Income Splitting
The Canadian tax system imposes a scale of graduated tax rates on individuals such that higher incomes are taxed at progressively higher rates. Therefore, a family unit can achieve a financial advantage where income is properly shifted from an individual taxed at the top marginal rate to an individual taxed at a lower marginal rate.
Income splitting is the term that refers to techniques that are allowed by the Income Tax Act to reduce the total taxes of a family unit.
The Income Tax Act contains a variety of anti-avoidance and attribution rules to limit income splitting. Therefore, taxpayers must ensure that any strategy followed is allowed by the rules of the Act. If CRA (Canada Revenue Agency) feels that you have set-up your affairs with the main intention to avoid taxes, they may challenge your structure and impose penalties.
The amounts saved can be significant if a top rate individual successfully transfers income to a lower tax rate family member. The annual savings for a family unit vary based on the income earned by the family members, their province of residence, and the assets or activities available for income splitting.
Since there is no minimum age limit to a child becoming a taxpayer, a trust can be structured to distribute income amongst family members including infants. When considering the transfer of income to minor children, you must consider the Kiddie Tax and the attribution rules. You must also consider the General Anti-avoidance Rules (GAAR), which could be applied by CRA if they felt that the only reason a particular scheme was used was to avoid taxes.
Rules to Prevent Income Splitting – Attribution
Although the income splitting concept remains a valid planning tool, the Income Tax Act contains two major obstacles known as the attribution rules and the Kiddie Tax.
The attribution rules are designed to prevent income splitting by ignoring the legal ownership of the property and taxing the transferor on income and certain capital gains/losses arising from the transferred property. Attribution results in the income being taxed at the transferor’s tax rate even though the income remains the property of the recipient.
Transfers of property to spouses, common-law partners and children may be subject to the attribution rules.
The Attribution Rules Do Not Apply
The attribution rules do not apply to loans or transfers made where:
- The loan for the transferred amount bears interest at a rate that is greater than or equal to CRA’s prescribed interest rate and the debtor pays interest every year and no later than 30 days after the end of the year (i.e. January 30th). The prescribed rate is presently 1% (fourth quarter 2014) and is subject to adjustment quarterly;
- The recipient pays FMV (Fair Market Value) for the property acquired and, where the recipient is a spouse, the transferor elects out of the spousal rollover rules;
- The recipient is a child who has reached the age of majority and received the property as a gift;
- Contributions are made to a TFSA (Tax-Free Savings Account);
- One spouse assists the other spouse in earning income from business as the attribution rules only apply to income from property.
Child Tax Benefits
The government pays Child Tax Benefits to qualifying parents. If the benefit cheques are deposited to an account segregated for the benefit of the child, the income earned from investing the benefits is taxable to the child and not the parents. The benefit payments would not enter the parents’ bank account but flow directly to a child or trust account.
Income on Income
The attribution rules do not apply to income earned on previously attributed income. Assume an individual invested $10,000 and received $1,000 interest, which is subject to attribution, the second generation interest earned on the $1,000 of accumulated interest is not attributable back to the original donor or lender.
Employing a Spouse or Children
You may pay family members a reasonable amount of salary or wages for services provided to your business. Where the family member invests the remuneration received, the income earned thereon will be taxable to the family member.
Individuals earning employment or business income may be entitled to claim a deduction in respect of childcare expenses incurred to earn income. You can pay your children over the age of 18, for tending to children under the age of 16 and receive a deduction for that payment if it was incurred to earn income. Be careful to document this activity and be prepared to justify the expense.
Pension Plan Benefits
You can elect to have your spouse receive up to, and be taxed on, 50% of your CPP (Canadian Pension Plan) benefits so long as you are both over age 60. The CPP benefits available for the split are computed by reference to the time you lived together compared to the period in which you earned your benefits. If the individuals make the election, the CPP of both spouses will be recalculated with separate CPP benefit cheques being issued. The election to split CPP can result in a transfer of taxable income from the higher income earner to the spouse with the lower taxable income.
In addition to the split of CPP benefit cheques described above, you are eligible to split certain pension plan benefits. The split is accomplished annually by electing for tax return reporting purposes only and does not affect your pension cheques. The amounts subject to the election include lifetime annuities from registered pension plans, RRSPs, RRIFs and DPSPs.
The amounts available for the election differs for those individuals who have reached age 65 from those who have not reached age 65.
In simple terms, a Canadian resident individual taxpayer continues to receive his or her eligible pension payments. Prior to filing the tax return, the individual calculates his or her tax under various scenarios to determine an optimum split of the benefits for tax purposes. Both individuals must jointly elect to allocate a specific amount of pension income between themselves with the pension recipient claiming a deduction for the agreed amount and the other reporting the agreed amount on their tax return.
The election is made annually with the personal income tax return so the elected proportion of one year will not affect an election in a subsequent year. Accordingly, a taxpayer and his or her spouse or partner will have maximum flexibility in splitting pension income from year to year.
Capital Gains
Capital gains or losses realized on property transferred to a spouse or partner are subject to the attribution rules whilst capital gains or losses on property transferred to children are not. Children may acquire investments such as mutual funds to avoid the attribution rules on the capital gains or losses realized.
There is no annual contribution limit for RESPs although the lifetime limit for a particular beneficiary is $50,000. Where the contributions from all subscribers for a particular beneficiary exceed $50,000, the subscriber(s) are liable for a tax on the excess contribution.
Qualifying payments from the plan for educational purposes are taxed to the designated person who takes post-secondary education. The portion of the payment that applies to subscriber contributions are not taxable whilst the portion that applies to income earned and government assistance will be taxable.
Contributions may be made to an RESP for up to thirty-one years after the plan was created (thirty-five years if the beneficiary qualifies for the disability tax credit). The RESP must terminate within the year that includes the thirty-fifth anniversary for the plan (fortieth anniversary where the beneficiary qualifies for the disability tax credit).
Registered Education Savings Plans
The Registered Education Savings Plan (RESP) is a vehicle that will assist you to save for the education of your children and close relatives. The plan is somewhat similar to the more familiar RRSPs in that the subscriber arranges for the plan at authorized financial/insurance institutions, names one or more beneficiaries and contributes funds to the plan. While your contributions to RESPs are not tax-deductible and interest paid on money borrowed to make contributions is not tax deductible, the income earned in the plan accumulates tax-free.
The Federal government provides financial assistance to RESP by paying a grant based on the amount contributed to the plan. The basic grant amount is 20% of the annual contributions to the RESP for a Canadian resident beneficiary to a maximum of $500 of grant ($1,000 if there is unused grant room from a prior year) and a lifetime limit of $7,200. In addition, the RESP may be eligible to receive an additional $500 (with an additional $100 for every year of eligibility until age of 15) grant where the beneficiary is under 18 years of age, and calculated by reference to the qualifying net income of the child’s family. The RESP for a beneficiary of a family with modest income may qualify for an additional financial incentive (known as the Canada Learning Bond) with a lifetime limit of $2,000.
Registered Disability Savings Plan
Parents or legal representatives are entitled to establish a Registered Disability Savings Plan (“RDSP”) for the long-term financial security of a Canadian resident who has a severe disability. The RDSP trust will be administered at an institution that accepts RRSP contributions. The essentials of the RDSP are as follows:
- The plan must be created and operated solely for the benefit of the beneficiary who is a Canadian resident at the time of creation and is entitled to the disability tax credit;
- The plan and other RDSPs for the same beneficiary may receive maximum contributions in the aggregate of $200,000;
- Contributions to the plan may only be made until the end of the year in which the beneficiary attains age 59 and are not tax deductible. Contributions cannot be made if the beneficiary fails to qualify for the disability tax credit, is not a Canadian resident or has died. Contributions are not recoverable by the contributor;
- The interest paid on amounts borrowed to contribute to the plan is not tax deductible;
- The RDSP can acquire investments that are, generally, the same as those qualified for RRSP investment;
- Income and net gains realized by the RDSP are not taxed in the year realized but will be proportionately taxed in the year withdrawn;
- The plan will normally mature on or before the end of the year in which the beneficiary reaches age 60. The plan will, however, be terminated by the earlier of the end of the year in which the beneficiary dies or throughout the year in which the beneficiary is no longer entitled to the disability tax credit;
- The plan will be subject to a penalty tax of 1% per month on over contributions, contributions received whilst the beneficiary is a non-resident or the plan acquires a non-qualified investment.
The RDSP will be entitled to a Canada Disability Savings Grant (CDSG) and a Canada Disability Savings Bond (CDSB) from the federal government with the amount being dependent on contributions to the plan and family income. The amounts received from the CDSG and CDSB are not taxed on receipt but will be taxed upon payment to the beneficiary or his or her estate.
Tax-free Savings Accounts
Canadian resident individuals who are aged 18 or older and who have a valid Canadian social insurance number can establish a Tax-Free Savings Account (TFSA). Individuals who live in Canadian jurisdictions in which the age of majority is higher than 18 will be not be able to establish a TFSA until the person reaches the age of majority. You may establish a TFSA at an institution that accepts RRSP contributions. Banks, credit unions, trust companies and insurance companies can issue TFSAs.
- If you do not contribute the maximum in the year, the portion not contributed will be eligible to be contributed in any subsequent year. CRA will inform you of your contribution limit annually. A person who is non-resident throughout the year for income tax purposes will not be entitled to an increase in contribution room. You can contribute to a TFSA up to the date you became a non-resident.
- You will be required to provide your social insurance number and date of birth to the institution which submits your personal information to CRA for a TFSA registration number. You may have more than one plan but be mindful of the contribution limits and the penalties for over contributions described below.
- Contributions are not tax deductible.
- Interest paid on amounts borrowed to contribute to the plan is not tax deductible.
- The TFSA can acquire investments that are, generally, the same as those qualified for RRSP investment. A TFSA will not be entitled to invest in entities with whom you do not deal at arm’s length or in which you and related parties hold a 10% or greater interest.
- Income and net gains realized by the TFSA are not taxable to you or the plan in the year realized or the year withdrawn. Losses are not deductible.
- Your plan will not have a maturity date but its assets will be valued at FMV upon your death with income and gains realized after that date being subject to tax. If the TFSA transfers to your spouse or partner upon your death, the plan will retain its tax-free status.
The essentials of the TFSA are as follows:
| Years | TFSA Annual Limit | Cumulative Total |
| 2009-2012 | $5,000 | $20,000 |
| 2013-2014 | $5,500 | $31,000 |
| 2015 | $10,000 | $41,000 |
| 2016-2017 | $5,500 | $52,000 |
- You cannot contribute directly to a TFSA for another account holder such as your spouse, partner or child. You may gift funds to the individual to contribute to his or her own plan. The income or net gains realized on the gifted funds are not subject to the income attribution rules.
- You will not be able to establish a TFSA at age 18 in a provincial jurisdiction where the age of majority is 19. Your contribution limit for the year in which you turn 18 will carry forward to the subsequent year.
- Withdrawals from the plan will not be taxable and will increase your contribution limit for the subsequent year unless you are a non-resident of Canada. If you move your TFSA from one carrier to another, you should do so by direct transfer arranged through the financial institutions. If you transfer funds indirectly by withdrawing from one account and depositing to another, you risk falling into an over contribution situation. Your transfer of funds directly from one TFSA to another is not a withdrawal or contribution for establishing your contribution room.
- You will be subject to a penalty tax of 1% per month on over contributions, contributions while a non-resident, non-qualified investments or where the plan confers a benefit or advantage on you or a related person. Where you are subject to the penalty tax, you must file tax form RC243 by June 30 of the year following the end of the calendar year in which the tax liability arose. CRA will levy a late filing penalty and interest should the return be late filed. You can inadvertently step into the penalty tax issues by failing to arrange direct transfers from one TFSA to another or by operating a chequing or other account in a TFSA because each deposit will be considered a new contribution.
Separation Or Divorce
In many cases of marriage breakdown, former spouses are significant adversaries in a bitter conflict. However, both individuals would be better off if they could remember that they continue to share a common participant to this struggle – CRA. The smaller the share of assets that is directed to CRA, the greater the pool of assets that remains for the two individuals to divide between them.
Loss Of Employment
Individuals who have been with the same employer group since before 1996 and lose their employment may be in a position to benefit by having their severance considered a Retiring Allowance. A Retiring Allowance is an amount received by the employee on or after retirement in recognition of long service. The Retiring Allowance is fully taxable, but may be reduced by qualifying amounts paid to your RRSP. You will not be subject to tax withholdings where your employer makes the payments directly to your RRSP. The special contribution limit in respect of Retiring Allowances is:
- $2,000 a year for each year of service up to and including 1995.
- $1,500 a year for each year of service up to and including 1988 where you have no vested pension entitlement.
