With Canada's high personal tax rates, there is a great desire among taxpayers to find ways to save on taxes within the family unit, particularly where one spouse has a significantly higher income than the other.
Income splitting is the process of redirecting income within a family group to take advantage of the lower tax brackets, deductions and credits available to each family member.
Income is split by transferring income-earning assets from high-income to lower-income family members. Savings can be achieved in a number of ways: from strategies as simple as making interest free loans to making more complex arrangements involving corporations and trusts. There are three important characteristics of the Canadian tax system that make income splitting attractive to taxpayers:
- Because of the progressive nature of our income tax system in Canada, marginal tax rates applied to taxable income rise as the individual's income increases.
- The Canadian tax system taxes individuals rather than households. In addition, each individual has a basic personal tax credit, and pays no tax on income earned up to the amount that generates the credit. For 2010, the basic personal amount is $10,382.
- Certain income sources are taxed more advantageously than others (capital gains and dividends are taxed at lower marginal rates than interest income).
Therefore, better tax results for the family unit as a whole can often be obtained when each individual in the family earns taxable income, as opposed to one person earning all of the income.
The Canadian Government is well aware of these potential tax savings and over time has enacted several rules to prevent it. The Attribution rules found in S. 74 and 75 of the Income Tax Act potentially apply whenever property is transferred or a loan is made at little or no interest to a family member.
Income Splitting Rules
Some important rules related to income splitting are as follows:
Transfers and loans to spouse or common-law partner
If an individual transfers or loans property either directly or indirectly, by means of a trust or any other means to the spouse or common-law partner for that person's benefit, any resulting income or loss from that property is taxable to the transferor. An exception to this rule is made if a bona-fide loan is made and interest paid at the prescribed rate or more (S. 74.1(1)).
Example: Inter-spousal Interest-free Loan
Issue: Bob makes an interest-free loan to his wife, Sue, of $50,000. Sue then invests the $50,000 in bonds so she can earn interest income. She will pay less tax than if Bob had invested the money, as she is in a lower tax bracket. Will this strategy work?
Answer: No. Loans to a spouse/common-law partner are subject to attribution where any income or loss from property is realized from the loan proceeds. Had the loan been made to earn income from a business that Sue runs, however, the business income would not be attributed.
Assignment of CPP Benefits
A specific exception to this rule surrounds the assignment of Canada Pension Plan (CPP) benefits to a spouse, which is allowed and results in the reporting of those benefits by the spouse to whom they have been transferred.
Example: Splitting CPP Benefits
Issue: Ethel's CPP benefits are larger than Elwin's. They wish to equalize the amount that is reported on their tax returns by splitting CPP benefits equally. Is it possible to do so?
Answer: Yes. By making application with HRDC, Ethel and Elwin can split the CPP benefits to the extent that the benefits were earned while the couple was together. Further, attribution rules will not apply on income from property earned on CPP benefits that have been assigned to a spouse. Therefore, Elwin can invest the assigned CPP benefits and report resulting earnings in his own hands.
Election to Split Pension Income
Beginning with the 2007 tax year, taxpayers who receive pension income that is eligible for the pension income amount may elect to have their spouse report up to 50% of that pension income. This election affects how much pension income is reported by each spouse but does not involve the actual transfer of those funds and therefore does not result in any attribution.
Transfers and loans to minors
Where property is transferred or loaned either directly or indirectly to a person who is under 18 and who does not deal with the transferor at arm's length or who is the niece or nephew of the transferor, the income or loss resulting from such property is reported by the transferor until the transferee attains 18 years of age. An exception to this rule is made if a bona-fide loan is made and interest paid at the prescribed rate or more (S. 74.1(2)).
Example: Loan to a Non-Arm's Length Minor
Issue: Maggie lends $5,000 (interest-free) to her son, Tom (16), who invests in the bond market. This year, Tom earns $625 in interest income from those bonds. How much income will Tom report on his tax return?
Answer: Nil. Attribution rules require the $625 earned by Tom to be reported by Maggie because the interest was earned by a minor, in a non-arm's-length transaction.
Gain or Loss Deemed That of Transferor
When property that is transferred to the individual's spouse or common-law partner earns taxable capital gains (or losses), such gains or losses will be reported by the transferor (S. 74.2(1))
Educational resources:For more information on tax planning provisions and compliance requirements, subscribe to The Knowledge Bureau's online tax reference for taxpayers, financial advisors and their clients: EverGreen Explanatory Notes.
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