Family Tax Planning

Give your spouse a loan
When it comes to paying tax, many people are in the habit of considering tax-saving strategies on an individual basis. However, if you have a spouse, you can incorporate tax-saving strategies that are effective at lowering your family's annual tax bill. In today's low interest rate environment, the use of an intra-family loan to split income is a good option to consider.

What is income splitting?
To understand how this strategy can work, let's begin by reviewing the opportunity that income splitting can provide. Income splitting involves the transfer of income from a high-income earner to a family member in a lower tax bracket. The goal of income splitting is to have the individual in the lower marginal tax bracket report this income, with the end result being that the family pays less tax overall.

What's the catch?
Canada Revenue Agency (CRA) restricts most forms of income splitting through the Income Tax Act's attribution rules. Under these guidelines, the individual in the higher tax bracket cannot simply give their spouse money to invest, and then have their spouse declare the income generated from the investment on their tax return at their lower marginal tax rate. If the spouse were to do so, CRA would "attribute" or credit the income generated from the investment back to the spouse who made the gift, which would then be taxed at the higher marginal tax rate.

How does income splitting using a loan work?
There are legitimate and effective ways to split income with a spouse – or a minor child – that can lower your family tax bill. By combining income splitting with an intra-family loan, the higher income-earning spouse can loan money to their partner who is in a lower income tax bracket. The spouse in the lower tax bracket can then invest the money and claim any income generated by the investment at their lower marginal tax rate. Not only will this result in a lower overall tax bill for the family, it also takes advantage of today's low interest rates — a key factor that will determine the success of this plan.

To ensure income attribution rules do not apply, two loan conditions must be met:

• When the loan is made, it must charge a rate of interest that is at least equal to the prescribed rate set that quarter by CRA. For example, the prescribed rate for the second quarter of 2004 was 3%. If a commercial loan rate is lower than the prescribed rate at the time the loan was made, the lower commercial rate can be used.
  
• Interest payments on the loan must be paid annually to the lending spouse, and within 30 days of the calendar year's end.

How much can your family save?
To demonstrate how effective this strategy can be, let's illustrate by way of an example: Spouses John and Jill are looking to lower their tax bill. They are in different tax brackets: John at 45% and Jill at 22%. John loans Jill $100,000 at the prescribed rate of 3%. Jill invests the money and earns $6,000 (a 6% return). She then pays John $3,000 in interest on the loan and deducts the same amount as a "loan interest expense." Jill pays $660 in tax on the remaining $3,000, and John pays $1,350 on his interest income. Here is how it stacks up:

	No Loan	Spousal Loan
	John 45% Tax Rate	John 45% Tax Rate	Jill 22% Tax Rate
Principal loan	$100,000	-$100,000	$100,000
6% investment return	$6,000		$6,000
3% interest payable on loan		$3,000	-$3,000
Net income from loan investment	$6,000	$3,000	$3,000
Tax payable per person	$2,700	$1,350	$660
Total family tax payable	$2,700		$2,010

In summary, John would have paid $2,700 in taxes had he invested the money himself. By loaning the money to Jill for the purposes of income splitting, the family tax bill is reduced by 25% to $2,010, which represents a savings of $690. Investment returns are for illustration purposes only and are not guaranteed.

How to use this strategy effectively:
The ideal candidate: Income splitting through a loan is only suitable if you have non-registered savings that you would like to invest, and you have a spouse or child that is in a lower marginal tax bracket.

Take advantage of today's low interest rates: If you loan your spouse money for the purpose of income splitting, the prescribed rate (the rate of interest you charge your spouse) remains fixed for the term of the loan. This is of considerable advantage in today's low interest rate environment. You can determine the current prescribed rate by visiting: www.ccra-adrc.gc.ca/tax/faq/interest_rates/menu-e.html

Invest carefully: The key to making this strategy work is to ensure that your return on investment is higher than the interest rate charged on the loan. Speak to your financial advisor to determine investments that are most appropriate for you.

Put it in writing: Make sure you formalize the spouse-to-spouse loan through a promissory note. You can get a copy of a promissory note from your financial advisor.

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