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Kevin Greenard: Lock in your spousal loan at a rate of one per cent

There is a once-in-a-lifetime opportunity for those thinking of utilizing a spousal loan strategy, but you need to act before July 1, 2022.
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Kevin Greenard

There is a once-in-a-lifetime opportunity for those thinking of utilizing a spousal loan strategy, but you need to act before July 1, 2022. Canada Revenue Agency’s (CRA) prescribed interest rate is currently set at one per cent, but not for long. Effective July 1, 2022, the prescribed rate will be doubling to two per cent. The CRA prescribed rate is the interest rate used to calculate spousal loans, so as July 1 approaches, this opportunity slips away.

Earlier this year we wrote an article on spousal loans, but with an upcoming increase to Canada Revenue Agency’s prescribed interest rate, we felt it was important to reiterate the benefits of this income splitting strategy and how you can lock in an interest rate of one per cent before it doubles. We have included the content from this past article below and have shown the impact the upcoming interest rate increase will have within the illustrations.

Spousal loans

The purpose of all income-splitting strategies is to transfer income from the higher-income spouse to the lower-income spouse. A spousal loan is a perfectly acceptable strategy for couples to income split. For this strategy to be effective, couples need to be in different marginal tax brackets. The greater the difference in income levels, the more advantageous the strategy is from a tax savings standpoint.

The highest marginal tax rate in British Columbia 10 years ago was 43.7 per cent. Today, the highest marginal tax rate in British Columbia is 53.5 per cent. This is an increase of more than 10 percentage points in a mere 10 years.

You don’t have to be in the highest marginal tax bracket to benefit from this strategy, as we will illustrate below. If your spouse is in a lower tax bracket than you, a spousal loan strategy is beneficial; however, the greater the difference in tax brackets, the greater the benefit.

Documentation and paper trail

It is important to document the terms of the loan, generally through a promissory note. Although this is not a requirement under the Income Tax Act, we feel it is prudent and provides appropriate evidence of the terms of the loan.

We assist all our clients that have a spousal loan agreement in drafting the promissory note (the “note”). The higher-income spouse signs the note as the lender. The lower-income spouse signs the note as the borrower. I will witness the promissory notes. A properly executed note document will provide clarity for specific terms. One of these terms relates to the interest rate and the payment dates.

Prescribed interest rate

When we draft these notes, we will always select the lowest prescribed rate allowed by Canada Revenue Agency.

CRA allows loans to be issued at the posted prescribed interest rate. Every three months, CRA sets the prescribed interest rate for loans. It is posted quarterly and is calculated based on the average yield of 90-day treasury-bills sold during the first month of the previous quarter.

As mentioned above, the rate is at a historic low of only one per cent. Once a spousal loan agreement is documented, the rate is guaranteed to stay at that level forever, even if the prescribed rate increases in the future. As the rate is currently at only one per cent, and set to increase to two per cent, we believe that this is the perfect time to act if the spousal loan strategy is suitable for your situation.

Demand note

In all situations, the notes we help clients set up are interest-only demand notes. The lender can request the repayment of the loan upon demand (written notice); however, this is typically not done. The longer a spousal loan is put in place, the more effective it becomes.

Interest-only payments

All the spousal loan agreements we help draft for clients are structured with interest-only payments. The specific CRA requirement, to ensure the funds are considered loaned (instead of gifted), is that the borrower (lower-income spouse) must pay the interest payment by Jan. 30 of the following year.

If the lower-income spouse does not pay the interest payment, then the total income of that spouse will be attributed back to the lender (higher-income spouse). Annually, we ensure that our clients make the appropriate interest payments (see Multiple Joint With Right of Survivorship Accounts below).

Purpose of Joint with Right of Survivorship accounts

Couples typically set up non-registered accounts that are Joint with Right of Survivorship (JTWROS).

JTWROS accounts are typically opened for two different reasons: income splitting and estate planning. In the situation where a couple is contributing approximately equal amounts into the JTWROS then the income on the account is typically split 50-50.

When one spouse is working and earning a significant income, and the other spouse is not working, then deposits to a JTWROS are typically done for estate planning purposes as the income is reported 100 per cent on the higher-income spouse’s tax return. The higher-income spouse is named as the primary account holder on this JTWROS account. For illustration purposes below, we will refer to this account as JTWROS 1 and the primary / higher-income spouse reports 100 per cent of the income.

Multiple Joint with Right of Survivorship accounts

When we set up a spousal loan note, we will simultaneously open a second JTWROS account with the lower-income spouse (the borrower) being the primary on the account. We still typically put the account in joint names for estate planning purposes. We will refer to this account as JTWROS 2 and the primary / lower-income spouse reports 100 per cent of the income. We will have a letter of direction that both the borrower and lender sign, that transfers the agreed loan amount from JTWROS 1 to JTWROS 2 on the agreed upon date. Annually, we have the interest payments being made from the JTWROS 2 account to the JTWROS 1 account.

Illustration one – one income household

Over the years, the higher-income spouse has made all the taxable income. Over a series of years, the accumulated savings have been put into an investment account. From a tax standpoint, 100 per cent of this income needs to also be reported on the higher-income spouse’s return.

Unfortunately, you cannot simply gift funds to your spouse, who has no other income, to buy investments. Some may feel that the higher-income spouse could put $300,000 in a non-registered investment account in the lower-income spouse’s name to earn at least the basic personal amount tax free of $14,398 (2022).

Let’s assume the account earns $12,500. The thought might be that the spouse has no employment income and transferring income would be below the basic exemption and not subject to any tax at all. The Income Tax Act has rules that prevent these types of transactions from taking place. These are referred to as the “attribution rules.” In the above case, the $12,500 of investment income would be attributed back to the higher-income spouse who earned the income.

One option is to lend funds to your spouse at the prescribed rate, currently at one per cent.

Dr. Brown has annual earnings from her medical practice of over $350,000 and overtime has accumulated $1.6 million in non-registered savings. The amount is currently in an account similar to JTWROS 1 above where Dr. Brown is reporting 100 per cent of the income.

Her portfolio has been invested and has earned an average rate of return of seven per cent. Every year she has been reporting 100 per cent of the T5 investment income (interest, dividends, and capital gains) on top of her employment earnings. Typically, this is in excess of $90,000 annually.

As Dr. Brown’s marginal tax bracket is already at 53.5 per cent from her medical practice, she is paying a significant amount of tax on the investment income generated.

Mr. Brown has been busy raising three children and has no income at all.

A strategy we recommended to the Browns is a spousal loan. Dr. Brown could loan Mr. Brown $1.6 million at the prescribed rate of one per cent. We would open JTWROS 2 where Mr. Brown is primary and would report 100 per cent of the income. We would assist them in drafting the promissory note and documenting the paper trail to formally transfer the funds from JTWROS 1 to JTWROS 2. We would also assist the Browns in ensuring that the annual spousal loan payment is made.

With a one per cent interest rate, Mr. Brown would be obligated to pay Dr. Brown $16,000 annually, which would be an interest deduction on his tax return. Dr. Brown would have to include the interest payment of $16,000 on her tax return, and at her 53.5 per cent marginal tax bracket would result in paying $8,560 in taxes ($16,000 x 53.5 per cent). This is significantly lower than the approximately $90,000 of investment income noted above, and the tax bill associated with that. The best part is that the investment income earned by Mr. Brown in JTWROS 2 will be taxed at significantly lower tax rates.

If the CRA prescribed interest rate increases to two per cent, Mr. Brown would be obligated to pay Dr. Brown $32,000 annually, which would still be an interest deduction on his tax return. Dr. Brown would have to include the interest payment of $32,000 on her tax return, and at her 53.5 per cent marginal tax bracket would result in paying $17,120 in taxes ($32,000 x 53.5 per cent), which is an additional $8,560 just as a result of the prescribed interest rate increasing.

It is still substantially lower than if Dr. Brown earned $90,000 of investment income in her own hands; however, this example shows the importance of acting before July 1, 2022 to implement a spousal loan strategy if you have been thinking of it.

Illustration two – large inheritance

Most of the spousal loan strategies we have implemented are when a large inheritance is received. We have had situations where a parent or sibling has left one of our clients a sizeable inheritance. To illustrate, we will use Mrs. Smith. She had an older brother that had not married and had no children. When the brother passed away, Mrs. Smith received $3.5 million from his estate.

Prior to this inheritance, Mrs. and Mr. Smith had approximately the same level of income. All the investments they currently had were in Registered Retirement Income Funds (RRIF). During our meeting, we noted that Mrs. Smith would have to report 100 per cent of all the investment income (i.e. interest, dividends, and capital gains) generated from investing the inheritance.

We recommended some strategies to assist them in minimizing tax during their retirement by splitting this income in a way that is acceptable for CRA. One of the most important discussion points in the meeting was explaining how simple it was to set up a spousal loan and how we take care of all the administrative components.

The steps we took with Mrs. and Mr. Smith were to open up Tax-Free Savings Account (TFSA) for each of them. We also opened up JTWROS 1 with Mrs. Smith as primary and JTWROS 2 with Mr. Smith as primary. We created a promissory note for Mr. and Mrs. Smith. Mrs. Smith was agreeing to lend Mr. Smith the principal sum of $1.65 million which was due on demand. The note would bear interest at one per cent and have annual payments of $16,500. The effective date for the transfer was set for April 30 for the spousal loan. If Mr. and Mrs. Smith were to set this up effective July 1, 2022, the annual interest payments would be $33,000 ($1.65 million x two per cent).

The $3.5 million first was deposited to JTWROS 1. We transferred $81,500 into each of their respective TFSA accounts immediately in the new year. There is no attribution for a spouse to fund the other spouse’s TFSA account. On April 30 of the first year, we had Mrs. and Mr. Smith sign a letter of direction to enable us to transfer the $1.65 million form JTWROS 1 to JTWROS 2.

We assist the Smiths in ensuring that the annual spousal loan payment is made. Annually, Mr. Smith is obligated to pay Mrs. Smith $16,500 which is an interest deduction on his tax return. As the spousal loan was initiated part-way through the year, the interest payment in the first year is prorated based on the number of days the funds were loaned.

Each year thereafter, the total amount of $16,500 will be paid. Mrs. Smith must include the interest payment of $16,500 on her tax return. This is significantly lower than the investment income the loaned amount would have otherwise earned.

Had the Smiths done the spousal loan after June 30, 2022, with a two per cent interest rate, Mr. Smith would have to pay Mrs. Smith $33,000, and Mrs. Smith would need to report $33,000 of interest income annually.

Illustration three – selling a dental practice

In situations where a privately held company is sold, the shareholder often receives a significant lump sum of capital. Dr. Wilson was in this situation when he sold his dental practice with a completion date of March 31. He received $2.5 million dollars in personal funds. Dr. Wilson immediately wanted to talk about investing these funds to generate investment income throughout retirement. In talking with Dr. Wilson, I recommended that we first structure the investments in a way that reduces taxes and increases his after-tax cash flows. I asked that Dr. Wilson and Mrs. Wilson both come in for a meeting to discuss the spousal loan strategy. Dr. Wilson primarily had his investments within a holding company that had been built up significantly over the years. We had spoken with the Wilson’s accountant and the plan was to declare annual dividends for Dr. Wilson from the holding company of $130,000. Knowing that Dr. Wilson was already going to have some significant cash flow from these dividends, we recommended that the proceeds from selling the practice be set up as a spousal loan in Mrs. Wilson’s name.

We created a promissory note for Dr. and Mrs. Wilson. In this note, Dr. Wilson agreed to lend Mrs. Wilson the principal sum of $2.5 million, which was due on demand. The note would bear interest at one per cent and have annual payments of $25,000. The effective date for the transfer is set up for April 1 for the spousal loan after the sale completed.

We explained that for the first year the interest payment will be prorated between April 1 and Dec. 31 and will be only for the first three quarters of the year, which equals $18,750 ($25,000 x 75 per cent).

In this situation, we only opened one JTWROS with Mrs. Wilson being the primary on the account. Dr. Wilson wrote a cheque to deposit the funds into the JTWROS on April 1. This strategy will enable the Wilson’s to significantly reduce their annual tax bill to CRA.

Had the sale of Dr. Wilson’s dental practice completed a couple months later after June 30, or had he waited until after June 30 to contact us, the interest rate of two per cent would result in annual interest payments of $50,000 for Mrs. Wilson and interest income of $50,000 for Dr. Wilson. Similar to above, while they will still result in significant tax savings, the savings would be even greater had they implemented the loan before June 30.

The spousal loan strategy has saved our clients a significant amount of tax dollars over the years. Each of the illustrations above are similar to households we have helped, and all are considerably further ahead, after taxes, each year as a result. As every year goes by, the benefit of this strategy is magnified even further.

Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management, with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250-389-2138, email greenard.group@scotiawealth.com, or visit greenardgroup.com.