Now that the CRA has set the prescribed interest rate at a historical low of 1%, you may be setting up spousal loans for clients to achieve income splitting. You may also be faced with the challenge of trying to refinance existing spousal loans to access the new, lower CRA prescribed rate. (See previous article on the subject here.) To stay onside with the attribution rules and accomplish clients’ income splitting objectives there are tax issues you must consider.
Let’s look at an example. Amber and Scott are married. Three years ago, Amber loaned Scott $100,000 under a spousal loan agreement. The prescribed rate at that time was 3%. Today Amber and Scott have come to your office to discuss renegotiating this arrangement to bring the rate down to 1%. What can you tell them? There are a few options.
1. Leave the loan as it stands.
Review the original reason the loan was established. If the arrangement is working well, and Scott does not have the money to pay off the existing loan, it might make sense to leave the arrangement as is, even though the interest rate is at 3%.
2. Pay off the existing loan and establish a new one.
When entering into a new spousal loan, it’s important that the original loan be repaid. The safest method to repay the existing loan is to liquidate the investments and use the proceeds to pay down the loan. This will ensure that the attribution rules will not apply. The second loan must represent an entirely new loan — it cannot be a continuation of the first loan. In the case of Amber and Scott, if Amber arranges another loan for Scott before the first loan is paid off, Amber may find that, under Section 74.1(3) of the Income Tax Act, future income on Scott’s investments is attributed back to her. As an advisor, the facts relating to the second loan need to be clear and not a “novation” (continuation of the first loan). A simple exchange of promissory notes will generally be considered a novation, and can make Amber subject to the attribution rules. What do you tell Amber and Scott? Advise them to have Scott pay off the first loan and have Amber make a record of the cash payment, (i.e. an actual flow of funds between the spouses should occur). Once this is completed, a second loan can be established with new documentation.
3. Forgive the loan entirely and establish a new one.
Due to the market downturn, Scott may not have enough cash or investment value to pay off the first loan. In that case, Amber may consider forgiving the loan, but you should advise them of the tax consequences of doing this. There are “debt forgiveness” rules in the Income Tax Act under Section 80(13). Under these rules, Scott would have to take the forgiven amount and apply it to reduce unused carryforward amounts, namely:
- non-capital loss carryforward
- farm loss carryforward
- restricted farm loss carryforward
- allowable business investment losses
- net capital loss carryforward
A few more atypical outstanding tax accounts may be reduced, but the above are the most common ones. Scott can offset any remaining unused forgiven amount by current year capital losses. If Scott still has an unused forgiven amount remaining, then he will have to include that amount in his income, taxable at a 50% inclusion rate. (This is covered in subsection 80(13) of the Income Tax Act.
As the lender, Amber may be able to make an election under subsection 50(1) of the act to deem the unpaid balance of the loan to be disposed for proceeds equal to zero, and to have reacquired the loan at zero. This will create a capital loss for Amber on the bad debt, which she can use to offset any capital gains in the current year or the previous three years, or she may carry it forward to any future year. The ability to claim this election generally depends on the financial position of the debtor (in this case Scott), and his ability to repay the loan.
4. Blend options one and three.
Instead of forgiving all or part of the original loan, it may work out better to have Scott repay a portion of the first loan and then establish a second loan for the repaid portion. In our example, Scott borrowed $100,000 from Amber. If he pays down this loan by, say, $80,000 of the initial $100,000 loan from Amber, then a new loan could be set up for $80,000 at 1%. The remaining $20,000 on the first loan would continue as originally set up, with the 3% prescribed rate. Supporting documentation is important to evidence the repayment and the new loan arrangement. Ideally, Amber should use a different source of funds to establish the new $80,000 loan, and not simply lend back the proceeds received from Scott.
Due to the complexities of spousal loans, it’s important to understand and explore the options available with your clients. In a bear market, new opportunities for re-allocating or income splitting are good topics for discussion with investors, but they must follow the rules to avoid undesirable tax consequences.