One of the more important strategies enabling individuals to reduce income taxes is income splitting between spouses. However, with the increase in the government prescribed rate from 1% to 2% set to take effect October 1, 2013, this strategy will be less lucrative.
First some background: If a couple wants to reduce their overall tax bill, the higher income spouse cannot simply gift money or investments to the lower income spouse, because the tax authorities will attribute income back to the higher income spouse. However, there is a way to split income legitimately, using a loan at the government prescribed rate. The prescribed rate is an interest rate that is based on the average Treasury bill rate. Since the second quarter of 2009, this rate has been at 1%. This has enabled an individual in a high tax bracket to pay tax on just 1% of the amount, while the low tax bracket spouse earns a higher market return. This effectively moves the investment income from one spouse to the other.
An example will serve to illustrate how this would work. Assume that the higher income spouse lends $1 million to the lower income spouse and that the funds invested earn 5%, pre-tax.
The above example results in a net tax savings of $8,000 per year for the couple. With the prescribed rate increasing to 2% as at October 1, the annual savings would be in the order of $6,000 per year, making the strategy very good, but less lucrative.
Prescribed rate loans are also used in funding family trusts whereby an individual or a couple can set up a trust for the benefit of their children and grandchildren. Such loans would be at the government prescribed rate in order to avoid the attribution rules. The income splitting possibilities are more interesting with a trust, because investment income from the trust can be allocated to multiple beneficiaries, such as children in university, who have might have minimal taxable income and are likely not taxable. Using the example above, if the income was allocated to beneficiaries who had no tax payable, the annual tax savings would come to $16,800 per year.
Some further points on prescribed rate loans:
- In the case of an existing prescribed rate loan at a higher rate, the rate cannot simply be changed to 1%. The old loan must be repaid and a new loan taken out with funds from a different source, i.e, cannot recycle an old loan into a new lower rate loan.
- In order to benefit from the 1% rate, the loan must be made before September 30. If lending to a trust, it must be established by that date.
- The interest on the loan must be paid by the borrower no later thanJanuary 30 of the following year. Otherwise the strategy is forever lost.
- The loan should be evidenced by a signed loan agreement.
Income splitting, as done above, provides an excellent tax savings opportunity. Please contact us if you have further questions with respect to implementing this strategy.