INCOME ATTRIBUTION RULES
Canada employs a progressive or graduated income tax system, under which higher levels of income attract higher tax rates relative to lower levels of income. At the Federal level, there are currently five tax brackets, the lowest being 15% and the highest being 33%. Depending on the province, the combined Federal and Provincial tax rates can range from about 20% to about 54%.
As a result, income-splitting amongst family members can save tax, particularly where there is a high income earner and one or more low income earners. For example, if my marginal tax rate is 53% and my spouse’s or child’s marginal tax rate is 20%, we are obviously better off on the whole if I can shift some income to them. Furthermore, we might be able to multiply some tax credits, such as the basic personal tax credit.
The government is not keen about income splitting, at least in most cases. The Income Tax Act contains income attribution rules, which, when they apply, shut down the beneficial tax effects of income splitting. Fortunately, there are some exceptions, which allow certain forms of income splitting.
The attribution rules
There are two main income attribution rules.
The first rule applies if you lend or transfer property, which includes cash, to your spouse or common-law partner. If they earn income from the property (such as dividends, interest or rent), or taxable capital gains from selling the property, the income will be attributed to you and included in your income. Exceptions are discussed below.
This rule can apply even if you lend or transfer property to them before becoming married or common-law. In such case, the rule can start once you are married or common-law, but not before that time.
The first attribution rule ceases to apply when you become divorced or are no longer common-law partners. If you are separate but still married, the rule relating to income from property does not apply, although the rule relating to capital gains ceases to apply only if you and your spouse or partner make a joint election in your tax return.
The second rule applies if you lend or transfer property to a child under the age of 18 with whom you do not deal at arm’s length (e.g. your child or grandchild), including a niece or nephew. This rule applies only to income from property such as interest, dividends and rent, and does not apply to capital gains. Therefore, splitting capital gains with your child is legitimate. For example, you could buy public common shares or equity mutual funds for your child, and subsequent capital gains would be taxed to them rather than you. (Of course, you don't know for sure that the shares will go up in value!)
The second rule ceases to apply in the year during which the child turns 18 years, regardless of the birth date. For example, if your child turns 18 on December 31 of this year, there is no attribution throughout this year.
Both rules can continue to apply for income from “substituted property”. For example, if you give cash to your spouse and she buys shares, then sells the shares and buy bonds, income from the bonds can still be attributed to you. The “substituted property” rule can continue regardless of the number of sales and purchases of new property.
I give some shares to my spouse. She receives dividends on the shares, and subsequently sells the shares, realizing a taxable capital gain. She uses the proceeds to buy mutual funds and receives interest and dividends from the funds.
Result: All of the income from the shares and mutual funds, including the taxable capital gain, will be included in my income.
In addition to the exceptions noted above, there are other exceptions that apply to both attribution rules.
One major exception applies where you lend money to your spouse or child and charge interest at the “prescribed rate” under the Income Tax Regulations in effect at the time of the loan. (You will have to include the interest in your income, but they can deduct it from the investment income they earn by investing the money.) The prescribed rate is based on 90-day Federal treasury bill rates and is set each quarter. The current rate is 2%. The only catch is that they must actually pay you the interest each year or by January 30 of the following year. If they miss any year’s interest payment by even a day, the exception ceases to apply. Interestingly, the exception can apply regardless of the term of the loan. So you could lend your spouse money with a repayment date of 10 or 20 years later, and still qualify for the exception.
Another exception applies if you sell property to your family member for fair market value proceeds. If the sale is to your spouse or common-law partner, you must elect out of the spousal tax-free “rollover” that normally applies on such sales, and if the consideration they give you includes debt, you must charge the prescribed rate of interest as discussed above.
The attribution rules do not apply if you (the transferor or lender) are not resident in Canada. They similarly do not apply after your death.
The rules do not apply to business income. Therefore, you can give cash to your spouse or child to be used in their business, and the business income will not be attributed to you.
The rules do not apply to income from reinvested income. For example, if you transfer bonds to your spouse and he or she uses the interest from the bonds to purchase other investments, the income from the other investments will not be subject to attribution.
The rules obviously do not apply if the transferred property or money does not generate income. Therefore, as an example, you could give your spouse or child cash for personal expenses or to pay their personal income tax, thereby freeing up their own cash to make investments. The income from the investments will not be attributed to you.
The rules do not apply if the income is subject to the “tax on split income” (TOSI) in the hands of your spouse or child. The downside is that your spouse or child will be subject to the highest marginal rate of tax on such income. TOSI can apply to items such as dividends from private corporations, and passive income from partnerships or trusts that provide services to your business or corporation. TOSI was discussed in our January 2018 Tax Letter, and will be reviewed again in a future Letter.