What is Income Splitting
Canada has a progressive income tax system – the more you earn the higher the rate of tax which you pay. Income splitting is a family tax planning technique designed to shift income from a high rate taxpayer to a lower rate taxpayer such as a spouse or children.
A number of different techniques can be used to accomplish this objective.Online tax software is available to help you figure out just what exactly you and your spouse will have to pay in taxes. However, you must be careful because Revenue Canada frowns on income splitting and there are provisions in the Income Tax Act designed to curtail it.
The attribution rules in the Tax Act have the effect of ignoring the legal recipient of certain property income or capital gains and attributing the income back to hands of a person who transferred or lent property to their spouse or children. The attribution rules are specifically designed to prevent income splitting.
Nevertheless, certain techniques can still be effectively used to shift a certain amount of income or capital gains from high income to low income family members.
An RRSP deduction is available for contributions made to your RRSP or to your spouse’s RRSP. Any contributions made to a spousal RRSP will belong to the spouse when withdrawn.
This technique is most effective when one spouse has little or no income. It is a method of retirement income splitting which can result in substantial tax savings.
Spousal RRSP contributions can also be used as a pre-retirement income splitting method, but there are attribution rules to avoid.
If funds are withdrawn from a spousal RRSP in the two years after the contribution was made and claimed, the withdrawn funds are attributed back to the contributing spouse. For example if a contribution is made to a spousal RRSP in 1999, the beneficiary cannot withdraw those funds until year 2002 without having them attributed back to the contributing spouse.
Caution should be exercised in situations where the marriage is not stable. Remember any funds contributed to a spousal RRSP belong to the spouse to whom the funds were contributed. In the event of a marriage break up this can pose a problem.
Capital Gains Earned by Minors
The attribution rules do not apply to capital gains earned by a minor. If you make a gift of cash to a minor and the minor then buys securities which appreciate in value, the capital gain earned by the minor on disposition of those securities will be taxed in the minor’s hands.
The attribution rules are not applicable if you lend money to your spouse or child for non-investment purposes.
For example, if you lend money to your spouse for a vacation or to purchase a car, this frees up your spouse’s money to be used to earn investment income. The investment income will then be taxed in your spouse’s hands rather than in yours, resulting in income splitting.
The attribution rules only apply to property income. If you make a loan to a family member, including a spouse, to invest in a family business, there will be no attribution of business income to you.
Fair Market Value Loans
An exception to the attribution rules exists where funds are lent to a spouse or child and interest at prescribed rates is charged and paid by January 30th of every year. In this case not only is there no attribution of income earned back to you, but your spouse or child is entitled to an interest deduction on the interest paid to you. Provided that the rate of return earned by your spouse or child is greater than the rate of interest paid to you, you have succeeded in income splitting.
Short Term Loans
Income attribution does not apply to interest on interest. While any interest earned on funds lent to a child or spouse will be attributed back to you, the actual interest earned belongs to your spouse or child. Furthermore, future interest on that interest earned will not attribute back to you.
A good planning technique is to make a short term loan for investment purposes. The income earned while the loan is outstanding is attributed back to you. Any interest earned by your spouse or child in the future on that initial income (which is now their capital) will be taxed in their hands, thereby resulting in income splitting.
If you own a corporation, you can arrange a loan from your corporation to your children for education purposes. If the loan is not repaid then it will be included in the child’s income. Assuming that your child has earned no income, this loan will be taxed at very low rates.
Furthermore, if your child repays the loan in the future when taxable, the child can claim a tax deduction in the year in which the loan is repaid.
Offshore Loans or Gifts
If your children receive money, either by way of loan or gift, from relatives who are not resident in Canada, the attribution rules will not apply. Any income earned on these funds will be taxed in your children’s hands at a low rate of tax.
Annual Interest Expense Payment
As indicated above, if you make a fair market value loan at the prescribed interest rate, the attribution rules will not apply, provided that the interest is paid by January 30th of every year.
If the borrower does not have sufficient funds to make the required interest payment, you can make a gift of the required amount, which will then be paid back to you as the required interest on the loan. The cash gift will not attract attribution because it was not made for the purposes of earning income. However, you should be aware that this is an aggressive technique which Revenue Canada may consider attacking under the General Anti-Avoidance Rule (“GAAR”) provisions.