Time running out for interest payments on spousal loans

With tax season upon us, clients who have loaned investment capital to a lower-income earning spouse should be reminded to collect the interest on that loan before January 30. Failure to do so means running afoul of the Income Tax Act’s Attribution Rules, which generally prohibit income splitting to spouses and common partners or minor children, except in specific instances.

“In Canada it is the individual, rather than the family or household unit that is taxed. What this means is that each person is required to report their own source income, from worldwide sources, in Canadian funds,” says Evelyn Jacks, president of The Knowledge Bureau and author of Essential Tax Facts, 2006 Edition. “Each person is also eligible for their own Basic Personal Amount and the taxation of their income at graduated rates — that is the higher your taxable income the higher your tax rates.”

Because of the tax advantages involved in such a strategy, the Income Tax Act has very specific rules governing loans to lower-earning spouses. The must be bona fide loans, with written documentation spelling out the terms. The borrower must pay a minimum rate of interest on the loan — the lesser of either the CRA’s prescribed rate (currently 3%) or the rate the borrower would have paid on a loan from an arm’s length lender.

Clients using this strategy should be reminded that the interest payment must be made in cash and cannot simply be compounded into the principal. On the upside, the borrower can claim the interest on their taxes, as the loan was taken out for investment purposes. Of course, CRA insists that the investment must be carry “a reasonable expectation of profit.”

Provided all the rules are followed, income generated from the investment is attributable to the lower-income spouse.

Jacks will be speaking at the Knowledge Bureau’s Line-By-Line Tax Update 2005-2006 conference tour next week. The Calgary and Vancouver events are already sold out, but tickets are still available for the conferences in Ottawa on the 23rd, Toronto on the 24th and Edmonton on the 25th.

Staff

The staff of Advisor.ca have been covering news for financial advisors since 1998.