I learned what little I know about how elected officials and the civil service come up with such twisted, convoluted, maze-like, labyrinthian rules and regulations by watching Yes, Minister and Yes, Prime Minster on TV. It still amazes me though. Why, exactly, do they think that making life horribly complex is a good thing? The current conundrum over which I’ve puzzled and puzzed till my puzzler was sore, to quote Dr. Seuss, is the spousal income attribution rules. All I want to do is optimize how we invest as a couple to make the most money and pay the least taxes. Why do they have to make it so complicated?
The Canadian Spousal Income Attribution Rules
Some countries seem to understand that in a good marriage people share their assets and liabilities. They let the happy couple (married, common-law, same-sex or whatever works) file joint income tax returns. Canada, however, prefers to treat each person as an island entire of itself. (Don’t worry, I’m Donne with the literary quotes. Wow, two great poets in one post!)
So in Canada, if you have, say, a bank account held jointly that pays interest, you must each declare your share of the interest.
No problem we just each declare 50% right? Wrong. Or at least, it might be wrong. If you both put in exactly the same amount of money into the account, then 50% is correct. However, if your incomes are different, and you put in say 60% and your partner put in 40% then you are supposed to declare the interest on your taxes 60/40 too.
So in conclusion it’s actually a good thing most bank accounts don’t pay any interest anymore.
No. That wasn’t what I meant.
What I meant was when you pay income taxes in Canada, you are supposed to divvy up any income from investments based on who provided the money that was invested.
In Canada You Can’t Just Give Your Partner Money to Invest
Canada is generally pretty reasonable about gifts. If your Mom gives you $5000 and you are a tax-paying adult, you just have to write a really nice thank you note on your best stationery and you’re done. You do not have to pay income tax on the gift. You do have to pay income tax on any money you earn by investing that gift.
It’s not the same though if the gifts are between adult partners. (Or between parents and under-age, non-independent children; or between adults and their under-age nieces and nephews; or grandparents and grandchildren. More on those issues another day.)
If my husband gives me $5000 and I invest it, he has to pay income tax on the interest, dividends, capital gains and other income earned by that investment. That’s right HE has to pay, even though my name is on the investment. As my spouse, the income from an investment paid for with money he gave to me is attributed back to him. This is the spousal income attribution rule.
There is one notable exception to this rule: A spouse can give the other spouse the money to invest in a TFSA. The income earned in the TFSA is not taxable and no tax has to be paid by either spouse. It’s as if the government came to their senses briefly and passed one law that made sense. In all other situations, though, a spouse cannot give money to a spouse to invest and shift the tax burden.
Why Would My Partner Want to Give Me Money to Invest?
Some people may be wondering why my husband would want to give me money to invest in the first place. Why doesn’t he just invest it? Well, one reason is because blogging does not pay as well as working. He pays income tax at a much higher rate than I do. So if I earned some income on an investment it would be taxed at a much lower rate than if he earned the same amount by investing for himself.
And that is what the government is worried about. They want to receive the most taxes they legally can. They want him to pay the higher rate. They do not consider us an inseparable unit that is deserving of a single lower blended tax rate.
Circumventing the Canadian Spousal Income Attribution Tax Rules
Of course, we Canadians are a canny lot. As soon as attribution was invented, the brighter lights in Canada started looking for a way to bypass this spousal attribution rule. And they found one. It’s complex and a bit expensive and requires lawyers and accountants. In short it’s the kind of challenge the government loves as it uses logic almost as convoluted as their own.
A Spousal Investment Loan Permits Legal Dodging of the Spousal Income Attribution Rules
Here’s my understanding of the solution:
One spouse loans money to the other spouse.
The loan is formally written up in proper legal terms.
The loan sets an interest rate.
The interest rate can be fixed for a very very long time.
The interest rate can be no lower than the Prescribed Interest Rate set by the government at the time the loan is made.
The rate does NOT have to increase when the Prescribed Interest Rate increases in the future.
The interest on the loan must be paid annually.
The interest payment must be made no later than January 30 of the following year for the preceding year’s payment.
The spouse who loaned the money must declare the interest paid back each year on their income tax. That’s right, they do have to pay tax, but only on the interest they are paid back by their spouse.
The spouse who received the money must declare any earned investment income each year on their income tax.
The principal of the loan does not have to be re-paid.
There are a variety of other rules. For example, you cannot pay back the loan and immediately take out another loan if the prescribed interest rate drops. These other twists and turns are why you need to talk to an accountant if you are setting up one of these loans.
Any income (dividend, interest, rental, capital gains etc) earned by investing the principal of the loan is taxed in the hands of the spouse who received the loan, not in the hands of the spouse who made the loan.
That’s right. So long as your spouse loans you the money, you can invest it, earn a profit and declare the profit on your own income tax return not on your spouse’s return. The spouse who loaned the money does have to pay some tax though. The loaner pays tax on the interest paid back each year.
Does this not seem incredibly complex to you? Why should my husband have to have a formal loan written just to give me money to invest! However, in Canada: “This is the Law.” (I never said I would stop quoting old TV shows.)
When the Spousal Investment Loan Method Makes Sense
The value of the spousal loan method depends largely on the “spread” or the gap between the Prescribed Interest Rate and the expected rate of earnings on making an investment.
If the Prescribed Interest Rate is high compared to the expected return on investment there isn’t a large tax savings from making a spousal loan for investment. For example, if the prescribed interest rate was 7% and the investment earned 9%, then only the 2% difference is being taxed at a lower tax rate.
However, right now, the Prescribed Interest Rate is at an all-time low. It is currently (January 2013) at 1%.
Right now the expected return on an investment might also be quite low. BUT in five years time, the expected return on investment might be quite high. At that time, the Prescribed Interest Rate might also be back up to 7%. But if the loan is made today at today’s prescribed interest rate, it can stay at that low 1% rate for a very very long time. (You’d need to check with an accountant about the longest term you can set for a spousal loan.)
So the benefit of this type of loan is particularly high for a loan made today that can be kept for years into the future when interest rates rise again.
For example, it is possible that you could make a loan today at 1% and that GIC rates could increase to 7% in ten years time. Then you would be sheltering the 6% difference and paying tax on it only at the lower tax rate.
Why This is Academic to Many Canadian Investors
The sad truth, however, is that most Canadians don’t have a huge pile of investments that they need to shelter from taxation. Many Canadians still have room in their TFSAs, RESPs and RRSPs.
But oh, it is interesting to imagine being rich enough to take advantage of this tax shelter. Maybe someday!
What Should You Do if You are Interested in Setting Up a Spousal Investment Loan?
If you could benefit from this tax shelter, you should speak with an accountant and a lawyer. The accountant can clarify the rules about the length of the term of the loan, the required interest rate and interest payment schedule, the rules about repaying the capital of the loan and other tax details. The lawyer can draft up the loan agreement ensuring it is in compliance with the Canada Revenue Agency requirements.
- 1% Prescribed Interest Rate Loan- A great income-splitting opportunity
- Prescribed Rate Loans Using a Family Trust
Have you set up a spousal loan for investments? How complex was the paperwork? Please share your experiences with a comment.