A newly released technical interpretation of the Income Tax Act by the Canada Revenue Agency states that interest owed on spousal loans must be paid within 30 days of the end of the calendar year, regardless of the payment terms in the legal loan agreement.

Advisors should make clients aware of this fact because missing an interest payment on a spousal loan could end a couple’s income-splitting opportunities for allfuture years.

Using spousal loans during periods in which interest rates are low is a popular way of circumventing Canada’s strict rules on income-splitting. If one person in a married or common-law relationship falls within a higher tax bracket, he or she can loan money to his or her spouse for investment purposes.

Under the CRA’s rules, any income earned on that money is then taxed at the borrower’s lower rate. However, it is vital the borrower pay the interest on time each year because the CRA imposes a “look-back” rule that requires all interest on such loans be paid on time for both the current year and all prior years. If interest on previous years’ spousal loans is not paid on time, then the couple is no longer eligible to take advantage of this income-splitting technique.

As well, the CRA considers it a bona fide loan only if interest is charged at the CRA’s prescribed rate, which is currently 4%.

“It’s always said in the Income Tax Act that you have to pay the interest within 30 days of the end of the contract year; we’ve always known that,” says Jamie Golombek, vice president of tax and estate planning with AIM Funds Management Inc. in Toronto. “But when you read the technical interpretation that came out, it seems to suggest that interest is payable within 30 days of the calendar year in which interest was accruing.”

What this means, in most cases — unless the loan was made precisely on Jan. 1 — is that in order to be in compliance with CRA regulations, some interest will need to be paid before the date set out in the legal loan agreement.

For example, a husband might borrow money from his wife on July 1 of this year with interest due annually on July 1, beginning in 2009. But the CRA interpretation published in April emphasizes the importance of paying the “interest payable, in respect of the particular year.” Therefore, in this example, the husband would be required to pay any interest accrued in 2008 by the end of January 2009 rather than on July 1, 2009, the date set out in the loan agreement.

The CRA’s interpretation also applies to loans made between parents and their children.

Cy Fien, a senior tax partner at Fillmore Riley LLP in Winnipeg, says this Income Tax Act provision is “ambiguous” and he is concerned the new interpretation will catch many taxpayers offguard. Fien says most loan agreements make interest payable either monthly or on the anniversary date. “That’s ordinary commercial practice,” he says. “But now the CRA is saying, even if the interest is paid on the anniversary date, it’s not going to work — which people who aren’t tax mavens would normally think is OK.”

Under this new CRA interpretation, the loan interest is due at different times for tax purposes than it is in the terms of the commercial agreement, he adds. “Nobody would think that you’d have to do a calculation and pay it at yearend [when] the promissory note itself doesn’t call for interest to be paid until the anniversary date.”

Because these types of loans are fairly common, many people handling them are not tax experts.

“The lesson that we are learning from this,” Golombek says, “is to make sure that in the loan agreement — no matter what your date of the loan is — you specify that interest is payable annually within 30 days of the end of the year.”

The CRA’s comments are not binding, but they do constitute the agency’s administrative position and the way it will assess a spousal loan situation. “It’s not the law; it’s how it interprets the law,” Golombek says. “An advisor would hate to give advice against a technical interpretation unless he or she truly believes that that technical interpretation is wrong at law.”

@page_break@Golombek says the interpretation goes back to the CRA’s basic philosophy that most income-splitting is not allowed in Canada: “It sounds crazy, but there is some logic here.” Spousal loans are only allowed if a fair market rate is applied and, therefore, it is assumed that a spouse must take on some level of risk in order to find an investment that pays out more than the prescribed interest rate. “[The CRA] wants to make sure that it is a real loan, that you really are paying the interest and that you are doing it every single year.”

The CRA interpretation, Golombek warns, could “pose a real problem for some people.” IE