Last Chance for "the 1% Solution"

May 28, 2022 by David Christianson

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Just when you thought all your tax deadlines were behind you (aside from a possible June 15 due date for your quarterly tax instalment), we are going to introduce another potential deadline of June 30.

This will apply specifically to married or common-law couples where one spouse is in a higher tax bracket and has substantial investment capital, while the other is in a low tax bracket.

Under current Canada Revenue Agency [CRA) rules, the higher income spouse can loan money to the lower income spouse at an interest rate of 1%, and all of the interest, dividends and capital gains earned on that money when invested can properly show up on the tax return of the lower income spouse.

With many Canadian company share investments currently paying dividends of 4% or more and even five-year GICs ramping back up to 3.5%, this can be a great long term income splitting strategy.

The deadline comes in because on July 1, the CRA "prescribed rate" for such loans goes up to 2%. Good news is that any loan that is properly documented and advanced prior to July 1 at 1% will remain at that rate as long as the interest payment is actually made in cash (cheque or electronic transfer) within 30 days of each year end, consistent with the rules.

Such loans can also be made to minor children or to a family trust with minor children and/or a spouse as beneficiaries. That can be even more effective.

To put some numbers on this, the first tax rate in Manitoba (combined federal and provincial) is on the first $34,431 of taxable income, after deductions. Any interest on income below this is taxed at 25.8%, while eligible Canadian dividends are taxed at just 3.84%. Eligible dividends are those dividends paid to you when you own the shares of any publicly traded Canadian company, like a bank, grocery chain or telephone company.

Remember that those shares trade on the stock market and are therefore subject to fluctuations in price. Eligible dividends are also paid by mutual funds or ETF investments that own shares of Canadian companies on your behalf.

The next tax bracket is between $34,431 and $50,197 of taxable income. In this bracket, interest is taxed at 27.75% and eligible dividends at just 6.53%. In both cases, unrealized capital gains are tax-deferred while realized capital gains are taxed at exactly half the rate of interest income.

So, if one spouse is in one of the first two tax brackets and the other spouse has taxable income in excess of $100,000, there can be a big advantage to the investment income being earned on the tax return of the lower income spouse. In Manitoba, tax rates are 43.4% between roughly $100,000 and $155,000 of taxable income, 46.78% above that up to $221,708, and 50.4% on taxable income in excess of $221,708.

Eligible dividends are taxed, respectively, at 28.12%, 32.79% and 37.78% in those three tax brackets.

Therefore, if $250,000 is loaned to the lower income spouse, invested and earns 4% in dividends, that’s $10,000 per year. If that can be taxed at 6.53% instead of, say, 32.79%, the tax is $653 per year instead of $3,279 per year, a saving of $2,626.

We are ignoring the complications of the dividend gross up and dividend tax credit and skipping to the bottom line.

On the flipside, the higher income spouse will have to pay tax of $820 on the $2500 of interest that must be paid each year from the lower income spouse to the higher. However, the lower income spouse also gets to deduct that interest, because it is paid on money used to earn taxable investment income. That reduces his or her tax to about $300 - $400 on the $10,000 of dividends.

The advantage is not quite as pronounced on interest income earned on instruments like GICs, because interest income does not get the big benefit of the dividend tax credit, which is very pronounced in the lower two tax brackets. For example, on $10,000 per year of interest income earned on a GIC, the relative advantage is between roughly $1000 and $2200 per year, depending on the relative tax brackets. Still pretty attractive, with a much bigger advantage on larger amounts of capital.

We’ve been utilizing this strategy for many years with our clients, and the long-term advantage has been profound. This structure requires a bona fide loan agreement, and the interest must actually be paid each year within 30 days of year-end. If you slip up, the loan will have to be repapered at the then-current prescribed rate.

I recommend professional advice before engaging in this plan of action, but with only one month left at the bargain interest rate of 1%, you’d best get at it. 

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Dollars and Sense is meant as an introduction to this topic and should not in any way be construed as a replacement for personalized professional advice.

Please consult legal, tax, insurance and investment experts for advice on your unique situation.


David Christianson, BA, CFP, R.F.P., TEP, CIM is recipient of the FP Canada™ Fellow (FCFP) Distinction, and repeatedly named a Top 50 Financial Advisor in Canada.  He is a Portfolio Manager and Senior Wealth Advisor with Christianson Wealth Advisors at National Bank Financial Wealth Management, and author of the 2021 book Managing the Bull, A No-Nonsense Guide to Personal Finance

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