Advisors with clients who are married, or are equivalent to married, may want to take a close look at spousal income-splitting strategies now — before the lowest prescribed loan interest rate in history disappears. The prescribed rate, which is used to set interest rates on loans between spouses, is currently just 1%.

Couples can use a low-cost loan to purchase income-producing assets in the name of the lower-income spouse. The result is more equitable distribution of income and lower taxation, as couples can take advantage of Canada’s system of graduated tax brackets. Splitting income with a spouse can also reduce or eliminate the old-age security clawback for the higher-income spouse down the road.

“Taking advantage of the 1% rate on spousal loans is the No. 1 tax-planning opportunity for couples if there is a differential tax rate between spouses,” says Jamie Golombek, managing director of tax and estate planning with Canadian Imperial Bank of Commerce’s private wealth management group. “It’s an outstanding opportunity to lock in a low-rate loan for a lifetime or as many years as you want. No matter what happens to interest rates in the future, if a loan is made now at the current prescribed rate, it will not move above 1%.”

The prescribed rate is set quarterly. It is based on the average yield of Government of Canada three-month treasury bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage. At 1%, this rate is now the lowest it has ever been, and is as low as it can go. That rate came into effect for the quarter ended June 30, 2009, and was renewed for the current quarter, ending Sept. 30. But, after that, nobody knows what will happen.

Historically, the prescribed rate has averaged 5% to 6%, Golombek says. At those higher rates, it is more challenging to find investments that yield a profit after the interest on the loan is paid. At 1%, income-splitting strategies become much more effective. Here’s how the strategy can work.

The Income Tax Act does not allow a high-income spouse simply to transfer assets such as securities to a lower-income or non-working spouse, or give the spouse the money to purchase those assets, without tax consequences. Any income earned on those assets would be attributed to the higher-income spouse.

But if the higher-income spouse lends money to the lower-income spouse to purchase income-earning assets — and is scrupulous about charging the prescribed annual rate of interest — the attribution rules do not apply. The lender would not report any income from investments made by the spouse with the borrowed money, but the lender would be required to report the interest paid on the loan as income. At a 1% lending rate, the interest income would be relatively low.

The loan should be formally documented with a promissory note that includes the date, the amount lent and the rate of interest. Interest must be paid each year, or within 30 days after the end of the year. It’s crucial not to miss the deadline, and to make sure there is proper documentation, such as a cancelled cheque, to prove the interest was paid on time. If the couple misses the deadline, that year’s income and all future years’ income on the investments purchased with that loan will be attributed back to the lending spouse.

The borrowing spouse may deduct the cost of borrowing from his or her own income.

“Couples need to do a bit of paperwork to show that the loan was made and that interest payments were made and received on a timely basis,” says Doug Carroll, vice president of tax and estate planning with Invesco Trimark Ltd. in Toronto. “There should be conscientious record-keeping; it can’t simply be manufactured after the fact. Advisors might be able to lend a hand in the area of record-keeping to ensure that clients are doing it properly and perhaps add extra credibility by acting as a signature witness.”

It’s also important that the borrowing spouse have enough money of his or her own to pay the interest on the spousal loan. If the source of the interest payment is discovered by theCanada Revenue Agency to be connected to the lending spouse, the attribution rules will apply.

@page_break@“If the receiver of the loan is borrowing money in order to pay the spouse interest, the transferor or lending spouse doesn’t want to be associated with that transaction,” says Carroll. “If lending spouses underwrite or guarantee anything, it’s considered by the CRA to be the same as paying themselves.”

The borrowed funds can be placed in any of a variety of investments, including stocks, bonds, guaranteed investment certificates, a private business or a property.

“The funds are not to be used for a vacation,” says Myron Knodel, director of tax and estate planning with Investors Group Inc. in Winnipeg. “The funds must be invested in something that has the potential for interest, capital gains or dividends.”

Here’s an example of the process: high-income earner Mr. A lends his non-working spouse, Mrs. A, $100,000 at the prescribed rate. Mrs. A invests the funds at 4% and reports the investment income. She must pay Mr. A 1% interest before Jan. 30 every year, and is then taxed on the 3% difference. In this example, taxation of the annual income of $3,000 is shifted to the lower-income spouse.

“The bigger the discrepancy in incomes between spouses, the better income-splitting strategies work,” says Adrian Mastracci, president of KCM Wealth Management Inc. in Vancouver. “If there is a non-working spouse with no income at all, that works even better. The goal of any income-splitting strategy is to equalize income between spouses to the extent possible, and pay less taxes between the two spouses.”

You may have clients who have already lent money to a lower-income spouse at previous, higher rates. A new loan can be negotiated to take advantage of the low rate. But it’s not simply a case of crossing out the old interest rate and changing it to 1%, says Golombek. The old loan must be formally paid off, and a new loan must be negotiated in a formal manner, he says, or the income-attribution rules could be applied to the couple.

Ideally, the borrowing spouse could sell the investments bought with the old loan, repay the loan in full and then enter into a new loan agreement using the 1% prescribed rate. If investment values have fallen, this may be an attractive strategy because it could crystallize capital losses, which could be applied against capital gains made this year or within the past three years, or used to reduce future capital gains.

However, given current market conditions, liquidation of the investments might not provide sufficient funds to repay the original loan. As well, this strategy may trigger brokerage fees or capital gains if the holdings have risen in value, resulting in immediate costs or taxes. Additionally, the assets could include an illiquid asset such as a piece of property or private business that can’t be sold easily.

Another potential strategy is to borrow from a bank on a short-term basis, using the investment assets as collateral, and repay the spousal loan. Again, it is important that the original lending spouse does not guarantee the financing. Once the old loan is formally repaid, a new loan could be obtained from the higher-income spouse at 1% — ideally, using a different source of funds — and the interim bank financing can be paid off.

“The loan could be made for as short a time as is necessary,” says Knodel. “It could even be a ‘daylight’ loan, for as little one day.”

If assets are sold to repay the spousal loan and capital losses are triggered, the borrowing spouse must wait 30 days to repurchase any of the same assets that were sold if they want to apply the capital loss against gains on other investments. Otherwise, the losses will be considered “superficial” and denied by the CRA. IE