Last week, I challenged business owners and incorporated professionals to take deliberate steps to reduce or defer the CRA’s take-home pay.
Here is part of what I said:
“The CRA is a devious partner. It shares in our profits but doesn’t participate in our losses. It’s never around when we need help landing a new client or have trouble paying the rent. Yet somehow, many of us have a partner that takes approximately 50% or more of everything we earn.”
I explained how shareholders of Canadian Controlled Private Corporations (CCPC) could lose some or all the small business deduction (SBD) if their corporation earns more than $50,000 of investment (passive) income.
I also provided several methods for reducing their corporation’s passive income and preserving all or some of the SBD.
This week, I am going to explain how loans and transfers may lower a family’s combined taxes.
Please note that these blogs are for informational purposes only. I won’t and can’t cover every possible scenario, so please speak with your advisors to determine if these strategies are useful for your specific situation before implementing.
So, here we go!
I’ll start by reminding you that in Canada, a married couple is taxed as two separate tax-paying individuals.
For example, assume Couple A both work and each earns $50,000 per year or $100,000 combined. In Couple B, one spouse doesn’t work and the other earns $100,000 per year.
(For now, assume there are no other sources of income or deductions and both couples reside in Ontario.)
Couple A pays approximately $10,775 each for a total of $21,550 in tax, and Couple B pays $27,133 in tax.
In short, both families earn the same $100,000, but because of our tax system, Couple B pays approximately $5,600 of additional tax per year.
If we take the future value of $5,600 for 30 years at 4% return, Couple B ends up with approximately $500,000 less money. And that’s a lot of money!
In the spirit of transparency, my late wife and I were Couple B.
Not a fair system, but neither is life. So I challenge business owners to spend time and money to consider effective and legal tax minimization strategies.
Many business owners have in the past paid dividends and/or salary to family members in lower tax brackets, such as school-aged children and stay-at-home spouses. It was called income splitting and would lower the family’s overall tax liability by spreading money to family members with little or no income.
Unfortunately, all good things eventually come to an end. In 2018, the federal budget restricted income splitting by introducing the new Tax on Split Income (TOSI) rules.
Due to the complexity of the TOSI, the blog will not explain the rules nor the exceptions to TOSI , we suggest this review is best completed with your advisors.
Despite the changes to the TOSI rules, there are some existing strategies that remain effective for high-income individuals.
Below are a few.
1) SPOUSAL LOANS
When one spouse earns a higher income than the other, like Couple B above, the overall tax bill may potentially be reduced by shifting investment income to the lower-income spouse.
For example, Richard (the working spouse in Couple B) lends his stay-at-home spouse Mary $100,000 for the purpose of buying investment assets and charges Mary the prescribed rate of interest. At the end of the year, the investment earns $4,000 of investment income, and the interest charged was $1,000.
The attribution rules would normally transfer the $4,000 of investment income back to Richard, but because the money was loaned and formalized by a legal agreement including charging the prescribed interest rate (which is 1% as of July 2020), the attribution rules don’t apply.
(note: interest must be paid by January 30 for the attributions to not apply).
So in summary, Mary records the investment income of $3,000 ($4000 less $1000). Because she didn’t earn any other income, her tax payable would be nil, and Richard records $1,000 of investment income and pays tax on the balance. The total family tax payable is lower under this approach.
Note that in this case, Mary’s income was nil, but it doesn’t have to be zero. The strategy works if one spouse is in a lower tax bracket and the prescribed rate is low.
Also note that the rate applied to the loan can remain unchanged even if the prescribed rate increases in the future, which could result in significant tax savings, especially if the loan remains outstanding for an extended period.
These types of loans are often structured as due on demand loans with no set repayment terms and could be outstanding for an unlimited amount of time.
I suggest considering a spousal loan now while interest rates are historically low.
2) TRANSFERRING ASSETS TO A SPOUSE
Instead of transferring cash to a lower-income spouse, this strategy entails transferring an asset such as a stock.
In order to avoid the attribution rules, Richard transfers a stock to Mary at fair market value and records the accrued capital gain in the year the transfer is made.
As in the above example, Mary provides Richard with a promissory note equal to the fair value of the stock and includes an interest rate equal to the prescribed rate.
All future capital gains and investment income sits with Mary, and Richard records the interest on the loan.
After a market decline as we experienced in March, 2020, I suggest reviewing assets with zero or very small accrued capital gains and investigate a transfer to the lower-income spouse.
3) PERSONAL GIFTING
In some cases, business owners have adult children who are in a lower tax bracket when compared to their parents.
Under this circumstance, it’s possible to gift money to an adult child, and any future investment income earned by the child would be taxed at the child’s lower rate and would not attribute back to the higher-income spouse.
I suggest business owners consider this option in connection with the pros and cons of providing an early inheritance.
4) SPOUSAL RRSP
Let’s go back to Couple B. Richard’s RRSP room is $18,000, and he has the option of either contributing to his personal RRSP or to a spousal RRSP. Either way, Richard gets the tax deduction.
In this strategy, Richard makes a spousal contribution on behalf of Mary and claims a $18,000 tax deduction. Note that this contribution doesn’t affect Mary’s ability to make her own RRSP contributions, assuming she has contribution room.
If Mary withdraws the $18,000 after three years, the withdrawal is taxed in her name and not attributed back to Richard.
(note: if Mary withdraws the RRSP within three years, attribution rules apply, and the strategy fails.)
Again, if Mary is in a lower tax bracket, she would be taxed less on the withdrawal (when compared to Richard’s tax rate), and any future investment income would be taxed in her name.
5) PENSION SPLITTING
This strategy enables the higher-income spouse to shift up to 50% of eligible pension income to the lower-income spouse, resulting in a lower tax bill within a family
Most tax preparation software offers the ability to test all possible pension splitting options and recommend the optimal pension split.
CASE STUDY: Taking a closer look at spousal loans
I get a lot of questions about this, so if you’ve read this far and want a little more detail on how this works, read on. Below is an example of prescribed rate loans to a lower-income spouse.[1]
Here are the basic assumptions:
- Mrs. X is a high-income earner with a tax rate of 50%.
- Mr. X is the lower-income spouse with a tax rate of 25%.
- Mrs. X wishes to invest $500,000.
Scenario 1
Mrs. X invests $500,000 in income-producing assets generating a 5% return, or $25,000 of investment income.
Mrs. X’s taxes payable is $12,500 ($25,000 x 50%).
Scenario 2
Mrs. X lends the $500,000 to Mr. X, with Mr. X issuing a promissory note bearing interest at the prescribed rate of 1%.
Mr. X pays tax of $5,000 ($25,000 less $5000 x 25% = $5,000).
Mrs. X pays tax on the interest earned of $2,500 ($500,000 x 1% x 50% = $2,500).
Total tax in scenario 2 is $7,500 ($5,000 + $2,500).
By loaning $500,000 to the lower-income spouse with the prescribed rate as the applicable interest rate, Family X pay $5,000 less tax annually, which could be significant over a long period of time.
Overall, prescribed rate loans may be a method for reducing a family’s overall tax liability, particularly where one spouse earns significantly more income than the other.
Any strategy is best considered as part of a comprehensive financial plan, where an individual’s overall goals and entire financial situation can be factored into any and all recommendations. The process of finding a financial advisor can be overwhelming. It is our job to make that process simpler and easier. Dri Financial Group’s proprietary Wealth Navigator Process is designed with you in mind. Its structured framework helps you make an informed decision and feel confident in our team and management practices before we get started.
We offer you a range of services from creating bespoke financial plans and providing investment advice to helping you take advantage of our investment models. If you would like more information on the Wealth Navigator Process or our team, call me any time at 416.355.6370 or email me at richard.dri@scotiawealth.com.
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Like his close friends Brian DePalma, Francis Ford Coppola, George Lucas and Steven Spielberg, Martin Scorcese helped to introduce a new kind of American filmmaking in the 1970s. A film school graduate, he broke out in 1973 with Mean Streets, his first film with Robert De Niro. His next De Niro film, Taxi Driver, was nominated for four Academy Awards, won the Palme D’Or at the 1976 Cannes Film Festival, and is considered so historically significant that the US Library of Congress has selected it for preservation in the National Film Registry. In addition to repeatedly working with De Niro, Scorcese also regularly collaborates with Leonardo DiCaprio, with The Departed winning Academy Awards for Best Picture and Best Director. In total, Scorcese has directed 20 films, won more awards than can be counted, and has three films in the American Film Institute’s top 100 American films of all time list (Raging Bull, Taxi Driver and Goodfellas). Scorcese’s visual, kinetic style has had a significant impact on modern filmmaking, and he’s at it again with Killers of the Flower Moon, a movie in pre-production starring both De Niro and Di Caprio. The 77-year-old master has no plans to retire. Martin Scorcese.
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