Taxes and Net Family Property Valuation of Pensions and RRSPs

August 2024

Introduction

Determining values of assets to be divided as part of a marriage breakdown is complex. Of course, so is the whole process of separation and divorce.  This article discusses how the taxable assets of defined benefit (i.e. lifetime) pensions and Registered Retirement Savings Plans (RRSPs) and Registered Retirement Income Funds (RRIFs) should be valued for use on the Net Family Property statement.  It also discusses the calculation needed when these assets are transferred as part of the equalization payment.

Clients and their lawyers often do not understand why income taxes must be considered as part of the valuation process.  Ignoring income taxes effects on certain assets can lead to costly errors and unfair settlements.  They also need to be considered in spousal support negotiations, but that is another topic.  Future taxes on other assets must also be considered in a similar manner to pensions and RRSPs, , such as capital gains taxes on real estate and investment portfolios.  Different tax rates and calculations may apply, and are not discussed in this article.  See my more detailed article, “Tax Calculations for Separation and Divorce.”

I often tell my financial planning clients, “Do not think that the $100,000 showing on your RRSP account statement is actually worth $100,000.” Everyone knows (or should know) that an RRSP withdrawal will result in a tax bill unless they have more tax deductions than income.  For the same reasons, income tax costs will reduce the values of assets when equalizing them upon your separation.

“Value” is seldom specifically defined in legislation.  However, valuation experts, such as Chartered Business Valuators, will tell you that value is the price that an asset would sell for in an open and unrestricted market where both buyers and sellers have a reasonable knowledge of the asset and the marketplace, are not subject to any undue pressure to buy or sell, are acting in their own best interest, and have a reasonable time period to complete the transaction.

For example, assume a husband and a wife have only two assets. The first asset is a bank savings account of $100,000 belonging to the husband.  I will use the bank account as an example, but it could be the family’s principal residence or other tax-free assets.  Assume that the second asset is an RRSP of $100,000 belonging to the wife.  It could also be a pension plan, real estate with large capital gains, or other taxable assets.  Next, let us consider income taxes.

The need for income tax adjustments

Is it fair to give the husband the bank account of $100,000 and give the wife the $100,000 RRSP? It certainly is not.  If the husband spends the money in the bank account tomorrow, he will have $100,000 to spend.  If the wife spends the money in the RRSP, she will first have income taxes to pay.  She will be left with much less money, typically only $60,000 to $70,000.  It will depend on her tax rate at the time of withdrawal.  Therefore, if you truly wish to equalize the assets, the husband must pay some money from the bank account to the wife to make up for this difference.  Once everyone realizes this problem, the question is, “How much must be paid to make up the difference?”  In a simple situation like this, it can be an easy calculation, as in the table below.  I am assuming the wife would pay 28% tax in this example.

A cash payment of $14,000 will make both parties “equal” based on values at the date of separation.

What tax rate should be used?

Choosing the correct income tax rate is important.  (The same rules apply to pensions and RRSPs, and I will use both terms throughout my examples.)  Certain professional advisors often use an arbitrary tax rate between 20% and 30%.  The correct rate would be the actual tax rate applicable at the time of withdrawal, which should be the obvious choice.  See my article, “Tax Calculations for Separation and Divorce” on more about determining the tax rate.

However, there could be more than one alternative. If it were known that the RRSP must be sold immediately to pay bills, then the person’s tax rate based on their current tax bracket should be used.  This would be the tax rate applicable on the next dollar of income earned, which is called the “marginal tax rate.”  Tax rates start out low, and gradually increase, such that the first amounts of income are always taxed lower than the later amounts.  Tax rates increase in steps (called marginal tax brackets) as income rises.

For example, assume a person over the age of 65 has taxable income of $50,000. They would pay taxes of about $7,500 based on Prince Edward Island 2024 tax rates (where I live).  Rates for other provinces will vary somewhat, usually a bit lower.  At $50,000 of income, they would be in a 28% “marginal” tax bracket.  This means that the next dollar they earn will be taxed at 28%.  However, if you do your math, you will note that $7,500 is only 15% of $50,000.  Their “average” tax rate on all of their income is 15%.  This is because they pay nothing on their initial income because of their personal tax credits, then they pay a low rate on some income, and they pay more tax on their income increases until it reaches their higher tax bracket of 28%.  However, overall, it averages out to 15%.

If the RRSP must be used immediately to pay for expenses, then a marginal tax rate of 28% would be an appropriate rate to use. In fact, the tax rate might be higher if the extra income will push them into an even higher tax bracket.  However, under normal circumstances, it would be expected that the RRSP would not be used until retirement age.  If that were the assumption (which is the normal scenario), then the average tax rate applicable to all income in retirement should be used.  This would be 15% in my example.  The marginal rate would not be appropriate because the RRSP should be treated no differently than any other retirement income, such as their income from Canada Pension Plan.  To determine the average rate requires a calculation of estimated retirement income.  This would include Old Age Security, Canada Pension Plan, pensions from employment, RRSP withdrawals and any other income.

Do you use the same or different rates for both spouses?

In many cases, I see the same tax rate being used for both spouses. This is certainly appropriate when both incomes are similar or taxable assets are small.  However, by way of another example, assume that both spouses have only two assets.  This time, each person has $100,000 in an RRSP.  Assume the wife has a retirement income, including RRSP withdrawals, of $50,000.  Her average income tax rate in PEI would be 15%.  In retirement, assume the husband will have a much higher taxable income.  If his expected income were $100,000, his average rate would be 28%, being higher than his wife’s tax rate.  For valuation purposes, her RRSP would be worth $85,000 ($100,000 less 15% tax).  His would be worth $72,000 (after deducting 28% tax).  Therefore, it would be unfair to say, “They both have equal RRSP’s, so we will let each keep their own RRSP and call it even.”  An after-tax equalization payment of $6,500 would be required by the wife to equalize their RRSP balances.  If the equalization payment is made by a bank account transfer of $6,500, both parties will have $78,500 as of the date of separation: the wife’s $85,000 minus $6,500 = the husbands $72,000 plus $6,500.

In many cases, all parties may agree that the difference created by using different tax rates is not material. In such cases, using the same rate will simplify the calculations and reduce professional fees.  However, such an agreement should not be made without due consideration of tax rate differences and the size of the assets.  This is especially true because some pension valuations for people nearing retirement may be near the million dollar mark.  In addition, differences in RRSP balances may be very high, which in themselves will trigger significant differences in retirement tax rates because of the required withdrawal rates when the RRSP is converted to a Registered Retirement Income Fund (RRIF).

What if the RRSP or pension asset is being transferred as part of the equalization payment?

However, what if the equalization payment is not made by cash, or by other non-taxable assets?  If, for example, the equalization payment is made by an RRSP (or pension) transfer, tax rates once again are important.  In order to receive an after-tax equalization payment of $6,500, the husband would expect to receive an RRSP transfer of $9,028  ($6,500/.72).  After he pays taxes in the future, he will only get $6,500.  On the other hand, in order to pay an after-tax equalization payment of $6,500, the wife would expect to pay an RRSP transfer of $7,647 ($6,500/.85).  This obviously does not work because the if the wife pays $7,647, the husband will only receive $5,506 after-taxes, not the $6,500 which is needed for equalization.  Conversely, if the wife pays $9,028, it will cost her $7,674 after taxes, which is more than the $6,500 that she owes him.  Either payment will still result in an unequal balance of net family property thanks to the Canadian tax system.  The resolution is to use the average of both of their tax rates – the average of 15% and 28% is 21.5%.  Note in Table 1 below that the equalization transfer of $6,500 is an after-tax amount, and $8,280 is the gross amount to be transferred, being $6,500 divided by (1.00 minus 21.5%).  Table 2 is the proof.

If $8,280.25 is transferred, and the NFP statement is re-done effective on the date of separation, the net assets are now equal, as demonstrated in Table 2:

The background for my tax adjustment opinions

Our goal is to equalize net family property as of the date of separation (or other valuation date as determined by the courts), not to give one person a preference over the other because of tax rates.  Income taxes are a real cost, and, although the future cannot be predicted with accuracy, reasonable assumptions are possible.  Discounting of the tax rate is not appropriate in this context because the RRSP and pension values are already discounted amounts if we use today’s values.  See further discussion in my article, “Tax Calculations for Separation and Divorce”

My theory, I believe, is consistent with the way taxes are calculated for defined benefit pension plans. The Standards of Practice (March 2013) published by the Canadian Institute of Actuaries, Standard 4320.27 states,

“Income tax may be taken into account in the calculation. If it is taken into account, then the actuary would do so by calculating the average income tax rate based upon the member’s anticipated retirement income computed in “current” dollars, including accrued and projected future pension income, Canada Pension Plan, Old Age Security and other anticipated income, and continuance of the tax environment at the report date or the calculation date; i.e., assuming continuation of the existing tax rates, brackets, surtaxes and clawbacks, applied to the projected income on retirement expressed in “current” dollars.”

In addition, in the Saskatchewan legal case of Knippshild v. Knippshild, 1995 CanLII 5840 (SK QB), Justice Kelbuc refers to Long v. Long [1989] W.D.F.L. 671 (Ont. H.C.) regarding a deduction for income taxes related to a pension valuation:

“In my judgment, the principles of fairness and equity require that a deduction for tax obligations be made even though the Plan cannot be collapsed immediately. As to the discount rate, I am of the view the procedures as set out in Long v. Long [1989] W.D.F.L. 671 (Ont. H.C.) are applicable. They are:

• when a court is satisfied as to when sheltered funds are to be collapsed, the tax deduction to be allowed should be the rate at which the owner would, in that year, be taxed, bearing in mind the sum total of all income including the face value of the R.R.S.P.’s for the given tax year.

• when a court is not so satisfied, they should be discounted at the minimum income tax rate then applicable, UNLESS;

• unusual and special circumstances warrant otherwise in which case a notional discount could be given depending on the unusual and special circumstances that might weigh in favour of this option.”

Conclusion

I hope this article, though complex, helps shed some light on the importance of considering income taxes in reaching asset valuations if a fair equalization of assets is intended. It also likely suggests the importance of using skilled financial advisors and legal counsel.

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Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum

Shared Custody and the Amount for an Eligible Dependant Tax Credit

August 2019

If separated parents are sharing custody of their child(ren) with their ex-partner, it is important to know the Canada Revenue Agency’s (CRA) current interpretation of the law (April 2019) for each to get their fair share of government benefits.

• What is shared custody (expected to be referred to as “shared parenting time” under the updated Divorce Act)?
• How is child support calculated for shared custody?
• Who can claim the Amount for an Eligible Dependant as a tax credit?
• Unfortunately, the answer is, “It depends.”

Shared Custody and Child Support

(Relevant reference is Section 9 of the Federal Child Support Guidelines)

The Federal Child Support Guidelines defines shared custody as when parents have physical custody of “a child for not less than 40% of the time.” This means having custody from 40% to 60% of the time. With shared custody, there is flexibility in how support can be calculated. The Guidelines provide that support is still based on the tables, but also considers “increased costs of the shared custody arrangements; and the conditions, means, needs and other circumstances of each spouse and of any child for whom support is sought.” In most cases, each parent’s support obligation is the table amount based on their income. However, adjustments can be made as appropriate for the circumstances. If, for example, the parents are distant from each other, the support amount may be adjusted to compensate for travel costs.

The difference between 39% and 40% shared custody threshold makes a significant difference in the amount of child support being paid by one parent. Equal incomes often result in no basic child support payments required by either party. For sole custody, a $30,000 salary would normally trigger basic child support payments of $442.00 per month in PEI, similar in other provinces. In shared custody with parents having equal incomes of $30,000, the support payment would normally be calculated as each parent owing the other $442.00, with no net amount being paid.

When each parent has the children roughly equal in time, this provision makes sense because each should have similar child rearing expenses. A line between shared and sole custody needs to be drawn somewhere, and the Department of Justice established this 40% threshold in 1997 when the Guidelines were first introduced. When I was on the Advisory Committee for Child Support for the Federal Deputy Minister of Justice in the late 1990’s, this ratio was the subject of much discussion, but no better solution was found.

In summary, unless unusual situations exist, you will calculate support to be paid by each parent using the table amount for each individual’s income. The parties then have a choice: pay each other the gross amount by exchanging payments, or the higher income parent may pay the difference (a “set-off” amount). Continue reading before choosing a preference.

Amount for an Eligible Dependant

(Relevant references being the Income Tax Act subsections 118(1)(b), 118(5) and 118(5.1), the case of Verones v. R (2013 FCA 69) and subsequent case law, and CRA Technical Interpretation 2013-0502091E5)

Section 118(1)(b) of the Income Tax Act allows a separated person living as a single individual to claim a tax credit for a dependent child living with them. There are certain other eligibility requirements but I will not review them here in order to focus on child support issues. This credit is reported on the tax return as the “amount for an eligible dependant” (abbreviated below as “EDA”). It is worth approximately $2,500.

As noted above, when calculating child support obligations, you will be calculating two amounts – one for each parent. I suggest that the wording of the agreement should be similar to this (subject to legal advice):

“Based on the shared parenting arrangement and the aforementioned income information of each party, and in accordance with the Federal Child Support Guidelines table, and for the benefit of the child(ren), Parent A shall pay Parent B basic child support in the amount of $Y per month, and Parent B shall pay Parent A basic child support in the amount of $X per month.”

Except in certain limited situations, DO NOT state that one of the parties is going to pay only a “set-off” amount. Why? Section 118(5) of the Income Tax Act states “where the individual is required to pay a support amount” they cannot claim the EDA. This could have created a problem for shared custody – no one would be able to claim the EDA if both parents paid support to the other person. However, Section 118(5.1) was enacted to fix this. This section has been interpreted by the courts to mean that if both parents make individual payments to each other based on a legal obligation to do so, then either parent can claim the EDA for a child. The wording of your agreement or court order must be clear evidence that both parents each have a legal obligation to pay child support without reference to any set-off amount.

If there is one shared child, with the correct wording and if the parents meet the normal qualifying requirements to claim the EDA, they can choose which parent claims the EDA on their tax return. To be fair to each parent, they could take turns from year to year claiming this tax credit (for example, Parent A in even-numbered years, Parent B in odd-numbered years). If one parent is not taxable, then it would obviously be better for the taxable person to claim the credit.

If there are two or more children being shared, both parents can claim the EDA for a child. They must agree on who claims which child.

To warn you again, if the agreement or court order prescribes use of a set-off payment, the parents lose the flexibility of choice if they have only one shared child, and with two children, the parent paying the set-off amount will lose out on the tax credit.

If there is a risk that one parent will not honour their payment requirements, then a set-off arrangement may be necessary. Consider this example. If one parent pays $442 per month, and the other pays $342, then a set-off would be $100. For both parents to get the EDA, a two payment system is the best choice. In that case, the lower income parent must save $342 to have it available on the payment date. Unfortunately, if the $442 cheque received from the former partner on the same day bounces, the recipient is going to be short by $442 for that month. If only a set-off payment of $100 was being paid, he or she would have been short by only $100.

In addition to the legal agreement requiring separate payments as discussed above, consider doing a “side agreement” if there is a risk of non-payment. The CRA has said a side agreement may be acceptable, but the use of the term “may” means there is no guarantee. Preference is for separate payments.

The disallowance of the EDA when a set-off payment is paid makes less sense when you realize that the impact of the EDA is built into the legislated tables of the Federal Child Support Guidelines[1]. By design of the Guideline tables, if the EDA is not shared, the custody amounts are biased against the payer of a set-off payment. Both parties are paying a support amount reduced by the EDA. However, only the recipient of a set-off amount gets the EDA; the payer is left short by this $2,500 credit.

The Minister of Finance, The Honourable Bill Morneau, P.C., M.P., in correspondence to me dated March 21, 2019, stated “Our Government continues to examine the tax system to ensure that it is fair and effective. That said, changes to rules in this area would need to be carefully considered in terms of the impacts on different groups and implications for the tax system as a whole.” His concluding paragraph stated, “Although our Government continues to monitor the issues you have raised, we are not prepared to recommend any changes at this time.”

Concluding Remarks

It is a shame that our political leaders do not appreciate the importance of the EDA tax credit to low and middle income families raising children. Why not share all child related tax credits and benefits equally in shared custody arrangements (including disability and caregiving credits for infirm children)? Why not define “shared custody” in the same way in all legislation? There is always hope that common sense will prevail, and the laws will be changed – which is why you should verify if there have been any changes since this article went to publication.

To review my correspondence to and from various government officials, including the Minister of Finance on this issue, see my web site article – My “Shared Custody” Communications with the Government.

[1] The Department of Justice Canada, Child Support Team Research Report, titled, Formula for the Table of Amounts Contained in the Federal Child Support Guidelines: A Technical Report, sets out the formula used to determine child support amounts. Specifically, it says, “Not included in the calculation of the receiving parent’s taxes are the federal Child Tax Benefit and the GST rebate for children. These are deemed to be the government’s contribution to children and not available as income to the receiving parent. The only difference in tax calculations between the two parents is the inclusion, in the calculations for the receiving parent, of the federal equivalent-to-spouse deduction and certain provincial tax reductions and credits.” The equivalent-to-spouse deduction is now called “the amount for an eligible dependant.”

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Blair Corkum, CPA, CA, R.F.P., CFP, CFDS, CLU, CHS holds his Chartered Professional Accountant, Chartered Accountant, Registered Financial Planner, Chartered Financial Divorce Specialist as well as several other financial planning related designations. Blair offers hourly based fee-only personal financial planning, holds no investment or insurance licenses, and receives no commissions or referral fees. This publication should not be construed as legal or investment advice. It is neither a definitive analysis of the law nor a substitute for professional advice which you should obtain before acting on information in this article. Information may change as a result of legislation or regulations issued after this article was written.©Blair Corkum