Michael D'Angelo- February 2021
I have come across something that I found would be beneficial to many families and wanted to share it with you. Investing your money is one of the biggest contributors to accumulating wealth, but how about lowering your family tax bill? By using intra-family loans, families can utilize the Canadian tax system by taking advantage of one of the most important income-splitting strategies.
The Basics of Income Splitting
Income splitting involves transferring income from a high-income earner to a family member in a lower tax bracket. Because the lower-income individual is taxed at a lower marginal tax rate, the family pays less tax overall. However, the Canada Revenue Agency (CRA) restricts most forms of income splitting through the Income Tax Act’s attribution rules. A person can’t simply give their spouse $100,000 to invest and have the spouse declare the investment income in their tax return at their lower marginal tax rate. In such a situation, the investment income would be attributed back to the original individual and taxed at their higher marginal rate.
There are, however, a few legitimate and effective ways to split taxable income with a spouse or other family members. One of the most effective strategies, especially in a low interest rate environment is through a loan directly to a family member or, where minors are involved, to a family trust. Provided the loan is properly structured, the recipient can invest the proceeds from the loan, with the income taxed at a lower marginal rate. Of course, one of the keys to a successful income-splitting strategy is to make sure that investment returns are higher than the interest rate charged on the loan.
Interest Rates and Deadlines
Intra-family investment loans most commonly involve a loan between spouses, either married or common-law. But this strategy can also be effective for funding the expenses of minor children, such as private school or extracurricular activities, through a prescribed-rate loan to a family trust with the minor children as beneficiaries. It’s a good idea to have a formal written loan agreement in place. For this strategy to work, the following criteria must be met:
Interest must be paid on the loan at a rate that’s at least equal to the CRA’s prescribed rate (updated quarterly). 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.
In order to be compliant with the CRA’s attribution rules, annual interest payments must be made to the lender no later than January 30 of the following year. Failure to do so may result in the income earned on the borrowed funds being attributed back to the high-income earner. And as a result, the income splitting strategy will no longer work.
Making it Work – An Example
Spouses Jack and Jill are in different tax brackets – Jack at 48 percent and Jill at 20 per cent. Jack loans Jill $200,000 at a prescribed rate of one per cent. Jill invests the money and earns four per cent, or $8,000. She then pays Jack the $2,000 loan interest (one percent of $200,000) and deducts the same amount as loan interest expense. Jill pays $1,200 in tax on the remaining $6,000 (20%- Jill’s tax rate), and John pays $960 on his interest income. (48%- Jack’s tax rate)
Here’s how it stacks up:
Jack would have had to pay $3,840 in taxes had he invested the $200,000 himself.
By loaning the money to Jill for the purpose of income splitting, the family tax bill is reduced by approximately 44 per cent to $2,160, representing savings of $1,680.
Income splitting can be a great tax-saving strategy for families that have a pool of non-registered capital that they’re willing to invest, and where a spouse or other family member is in a lower marginal tax bracket. To take advantage of income splitting, reach out to us as we would love to walk you through the necessary steps.
© 2020 Manulife. The persons and situations depicted are fictional and their resemblance to anyone living or dead is purely coincidental. This media is for information purposes only and is not intended to provide specific financial, tax, legal, accounting or other advice and should not be relied upon in that regard. Many of the issues discussed will vary by province. Individuals should seek the advice of professionals to ensure that any action taken with respect to this information is appropriate to their specific situation. E & O E. Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the fund facts as well as the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Any amount that is allocated to a segregated fund is invested at the risk of the contractholder and may increase or decrease in value.