While facing COVID-19 financial challenges, tax planning may not be your top priority. However, putting tax strategies into place could help you save money during today’s economic environment.
When it comes to tax minimization, you should look into strategies that reduce not only your tax bill but also that of your family as a whole – one way of doing this is income splitting between family members.
Income splitting is the concept of shifting income from a high-income tax rate family member to another who will pay tax at a lower rate. Attribution rules of the Income Tax Act state that if you give a spouse funds for that person to invest, any income or capital gains generated on those funds would be taxed in the hands of the other spouse. Similar rules apply with respect to gifts to minors, with a few differences.
A way to steer clear of the attribution rules is by, for example, creating a loan between the spouses at an interest rate equal to or greater than the CRA prescribed rate. The loan must be documented in writing.
As of July 1st, 2020, the CRA prescribed rate is at its lowest possible rate of 1%, down from 2%. This represents an excellent planning opportunity that would allow family members to income split. The net effect would be that any investment return generated above 1% would be taxed in the hands of the lower-income family member.
Assume Mrs. A is a successful business owner and is currently paying tax at the highest income tax rate, which in Ontario is 53.53%. On the other hand, Mr. A has no income.
Mrs. A currently has $1 million of investable assets, which are generating a 5% return on investment. The investment income of $50,000 is taxed at the top marginal rate for Mrs. A.
Mrs. A has decided to loan her near-cash investment assets to Mr. A. Note there may be capital gains/losses on any dispositions. A loan agreement is documented at the prescribed interest rate of 1%. Mr. A then goes ahead and invests the $1 million. At the end of the year, Mr. A generates $50,000 of investment income, assuming the same 5% rate of return. He would end up paying tax at his marginal income rate of under approximately 15%, rather than the higher rate of 53.53%.
By January 30th of the following year, and every year the loan is outstanding, Mr. A must pay interest of 1% on the $1 million loan from Mrs. A ($10,000). Mrs. A will report this $10,000 as income on her personal income tax return, and Mr. A would be able to deduct this $10,000 as an interest expense on his return. Tax savings for the spouses could be over $20,000 for the first year, and available thereafter on an annual basis.
Something to keep in mind is that the interest rate is set at 1% for the life of this loan. The interest on this loan for each calendar year must be paid in cash by January 30th of the following year. The Government sets the prescribed interest rates every 3 months, meaning the 1% rate will remain for at least July to September 2020. Future rates would depend on where interest rates go in Canada.
A professional tax advisor’s assistance is strongly recommended to determine if this or any other type of tax planning strategy could benefit you.
About Stephanie Jindal and SBLR:
Senior Tax Manager at SBLR LLP who specializes in corporate restructurings and estate planning.
SBLR LLP is a mid-sized accounting and tax firm that delivers proactive service to the small and medium-sized entrepreneurial business owner. We provide accounting, tax, and business advice to clients across multiple industries. Learn more at www.sblr.ca