Loans to Spouse and Minor Children – Effective Tool for Income Splitting to Reduce Taxes
May the 4th be with you!
Time to take advantage of income splitting by having higher income taxpayers loan funds to lower income Spouses/Minor Children. The Prescribed rate of interest will fall to 1% on July 1, 2020. This low interest rate means that loans to lower income spouses and minor children for their investment portfolio will only incur 1% income to the higher income transferor, but the investment income (which hopefully exceeds the 1%) can then be reported on the Spouse/Minor Child’s tax return!
When non-arm’s length parties transfer property to each other, the Income Tax Act prevents income splitting by sometimes causing the income from the property to be attributed back to the property transferor. For instance, if an individual transfers property to a spouse under a spousal rollover, all future realized property income and capital gains from that property is attributed back to the transferor spouse pursuant to sections 74.1 and 74.2 of the Income Tax Act. Similarly, property income (but not capital gains) is attributed back to a parent for transfers to a minor child. However, the Income Tax Act recognizes that an individual can sometimes enter into bona fide sale with a close family member, and in such cases, the attribution rules should not apply. How does it draws the line as to whether a sale is bona fide: when a sale is transacted at fair market value and no tax rollover is relied on so that the transferor reports whatever gains arises on the transfer. What if the transferee has no cash to satisfy the purchase? Then the transferor can receive as consideration a promissory note owing from the transferee. As long as at least the prescribed rate of interest applicable at the time of the arrangement is charged on the note and such interest is paid on or before January 30th of each year, the Tax Act will not apply the attribution rules.
In other words, the prescribed rate of interest is the price to pay to avoid attribution and split income with family members. The transferor has to report the interest income. The lower the prescribed rate, the lower the tax cost of the arrangement. As long as the transferee is using the property to earn income, the transferee should be able to deduct the interest expense. Properly structured, a prescribed rate loan arrangement may be used to income split with multiple family members, including minors, without the dreaded tax-on-split-income (TOSI) applying.
Careful planning and advice should be sought before implementing such a plan!
ROMANOVSKY & ASSOCIATES LLP
CHARTERED PROFESSIONAL ACCOUNTANTS
Keith M.J. Anderson* BCom, CPA, CA-IT, CITP
Chartered Professional Accountant and Chartered Accountant (Canada)
CA-Designated Information Technology Specialist (Canada)
Certified Information Technology Professional (US)
* Professional Corporation