Manulife tax expert explains how families can contribute to lowering their overall bill, saving potentially thousands of dollars
Canadians often consider tax-saving strategies on an individual basis but may not always realize that their families can also contribute to lowering the overall tax bill.
The Canadian government recently announced the reduction of its prescribed interest rate from 2% to 1% starting on July 1, 2020 – the lowest it has been since April 2018. This represents a significant opportunity for clients to make a loan directly to their family members or where minors are involved, to a family trust, and take advantage of this income-splitting strategy that can potentially save them hundreds or even thousands of dollars each year.
If a person loans their spouse money for the purpose of income-splitting, the prescribed rate (the rate of interest they charge their spouse) does not change for the term of the loan. Through this tax-saving strategy, transferring income from a high-income earner to a family member in a lower tax bracket allows Canadian families to pay less taxes overall.
Although the Canada Revenue Agency (CRA) restricts most forms of income-splitting, there are effective and legitimate ways to split taxable income with a spouse or minor child such as through this strategy. Provided the loan is properly structured, the loan proceeds can be invested by the spouse receiving the loan, with the income taxed at their lower marginal rate.
A real-life example
Let’s suppose spouses Paul and Sandra are looking for ways to lower their family tax bill. They are in different tax brackets, Paul at 48% and Sandra at 20%. Paul loans Sandra $100,000 at a prescribed rate of 1%. Sandra invests the money and earns 4% – or a total of $4,000. She then pays Paul the $1,000 loan interest and deducts the same amount as “loan interest expense”. Sandra pays $600 in tax on the remaining $3,000, and Paul pays $480 on his interest income. Here’s how it stacks up: Paul would have had to pay $1,920 in taxes had he invested the $100,000 himself. By loaning the money to Sandra for the purpose of income splitting, the family tax bill is reduced by approximately 44% to $1,080, representing a savings of $840.
How to ensure a successful strategy
To ensure the income attribution rules don’t apply to investment income earned by the proceeds from this loan, two conditions must be met:
- The loan must carry interest at a rate that is at least equal to the prescribed rate (updated quarterly) as 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 particular year.
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 loan. Therefore, keep that in mind when recommending an investment to a client who has adopted this strategy.
This income-splitting strategy through loans is best suited for those with a pool of non-registered capital they are willing to invest and for those who have a spouse or minor children in a lower marginal tax bracket.
We recommend formalizing the spouse-to-spouse loan through a promissory note.
Lastly, many people tend to shy away from tax-saving strategies they may not be familiar with – either due to lack of awareness about how exactly it works or because they’re more comfortable doing what they’ve always done. In that case, the help of a wealth professional can be key to ensuring clients are aware of these solutions and to ensure no mistakes are made along the way.
John Natale is the Head of Tax, Retirement & Estate Planning Services, Wealth, at Manulife Investment Management. He joined Manulife in 2001, having previously worked for a national account firm and a private law firm. He has experience with estate planning and wealth management strategies and a wide variety of general tax matters including trusts and annuities. John is a frequent speaker at industry conferences and seminars, has published articles on estate planning and income strategies, and has appeared as a guest speaker on BNN.