The Canadian income tax system uses the individual as the tax unit rather than the family. In many cases, this results in unequal tax treatment of families that make the same amount of “total family income”. If spouse A earns $150,000 a year in salary and spouse B earns $0 a year, the tax will be significantly more than a family where each spouse earns $75,000. Shifting income from the higher income-earning spouse to the lower income-earning spouse can significantly reduce the family’s overall tax burden. Sounds simple, right? Not entirely… enter the attribution rules. The attribution rules potentially apply whenever a loan is made or property is transferred to a spouse or common-law partner.* Any income or capital gains earned in respect of the money loaned or the property transferred will be attributed back to the lender-spouse, thus negating the purpose of shifting assets.*
However, the attribution rules can be avoided by implementing a common strategy called a prescribed rate loan. If the higher income-earning spouse loans money to the lower income-earning spouse for investment purposes, and charges the borrower-spouse interest on the loan at the “prescribed interest rate”, there is no attribution of income or capital gains back to the lender-spouse. This strategy is particularly attractive in a low interest rate environment like we’ve been experiencing for the last several years.
The Canada Revenue Agency sets the prescribed interest rate quarterly. It is currently 1% but is expected to rise to 2% on July 1, 2022. Here’s the real magic – the interest charged on the loan does not have to be adjusted each time the prescribed rate changes. Rather, the prescribed rate in effect at the time the loan is made is “locked-in” for the entire duration of the loan, and there is no limit on the length of time the loan can be in place. However, if the lender-spouse loans additional money at a later date, the rate charged on the second loan must be the then-current prescribed rate. Similarly, if the borrower-spouse repays a portion of the existing loan, it cannot be re-advanced at the original prescribed rate.
One must be careful not to run afoul the attribution rules. The loan must be done properly:
The loan must be evidenced in writing by a loan agreement and/or promissory note;
Once the loan is in place, the lender-spouse must actually transfer funds to the borrower-spouse;
The interest on the loan must actually be paid by the borrower-spouse;
The interest must be paid by no later than 30 days after the end of the calendar year, so on or before Jan 30th of each year. If the interest payment is missed or late even one time, the strategy is permanently tainted; all income earned thereafter will be subject to the attribution rules; and
Each year, the lender-spouse must report the interest income on their income tax return, while the borrower-spouse can generally claim a deduction for the interest paid.
If you are considering implementing this strategy, you should speak with your tax advisor before doing so. It’s not always appropriate, and in fact, may not be available in your situation.
*the attribution rules may also apply to loans made to certain other family members and family trusts
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