Take advantage of spousal loans now

July 17, 2012 | Last updated on September 15, 2023
3 min read

For the 14th consecutive quarter, the prescribed rate on spousal loans is staying at 1%.

To put that in context, during the 25 years leading up to April 2009, the lowest rate was 2%, and it only occurred in three quarters during that interval.

So is it time for couples to get on this bandwagon?

A spousal loan recap

Our tax system is based on the individual as the taxable unit, as compared to some economies where spouses or a broader family unit is the taxable entity.

That being the case, taxpayers have an incentive to split income – or at least attempt to do so – with household members who face lower tax rates on their marginal income.

Read: Income splitting in the TFSA era

In response, the Income Tax Act has a number of anti-avoidance rules that attribute income earned on transferred assets or sources back to a transferor. An exception to attribution is available on loans between spouses at the prescribed rate.

A low-income spouse could be taxed on the investment income generated on borrowed money. Interest charges paid to the higher-income spouse would be deductible to the borrower spouse, and correspondingly taxable to the higher income lender spouse.

Be careful when servicing the loan

The lower the interest rate allowed on such loans, the more desirable the arrangement could be. This is particularly so because such loans have no mandatory horizon date, and the rate can be locked-in for life at the initial rate setting.

Still, the decision to establish a loan cannot be dictated by tax considerations alone, even when the 1% rate is the lowest possible point (based on the rounding formula used in the regulations).

Read: Spousal loan pitfalls

As well, a significant disparity in spouses’ marginal tax rates may make this strategy appealing, but there are no guarantees. For example, had a loan been established back in 2009, the intervening interest payments would have been taxable income to the lending spouse, and yet the borrowing spouse may not have experienced much or any income or gains in that time period.

Indeed, had the investments declined in value, the higher income spouse may have been able to make more effective use of resulting capital losses.

Thus, tax motivation must be tempered with investment risk and outlook.

Read: Refinancing spousal loans

What’s more, the borrowing spouse must keep that loan in good standing every year. This means the interest must be paid during the year or within 30 days of its end, and those payments must be made from the borrowing spouse’s own resources.

In particular, if some of the investment portfolio is sold or redeemed in order to make those interest payments, in effect the lending spouse is getting his or her own money back. The attribution rules would apply from that point forward, even if the loan is properly serviced in future years.

With all that in mind, the borrowing spouse should consider including income-generating components within the portfolio to cover the interest charges. To be even more tax-efficient, Canadian dividends may be particularly worthwhile, as the gross-up/credit treatment leads to a much lower effective tax rate at lower brackets.