INCOME SPLITTING AND ATTRIBUTION RULES
The Canadian income tax system employs a graduated tax rate system, which means that the higher your taxable income, the higher tax rate or tax bracket that applies to the income.
As such, if you are in a high tax bracket and a family member is in a low tax bracket, it obviously would be beneficial to shift some of your income to them. For example, if you are in a 50% tax bracket and your spouse (or common law partner) is in a 20% tax bracket and you could shift $40,000 of income into their tax return, your family would save $12,000 of income tax, that is, $40,000 x (50% − 20%).
On top of that, every taxpayer in Canada gets at least one tax credit, being the basic personal tax credit. This credit effectively exempts from tax about $13,000 of taxable income (the actual number varies from year to year, as it is indexed to inflation, and the provincial amounts vary).
However, there are some significant barriers to income splitting amongst family members.
For example, you cannot simply direct that some of your employment income or business income be paid to your spouse or children with the expectation that you have achieved income splitting. Rules in the Income Tax Act will shut that down and ensure that you are taxed on that income at your tax rates.
Perhaps more significantly, there are also income attribution rules, which can apply to most forms of passive investment income. These rules can apply where you transfer or lend money or property to your spouse or minor child, and they use the property to earn income from property such as interest, dividends, or rent. When these rules apply, the income from the property is “attributed” to you and included in your income rather than their income.
In the case of a transfer or loan of property to your spouse, if they subsequently realize taxable capital gains from a sale of the property, the attribution rules can also apply and attribute the taxable capital gains to you, and you will therefore include them in income.
The attribution rules apply to losses as well as income. That is, if the transferred or lent property generates property losses or allowable capital losses, those losses are attributed to you.
The income attribution rules do not normally apply to taxable capital gains (or allowable capital losses) realized by your minor children. Therefore, you have a legitimate way of capital gains splitting with your children. For example, you could purchase common shares or equity mutual funds in their name (or as a bare trustee for their benefit), and any resulting taxable capital gains will be taxed in their hands rather than yours.
The income attribution rules can apply to income from “substituted property” (or, in the case of your spouse, taxable capital gains from substituted property). For example, say you transfer some shares to your spouse and the attribution rules apply to any income or gains from the shares. If your spouse sells the shares and uses the proceeds to buy other shares, or bonds, mutual funds or indeed any other income-producing property, the attribution rules can continue to apply to income or capital gains from that other property.
Fortunately, there are various exceptions where the income attribution rules do not apply.
The rules do not apply to you if you cease to be resident in Canada, or after your death.
In the case of transfers or loans to your minor children, the attribution rules do not apply in the year in which they turn 18 years of age and subsequent years.
The rules do not apply after you divorce (or cease to be common-law partners). If you are separated and living apart due to the breakdown of your relationship, the regular income attribution rules do not apply, but the capital gains attribution rules can apply while you are separated (and not divorced) unless the two of you jointly elect otherwise in a form filed with your tax returns.
The rules do not apply to business income. Therefore, for example, you can give cash or other property to your spouse or minor child which they use in their business, and any resulting business income is not subject to attribution.
The attribution rules obviously do not apply to property that generates no income or capital gains, or cash that is used simply for personal purposes. Therefore, for example, you could pay your spouse’s or child’s personal expenses or their income tax bill, thereby freeing up their own cash resources which they can invest without the attribution rules applying.
The rules do not apply if the property or cash you transfer to them is included in their income. For example, if your minor child works in your business and you pay them a reasonable salary that is included in their income (and deducted from your business income), any investment income that they earn by investing that salary is not subject to attribution. Of course, paying that salary is itself a valid method of income splitting, as it will reduce your income.
There is a “fair market value consideration” exception from the attribution rules. This exception applies if you sell property to your spouse or child and they pay you at least “fair market value” for the property. If they pay you by way of debt – that is, they owe you the fair market value amount – you must charge them at least the prescribed rate of interest under the Income Tax Act at the time of the debt (currently 1% per year), and they must pay you the interest on the amount owing in each year or by January 30 of the following year. If they are late or miss even one payment of interest, this exception no longer applies. Furthermore, in the case of a sale to your spouse, under the fair market value conditions exception you must elect out of the tax-free “rollover” that normally applies to prevent any capital gain when you transfer property to your spouse.
In a similar vein, there is a fair market loan exception. This exception applies where you lend cash or other property and charge them at least the prescribed rate of interest at the time of the loan. The prescribed rate of interest is set each quarter of each year, and is currently 1%. As above, this exception continues to apply only if they pay you the interest on the loan each year while it remains outstanding or by January 30 after the year. Interestingly, this exception can apply regardless of the term of the loan.
Example of fair market loan exception
You lend $1 million to your spouse when the prescribed rate of interest is 1%. The term of the loan is ten years. Over the ten years, your spouse uses the money to earn investment income and / or taxable capital gains at a rate of 6% per year ($60,000 per year).
If your spouse pays you the 1% interest ($10,000) each year or by January 30 after the year, the $60,000 will be included in their income and not subject to attribution. They can deduct the $10,000 interest paid to you, leaving them with a net $50,000 return, and you will include that $10,000 interest in your income.
Because of this exception, you have effectively shifted the net 5% annual return to your spouse. If you are in the highest tax bracket and your spouse is in a lower tax bracket, the tax savings over the ten years can be significant.
Loans to adults
Normally, the income attribution rules do not apply to transfers or loans to your children or adult relatives (other than your spouse) if they are 18 years of age or older.
However, there is a special attribution rule that can apply if you lend money to a related adult. Unlike the regular attribution rules, this rule can apply only if it can be reasonably considered that one of the main reasons for the loan was to reduce or avoid tax. The “main reason” does not have to be shown for the regular attribution rules.
To ensure this special rule does not apply, you should charge the prescribed rate of interest (currently 1%), and, like the exception discussed earlier, make sure they pay you the interest each year or by January 30 of the following year.
Lastly, even if the income attribution rules do not apply, certain types of income, such as dividends from private corporations, and income earned through a trust or partnership by providing services to a business of a related person, may be subject to the “Tax on Split Income” (TOSI) rules. We have discussed these rules in previous Tax Letters and will revisit the issue in a future Letter.