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Tax Planning Using Income Splitting

Income splitting is a method of reducing the combined income tax costs of two or more persons by transferring taxable income from one individual to another. Typically, a high-income person wishes to allocate some of this income to his or her spouse, child or grandchild. Income splitting is beneficial when one individual pays income tax at a higher rate than another.  Caution – just putting your money in your spouse’s name will not allow him or her to report that income – it must still be reported by you (called income attribution – see archived CRA Interpretation Bulletin IT-511R for a technical explanation)

The Canada Revenue Agency (CRA) has a number of rules to prevent some types of income transfers, the most significant of which prevents income splitting by use of gifts or interest-free loans to a spouse or a minor child/grandchild. You must remember that certain income tax planning procedures may have other implications. For example, a gift cannot be recovered once it is given away, and only the recipient will have control over its use in the future. A gift may also trigger immediate taxes in the same way as if it were sold for a fair price.  Prior to implementing an income splitting strategy, you should contact a professional financial planner or tax advisor to discuss your plans.

Some acceptable income splitting ideas are as follows:

  • You may provide funds to your family members age 18 or over to invest in a Tax Free Savings Account. The income earned on the amount will be tax-free to them.
  • Spousal Registered Retirement Savings Plans (RRSP) should be used to plan for equal retirement incomes, and to use two pension income credits (federally $2,000 each; PEI – $1,000 each).  The higher income spouse opens a spousal RRSP and claims the deduction for deposits to this plan.  In the future, the money will be withdrawn and taxable to the lower income spouse.
  • If you have a lifetime pension from work, or certain other pension income, including a RRIF and certain other annuities, you may qualify for pension splitting.  Generally, income that qualifies for the federal $2,000 pension amount can be split with your spouse for tax purposes (only at age 65 or over for RRIFs and purchased annuities, unless as a result of death of a spouse). Up to one-half of an eligible pension may be reported on your spouse’s tax return, which may result in substantial tax savings for a number of reasons.
  • Upon retirement, Canada Pension Plan benefits can be split between spouses, which is worthwhile if one is in a higher tax bracket. An application to the government is required, and the allocation will be determined based on contributions made by both spouses, and the number of years of marriage.  Both spouses must have applied for their retirement pension.
  • If you are self-employed, consider paying wages to your spouse or children for services they can provide. The wages can only be paid if the services are performed and the wages must be reasonable for the work performed.
  • If you are commencing a business, seek professional advice from a professional accountant with tax experience. Consider whether part ownership of the business by lower income family members is justified, and whether use of a a corporation is appropriate.
  • It may be a benefit to establish trusts in your Last Will and Testament to hold investments on behalf of your beneficiaries. Seek advice first, as costs for small trusts may exceed the benefits. Furthermore, tax law changes increases taxes on income retained in a trust created on death for 2016 and future years, so advice is warranted.
  • Property that earns no income but has the potential of realizing capital gains may be gifted to minor children (such as mutual funds). You may have a taxable gain on which to pay tax at the time of the gift, but future growth would be taxable to the children. Income, such as interest or dividends, from such gifts would continue to be taxable to you.
  • Gifts of cash may be given to children age 18 or over with future investment gains (interest, dividends and capital gains) taxed in their hands. (Interest-free loans are no longer allowed). For minor children (under age 18), this technique works only for capital gains.  The first round of interest or dividends on gifts to spouses or to children under age 18 remains taxable to the donor. Future compounding income earned on the initial first income will not be attributed back to the donor. Therefore, income earned on the original gift should be carefully recorded each year to properly allocate taxable income. By way of example, assume $100,000 is gifted by parents to a minor child, and interest income of $5,000 is earned during the first year. This $5,000 is attributed and taxed to the parents. In year two, another $5,000 is earned on the $100,000, and $250 on the first year’s interest. The $5,000 is attributed, but not the $250. Each year, a similar process must be followed, and the benefit gradually grows.
  • The higher income spouse should pay all personal and living expenses, while the lower income person should accumulate their cash to earn investment income until both their tax brackets are identical. If the lower income spouse is expected to become the higher income earner at a later date, make the payments for personal and living expenses in the form of a loan to be repaid at a later date.
  • The higher-income spouse may lend funds to an adult child or to the lower-income spouse at the prescribed rate of interest specified by the Canada Revenue Agency, basically being fair market rates. If the funds can be invested at a higher rate of return, the plan will provide tax benefits. At the time of writing this article, this rate was 1%, but it can change quarterly.
  • The higher-income spouse may buy non-income earning assets for a fair price from the lower-income spouse (such as the principal residence or personal items). If the purchase price is paid in cash, the lower-income spouse will then have money to invest.
  • Contribute to a Registered Education Savings Plan (RRSP) for your child or grandchild. The income earned (including grants) will be taxable to the student if they continue their education at a qualifying institution after high school.  Similarly, contribute to a Registered Disability Savings Plan (RDSP) for a disabled person, and the income earned will be taxable in the future to the disabled person.  Speak to your financial institution and tax advisor to obtain more details.

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