Tax Savings - Income Splitting
Income splitting is a complex area and proper planning with your Chartered Professional Accountant is essential.
The main purpose of income splitting is to take advantage of the fact that Canada has a graduated income tax system. Whenever you can shift income from a higher bracket family member to a lower bracket family member you have reduced your overall income tax burden and derived a tax savings. Click HERE for a summary of the various tax brackets in Alberta.
There are tax rules to prevent excessive income splitting. Collectively, the rules are generally known as the Attribution Rules. The attribution rules will attribute income from property (but not income from business) back to an individual who may have transferred or loaned the property to split income. For example, transfers or loans of property to a spouse (also common-law spouse) will result in attribution of income and capital gains back to the spouse who transferred the property. A taxpayer transferring or loaning property to his or her spouse is still accountable for any capital gain, or loss, on the sale of the property (including money). Also, transfers or loans of property to a minor who is a non-arms-length person (for example, your child) will also result in attribution of income (but not capital gains).
A quick guideline to see if loans or transfers (gifts or sales) of property are subject to attribution is as follows:
Click HERE for discussion on transfers or loans to Spouses.
Click HERE for discussion on transfers or loans to Relatives.
Click HERE for further discussion on attribution on Investment Income.
Click HERE for a discussion on attribution involving corporations.
Click HERE for some problems using management fees for income splitting.
The Attribution Rules are far more complex than just discussed and caution should be exercised when doing any tax planning in this area. There are however, several opportunities to do some tax planning to obtain some benefits of income splitting. All of the following tax planning opportunities should be discussed with your Chartered Professional Accountant before implementation.
There is no attribution on funds loaned to a spouse and the invested funds earn business income.
There is no attribution on attributed income.
Take the example of say Mr. & Mrs. Anderson. Mr. Anderson loans his wife $100,000 to invest. As a result she earned $10,000 interest (10% interest). Because of the attribution rules, Mr. Anderson has to report the $10,000 in interest as income on his return. In the second year, Mrs. Anderson re-invests the $100,000 as well as the $10,000 of interest. As a result, she created income of $11,000 in interest (10% interest on $110,000). The additional $1,000 ($11,000 - $10,000) in interest will be taxable in Mrs. Anderson's hands, not Mr. Anderson's hands. In other words, the income from attributed income is not attributed back to Mr. Anderson. Many financial organizations will set up such a plan and keep track of the secondary income calculation.
The RRSP rules allow you to contribute to an RRSP for your spouse and claim the deduction yourself. The advantage is that your spouse will ultimately report the income for tax purposes once the funds are withdrawn when he/she retires.
But, the amount you contribute will be taxed back to you (not to your spouse) if your spouse withdraws any amount you contributed in year one, or in the next two calendar years.
Unlike your own RRSP contributions that you usually contribute to in January or February, contribute to your spouse’s RRSP by December 31. This method allows him or her to withdraw funds at the start of the maturity period without the attribution costing you money due to early withdrawal.
The attribution rules apply to children under 18. Where property is transferred or loaned to a child under 18 there will be attribution of income but not of capital gains.
One strategy is to provide funds for your children’s education by purchasing a mutual fund that relies on growth and doesn’t pay interest or dividends. The growth counts as a capital gain that is taxed in the child’s hands.
Give funds to your child who turns 17 years of age by the end of the year. The funds will be Invested to pay income when your child is 18 years of age.
Funds can be invested in a one-year minimum term deposit or certificate, that won’t require its interest reported until the child turns 18 years of age.
Transfer Property To Adult Children
Loans to adult children result in attribution, but not to property transferred. The transfer can be by way of gift, but remember that gifting results in deemed disposition at Fair Market Value. So tax could be owing on capital gains and capital losses may be denied under the Stop Loss Rules. Gifting of cash will result in no capital gains or losses.
Capital Gains Do Not Attribute
Except for loans or transfers to spouses, loans or transfers to other relatives (including minors) does not result in the attribution of the capital gain. However, if the investment results in a capital loss, the loss also does not attribute back to the transferor and stays with the relative.
Once your child turns 18 years of age and if you are the lower income spouse, you can deduct wages paid to your adult child for baby-sitting services for your minor children. This expense is allowed because it permits you to earn employment or business income. But, as any wage earner must, your adult child has to report this income to CRA and give you a receipt.
Simply make sure that the cheque to pay your spouse’s income tax liability, for both April and any installments, is drawn on your own account.
Your spouse will like this arrangement, but he or she should invest the rescued amount of money normally paid in taxes. The result is no attribution on the income earned from these savings.
Loan funds at a reasonable rate of interest
A taxpayer can lend funds to his spouse or other relative at the CRA prescribed rate. The spouse or relative pays the interest, but reinvests the principal in investments which return a higher return on investment than the prescribed rate.
This income splitting strategy allows the lower income earning spouse to save their income to build a larger investment base for future income that is taxed at a low rate.
If you carry on a business either personally or through a corporation you can pay a reasonable salary to your spouse or children. Ensure that proper payroll records are maintained and that proper source deductions are remitted to CRA.
The attribution rules don’t apply where property is transferred to a spouse or relative for the property’s fair market value and the fair market value is paid in cash or other property or is financed with debt to the Transferor at CRA prescribed interest rates. If financed, interest has to be paid within 30 days of each calendar year (i.e. January 30 of the year following the loan). A transfer at fair market value may be beneficial when the asset is expected to produce a high yield or to increase in value in the future.
There are five tax credits that CRA allows spouses to transfer on schedule 2 of the income tax return. Once the spouse with the extra credits has reduced his/ her federal income tax to zero, then the remaining tax credits are available to further offset the spouse who doesn’t have enough tax credits.
Course fees greater than $100 then a tuition fee credit may be claimed. As of 1998, an additional monthly claim of $200 per month while attending a qualifying, post-secondary educational facility is also transferable.
You may direct that up to 50% of your Canada Pension Plan benefits be paid to your spouse provided both of you are over 60 years of age.
If you and your spouse are both over 60 and you have higher CPP benefits and are in a higher tax bracket you should consider such an assignment. The assignment form is available from Health and Welfare Canada.
Capital losses can be used to offset capital gains a spouse may have realized, but can’t be applied against other sources of income. You may not have other sources of income, but maybe your spouse does. If so, then you can take advantage of the superficial loss rules and stop loss rules in the Income Tax Act to transfer your capital loss to your spouse, thus sheltering his or her gain from tax.
Generally, transfers by way of gift to a spouse are deemed to be a disposition of property. However, a capital gain or loss on the disposition of property is not automatic. The default tax position is that the proceeds of disposition and the cost to the transferee spouse is deemed to be equal to the adjusted cost base of the transferor spouse. For example, say Spouse 1 has property with a fair market value (FMV) of $100 and an adjusted cost base (ACB) of $10 gifts the property to Spouse 2. Nothing happens as Spouse 2 acquires the property for proceeds and cost equal to the ACB of Spouse 1 = $10. This is commonly referred to as a Spousal Rollover in that nothing happens for tax as the property is simply rolled over to the spouse. When Spouse 2 subsequently disposes of the property to a third party, any actual gains or losses on disposition attribute back to Spouse 1. So in effect, no transfer of gains or losses has occurred.
The attribution in the preceding paragraph does not occur if FMV consideration was actually paid on the transfer and the spouse transferring the property elects in their tax return to not have the Spousal Rollover rule under Subsection 73(1) of the Income Tax Act apply. In this case, Spouse 2 would pay $100 for the property and Spouse 1 would pay tax on the gain on sale. Any subsequent gains or losses would be reported by Spouse 2.
Consider the case then if the property has a FMV of $10 and an ACB of $100. Spouse 1 could then trigger a FMV sale to Spouse 2 for $10 by having Spouse 2 pay $10 and Spouse 1 elects in their tax return to not have the Spousal Rollover rule under Subsection 73(1) of the Income Tax Act apply. At this point, Spouse 1 has a loss, but since Spouse 2 acquired the property from Spouse 1, the loss cannot be claimed by Spouse 1 under Section 54 and Paragraph 40(2)(g) of the Income Tax Act. Under those sections, where a taxpayer who has disposed of a property at a loss but an affiliated party has acquired a “substituted property” within 30 days is deemed to have realized a “superficial loss” which is deemed nil and cannot be claimed. The superficial loss is however, added to the ACB of the substituted property under Paragraph 53(1)(f) of the Income Tax Act. In this example, the superficial loss of $100 - $10 = $90 is added to Spouse 2's ACB. Therefore, we have effectively transferred the high ACB of the property from Spouse 1 to Spouse 2. The final step is that Spouse 2 must wait over 30 days before selling the property to a third party in order to have the loss on sale stay in Spouse 2's hands. If Spouse 2 sold the property within 30 days, then Spouse 1's capital loss on the initial transfer would not be a superficial loss and the capital loss would then remain with Spouse 1.
Four steps to transferring capital losses to avoid the attribution rules:
Careful planning with a Chartered Professional Accountant is warranted. Contact Keith Anderson, BCom, CPA, CA-IT, CITP at (780) 447-5830 if you need advice.
Minor relatives in this case include children, stepchildren, grandchildren, great grandchildren, brother or sister (including in-law "siblings"), nieces and nephews.
Adult relatives in this case include parents, brother, sisters, children, grandparents and grandchildren but exclude nieces and nephews.