immediate alert here is it is becoming a concern of the tax community that this one per cent rate may increase to two per cent at the Sept. 30 update.
Although this week the Bank of Canada again kept its key policy rate at the one per cent it has been for three years, the 90-day treasury bill rates on which the prescribed rate is based have been inching up.
I'm not convinced there'll be an increase, but caution says putting in place any appropriate tax strategy before Sept. 30 makes sense. The rate in effect at the time the strategy is put in place remains in effect for the duration of the structure, even if the CRA rate increases.
Under the tax rules, gifting money from the high-income spouse to the lower-income spouse for investment purposes does not avoid tax. The rules attribute investment income earned on this money to the person who gave it.
To avoid this attribution of investment income to the higher-income spouse, the money needs to be loaned at the prescribed rate. The lower-income spouse will deduct the interest (currently one per cent) and the higher-income spouse will claim the interest. However, if the money is used to buy stocks paying a four per cent dividend and earning capital gains, there is both a short- and long-term tax saving available.
You may qualify for these opportunities if one family member (let's call her Mom) is in a higher tax bracket than the others, and Mom has significantly more assets (cash, investments, company shares, inherited money) than the others.
In the case of minor children, a gift to the child for investing (properly through a formal trust) will result in attribution of interest and dividend income to the loaning parent or grandparent, but the child can claim capital gains earned on the invested money.
Many Canadian taxpayers arbitrarily split investment income with their spouses on their tax returns each year to decrease taxes. However, if the invested capital actually belongs to one spouse (under the tax rules, not family law), they may be breaking the attribution rules.
In other words, if Mom earned or inherited the money, she is supposed to pay the tax on the investment income earned on that money after it is invested.
To legally avoid these rules, arrange your affairs (and those of your parents) so the lower-income spouse inherits all the money, gets the proceeds of asset sales, owns the business and puts his or her name on the winning lottery tickets.
If you are in a situation where one spouse has a lot of investment capital and the other would pay much less tax on the same investment income, create a legitimate loan agreement between spouses and loan the money to the lower-income spouse at one per cent. This rate remains in place for the life of the loan.
It may be your last chance at this low, low rate!
David Christianson, BA, CFP, R.F.P., TEP, is a financial planner, adviser and vice-president with National Bank Financial Wealth Management, and author of the book Managing the Bull, A No-Nonsense Guide to Personal Finance.