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Low rates mean tax savings

A few years ago, the résumé of the newly appointed Mexican secretary of education, Fausto Alzati, came under scrutiny. Mr. Alzati claimed to have a doctorate from Harvard, but when challenged, his office conceded that he had only a master's degree in public administration. A month later, Mr. Alzati's office said that actually, he did not even have a bachelor's degree. Shortly after, Mr. Alzati resigned, admitting that he was expelled from the second grade for bad behaviour.

Pretty low. Mr. Alzati's grades, I mean. His conduct, too.

Ask Bank of Canada Governor David Dodge how low one can go, and he's likely to tell you 3.75 per cent -- maybe lower. I'm talking about interest rates, of course. Fact is, the prime rate could drop to 3.75 from 4 per cent after the next Bank of Canada policy announcement on Jan. 15.

What do low interest rates mean for you? Plenty. In fact, there are five key tax strategies to consider today given that interest rates are so low.
1. Loans to your spouse.

If your spouse is in a lower tax bracket, consider lending him or her some money. Now, the attribution rules in Canadian tax law normally work to ensure that you, and not your better half, will pay the tax on any income earned on those dollars lent.

The good news? You can avoid this attribution by charging your spouse interest at Canada Customs and Revenue Agency's prescribed rate, which as of Jan. 1 has sunk to just 3 per cent (for the first quarter of 2002). Better still, you can lock in at this low rate indefinitely.

Draw up a promissory note to be signed by your spouse, make sure your spouse actually pays the interest by Jan. 30 each year for the prior year's outstanding loan, report that interest on your tax return, ensure your spouse claims a deduction for the interest paid to you, then enjoy the tax savings as that portfolio grows and is taxed in your spouse's hands -- and not yours -- over the years.
2. Employee and shareholder loans.

Think about borrowing money from your employer where possible, or from your own corporation. The reason? You may be able to borrow at no or low interest. Sure, you'll face a taxable interest benefit, but thanks to low interest rates, that benefit today will be calculated at the 3-per-cent prescribed rate. The taxable benefit will be reduced by any interest you actually pay on the loan.

Further, if you use the loan for investment purposes, or to buy a vehicle for use in your employment, you'll be entitled to a deduction for the amount of the interest benefit. The rules around shareholder loans are complex, so talk to a tax pro if you're in this boat.
3. Borrowing to invest.

Tax deductions in Canada are in short supply. Borrowing money to invest can provide a deduction for interest costs while helping you to build wealth more quickly. With interest rates so low today, there may be no better time to borrow to invest.

Not only will your break-even rate of return be quite low (visit for a break-even return calculator), but today's low interest rates can only spell good news for equity markets. While borrowing to invest is not for everyone, it could be for you if you have stable cash flow to make debt payments, and understand both the upside and downside potential of the strategy.
4. Borrowing for your RRSP.

Time to plow more bucks into your registered retirement savings plan. If you have significant unused RRSP contribution room, and you're behind in saving for retirement, it could make sense to take out an RRSP catch-up loan to use up that contribution room. Most banks will lend you money at prime to contribute to your RRSP -- and with prime rate at 4 per cent and falling, use of the money is pretty cheap.
5. Refinancing your mortgage.

Thousands of Canadians have paid the penalty to get out of an existing fixed mortgage in order to refinance at today's lower rates. The interest savings could leave you much better off, even if the penalty is substantial. Here's an idea: Consider paying the penalty to get out of that fixed mortgage, then liquidate some non-registered investments you may have on hand and apply those dollars to reduce the amount of the new mortgage you take out. Then borrow to replace those investments.

The interest costs on the money borrowed to invest will now be deductible for tax purposes. In effect, you're turning mortgage interest into deductible interest. And with so many investments in your portfolio that may have dropped in value, you may not trigger a tax hit when liquidating those investments for this strategy.

Tim Cestnick, CA, CFP, TEP is author of Winning the Tax Game 2002, Winning the Estate Planning Game, and is managing director, Tax Smart Services, AIC Ltd.

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