The strategy involves loaning money to a spouse or partner, to split investment income and to bypass the attribution rules, which are designed to prevent taxpayers from income splitting with family members at a lower tax rate. Essentially, the rules say that if you give your spouse or partner money to invest, all interest income, dividends and capital gains earned from that money is attributed back to you and taxed at your higher rate.
But the income tax act contains a rule, saying that instead of gifting your spouse the money you loan it to him or her. Provided you charge the prescribed interest rate, all income will be charged in the other spouse’s hands.
The advantage of setting up this loan when the prescribed rate is two per cent is that the tax act only requires you to use the prescribed rate at the time the loan was originally extended. So, let’s say you give a loan to your spouse today, you can use the 2 per cent rate for the entire duration of the loan, which could be years or even decades. The only requirement is that the interest on the loan must be paid by January 30 for the previous taxable year (and each future Jan. 30) otherwise the strategy falls apart.
Here’s how the loan to spouse income splitting strategy works, using an example of Lisa, who is in the top tax bracket and William, who is in the lowest bracket of the household. Let’s say Lisa loans William $200,000 at the current prescribed rate of two per cent secured by a promissory note. William invests the money in a stock portfolio paying dividends with a current yield of four per cent. Each year, William takes $2,000 of the $8,000 in dividends he receives to pay the 2 per cent interest on the loan to Lisa.
The net tax savings for the couple would be having the dividends taxed in William’s hands at the lowest rate instead of in Lisa’s hands at the highest rate. This benefit would be offset slightly by having the $2,000 of interest on the promissory note taxable to Lisa, but it would still be tax deductible to William, since the interest cost was incurred for the purpose of earning income (line 221 in your income tax return Carrying charges and Interest Expenses)
This strategy may not be suitable to all investors. For advice related to your individual tax situation, please consult your tax advisor.