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Three income-splitting techniques couples can use to save taxes on investment income

by Wayne Cheveldayoff, 2004-05-27

Couples can take advantage of at least three income-splitting techniques to save income taxes on investment income. These mainly require the higher-income spouse to lend or give money to the lower-income spouse to invest.

The tax-saving opportunity arises from the progressive nature of Canadaís income tax system.

Someone with taxable income of $100,000 pays a marginal tax rate of around 46 per cent on extra income earned, while a person earning $25,000 a year pays a marginal rate of only around 23 per cent on that extra income.

Obviously, if investment income can be reported by the lower-income spouse, the couple will save money on income taxes.

Canadian tax authorities have anticipated that couples will try to take advantage of the differences in marginal tax rates when investing. As a result, they have set out a number of rules to govern such investment-income splitting.

However, as long as you play by the rules and patiently plan for results over several years instead of months, there are three main ways for couples to save significant amounts of income tax:

∑ Spousal RRSPs Ė If Spouse A with a 46-per-cent marginal tax rate contributes $10,000 into a spousal RRSP, he or she will get a tax refund of $4,600 on that contribution. If Spouse B with a 23-per-cent tax rate later withdraws the $10,000 from the spousal RRSP, the amount of income taxes owing would be $2,300. The couple will save $2,300 ($4,600 minus $2,300) in income taxes. However, for this to work, the contribution has to stay in the spousal RRSP for three years. Also, the tax authorities apply a last-in, first-out attribution rule on spousal contributions. This mean that in order for this technique to work, Spouse A cannot make any spousal contributions for Spouse B in the three years prior to Spouse B withdrawing the money. If Spouse A makes contributions within the three-year period, Spouse Bís withdrawal would be attributed back to Spouse A and taxed in Spouse Aís hands. At that time, if Spouse A is still subject to a 46-per-cent marginal tax rate, nothing would be saved.
∑ Gift to Spouse Ė If Spouse A gives $10,000 to invest to Spouse B, the attribution rules require that Spouse A has to report and pay income tax on any income from that investment. However, over a period of years, Spouse B can accumulate the investment income and invest it as his or her own and would thus be taxed at a lower rate on it. For example, if Spouse B invests the $10,000 in an income trust paying 10 per cent a year, Spouse B would have $1,000 at the end of the first year. This $1,000 would be for Spouse B to keep and invest (with Spouse A paying the income taxes on it). Suppose that in the second year, Spouse B again earns 10 per cent on the original $10,000 plus the $1,000 that is now Spouse Bís. Of the investment income earned, $1,000 would be attributed to Spouse A and $100 to Spouse B. The $1,100 of income in the second year would be added to the $1,000 accumulated by Spouse B at the end of the first year, meaning Spouse B would have $2,100 to invest as his or her own for the third year. Using this technique and a well-documented paper trail, couples can gradually over several years legitimately transfer a significant amount of investment capital to the hands of the lower-income spouse.
∑ Loan to Spouse Ė The rules also permit effective income splitting via lending between spouses but only under certain conditions. If Spouse A lends the $10,000 to Spouse B and Spouse B invests it in income trusts paying 10 per cent, Spouse B would have $1,000 of investment income in the first year. This investment income would be taxed in Spouse Bís hands under two conditions: (1) Spouse A charges interest of at least Revenue Canadaís prescribed interest rate (currently 3 per cent) on the loan; and (2) Spouse B pays this interest within 30 days of the end of each year. In this situation, of the $1,000 investment income earned by Spouse B, $300 would be paid in interest to Spouse A, who would report the income. The remaining $700 would be Spouse Bís income to report. If Spouse A had invested the money and earned the $1,000, the total tax bill would have been $460 (due to the 46-per-cent marginal tax rate). But since the money was lent to Spouse B and the rules followed, Spouse Aís marginal rate only applies to the $300 interest earned on the loan (for a tax bill of $138), while Spouse Bís 23-per-cent tax rate applies to the other $700 (for a tax bill of $161). Instead of paying $460 in tax on the $1,000 investment income, the couple ends up paying only $299. Thatís a saving of 35 per cent. But it is important to remember that the technique works only if the conditions are met. If they are not, the $1,000 of investment income would be fully attributed back to Spouse A. At the same time, this is a particularly good time for couples to be contemplating this technique. The rules allow the interest rate on the loan to be locked in indefinitely at todayís level. At 3 per cent, the prescribed rate is the lowest it has been in decades. If market interest rates rise, so will the prescribed rate.

Splitting income in these ways could bring even greater tax savings if Spouse B earns no other income and therefore has a zero marginal tax rate. But it depends on the circumstances.

If Spouse A is claiming the federal spousal tax credit for Spouse B, this could be lost if Spouse B earns more than about $7,300 in income during the year.

In such a situation, one would have to weigh the potential tax savings from splitting investment income against the loss of the spousal tax credit. If you are unsure how to do that, it may be best to consult a tax accountant.

Wayne Cheveldayoff is a former investment advisor and professional financial planner. He is currently specializing in financial communications and investor relations at Wertheim + Co. in Toronto. His columns are archived at www.smartinvesting.ca and he can be contacted at wcheveldayoff@yahoo.ca.


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©2004 Wayne Cheveldayoff