Among the various strategies available, spousal loan arrangements stand out as a sophisticated and legal way to reduce overall family tax burdens in Canada. For those who have one, remember interest is due before the end of this month (i.e., January 30, 2025) to maintain the arrangement. For those who do not have one, it is worth understanding how this planning arrangement works and why it might be beneficial for you.
What are they?
A spousal loan is a tax planning strategy where a higher-income spouse lends money to a lower-income spouse or common-law partner. The lower-income spouse then invests this money to generate income, which is taxed at their lower marginal tax rate. This can significantly reduce your family’s overall tax liability.
When should they be used?
Spousal loans are particularly useful in the following situations:
- If one spouse earns significantly more than the other.
- When the high-income spouse has a lump sum of capital that is not required for immediate expenses and can be invested for the long term.
- For couples who want to equalize retirement savings or taxable income in the future.
How do they work?
To ensure the legitimacy of the arrangement, you must comply with Canada Revenue Agency’s (CRA) regulations as follows:
- Interest Rate: The loan must carry interest at the prescribed rate set by the CRA at the time the loan is made. This rate changes quarterly and is currently set at 4%.
- Timely Interest Payments: Interest on the loan must be paid by January 30 of the following year. Failure to meet this deadline can negate the benefits of the arrangement.
- Documentation: Keep detailed records of the loan agreement and interest payments. Proper documentation is essential in case of an audit.
- Purpose of Loan: The borrowed funds should be used for income-generating investments. Using the loan for personal expenses will not provide the intended tax benefits.
Other considerations?
While spousal loans can be an effective tax planning tool, there are some risks to consider:
- Market Volatility: Investment income is not guaranteed, and poor investment performance can result in a loss.
- Administrative Burden: The requirement to track interest payments and keep proper documentation can be time-consuming.
- CRA Scrutiny: Incorrectly executed arrangements may attract CRA audits, leading to penalties and the application of attribution rules.
Other alternatives?
You can also make prescribed rate loans to a trust set up for your family. This option is flexible because the trust can share the income it earns from the loan with different family members, helping to lower the overall family tax bill. By using a family trust, you can give more income to family members who pay less tax, saving money for everyone.
The trust can manage and distribute the income based on each family member’s needs, making sure everyone benefits while following tax rules. It’s important to have a formal loan agreement and pay the interest on the loan each year at the rate set by the CRA when the loan is made.
Consult with a representative from Welch LLP to decide whether these tax planning tools align with your financial goals and to ensure full compliance with Canadian tax law.