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Income Splitting – Part One

One of the most important tax planning strategies a family can utilize is income splitting. The higher income spouse can transfer assets to a spouse or children and have the income taxed on their return. The tax department finds most of these schemes offensive and they introduced what is known as the attribution rules to stop this practice. In this update, we shall review the attribution rules and how they can be beaten. Our next update will outline various legitimate income splitting strategies.

Successful income splitting strategies allow a family to achieve three legitimate financial planning objectives:

1) reduce the family’s total tax liability by shifting income to family members with lower tax rates;
2) restructure family income to utilize the various credits and deductions that are available; and
3) distribute assets prior to death as part of an estate planning strategy to minimize taxes and probate fees.

Attribution Rules

From CRA’s perspective, income splitting unless specifically sanctioned by the Income Tax Act is viewed as an artificial reduction of family taxes. The attribution rules are designed to restrict an individual’s ability to shift income to family members with lower marginal tax rates. They restrict transfers and loans to spouses and children under the age of eighteen. They state if an individual transfers or loans property, either directly or indirectly, by any means to a spouse or certain individuals under the age of 18, any income will be that of the person who made the transfer.
The attribution rules restrict transfers and loans made “either directly or indirectly” and “by any other means whatsoever.” This would appear to be a comprehensive approach to restrict income splitting among family members. Despite these rules, there are still numerous opportunities to implement an effective income splitting strategy. Before examining these strategies, it is important to be aware of two anti-avoidance provisions in addition to the attribution rules that may apply to income splitting situations.
One anti-avoidance provision is applicable to interest-free or low-interest loans. It will apply to transactions when a loan is made to a non-arm’s length person and the purpose of the loan is to reduce an income tax liability. The section would apply when a parent loans funds to a child over the age of seventeen and the purpose of the loan was to generate investment income in the hands of the child, rather than the parent. The standard defense, if CRA attacks the loan is to show that the primary objective was not to reduce taxes; rather it was to achieve a family objective such as funding an education or providing savings for the future purchase of a home. The attribution rules would not apply to this transaction as they only apply to loans to children under the age of eighteen.
The second provision is known as the general anti-avoidance rule. It gives the tax authorities the power to set aside any transaction, or series of transactions if the purpose was to avoid tax by a perceived abuse of the provisions of the Act. This section may apply even if the tax planning strategy was legal and otherwise consistent with the Act. There is an important exception to the general anti-avoidance provision. These rules will not apply if the transaction was undertaken primarily for a bona fide business, investment or family purpose. In making this determination, it is the purpose of the transaction that is important, not whether or not the transaction has an “effect” on a business, investments or family matters.

The attribution rules are effective at restricting the following income splitting techniques:

Loan and Gifts – If money is loaned or gifted to a spouse or a child under the age of eighteen, any investment income generated on the transferred funds would be taxable in the hands of the individual that made the transfer. This restriction will normally stop income splitting by unsophisticated taxpayers.

Back to Back Loans – If Mr. Smith loans $10,000 to Mr. Jones who in turn lends $10,000 to Mr. Smith’s wife, any investment income generated by Mrs. Smith would be taxable to Mr. Smith.

Loan Guarantees – If an individual guarantees the repayment of a loan that was received by a child or spouse, any income generated from the loan would be included in the guarantor’s income. An exception to this rule would apply if the individual who received the loan paid a rate of interest equal to the prescribed rate set quarterly by CRA. For example, assume:

1) a spouse borrowed $100,000 from her father on an interest-free basis; and
2) the husband provided a guarantee to the father-in-law that the loan would be repaid if his spouse defaulted.

In this case, the investment income would be taxable to the husband, rather than the spouse. If the spouse had borrowed the money and paid interest based on the prescribed rate and her husband provided a guarantee; any investment income would be taxable to his spouse. The attribution rules would not apply to the latter case.

Avoiding the Attribution Rules

Although the attribution rules are complex, they do not restrict all of the available income splitting strategies. Let us examine some opportunities to avoid these rules:

Business Income – The attribution rules apply to the transfer of property and not to business income. If a husband transfers money to his spouse to start her own business, the income generated by the business would not be attributed to the husband.

Transfers at Fair Market Value – The attribution rules do not apply if the property is transferred to a spouse and the transferor receives the fair market value of the asset in return. This is a common technique to avoid the attribution rules.

Loans with Interest – If a loan is involved in the transaction and the spouse who received the property pays a rate of interest based upon the prescribed rate, the attribution rules will not apply.

Income on Income – If the property is transferred to a spouse or minor, the income generated on the property is attributed to the individual that made the transfer. However, any investment income generated on the original investment income is not attributed back. For example, if a spouse transferred $10,000 to her husband and he earned a 10% return; the $1,000 of investment income would be included in the wife’s income. If the $1,000 of investment income were reinvested at 10%, the $100 of investment income would be taxable to the husband, rather than the wife.

Transfer of Capital Gains to a Minor – If the property is transferred to a spouse, any resulting income or capital gain is attributed to the individual that made the transfer. However, if an asset is transferred to a minor, any income that is generated would be attributed to the transferring parent, but not the capital gains that are realized on the eventual sale of the asset. A tax planning strategy to consider is transferring shares in growth companies to your children. Any dividend income would be attributed to the parent who made the share transfer, but future increases in the value of the shares would be taxable to the child. Many growth companies do not pay dividends.

Transfers to a Child over the Age of 17 – The attribution rules apply to children, grandchildren, nieces and nephews under the age of eighteen. Once a child reaches age eighteen, the attribution rules no longer apply. However, as mentioned earlier in the article, there is an anti-avoidance rule that applies to transfers of property to non-arm’s length individuals if the transaction was motivated by tax reasons. To implement this strategy it is important to emphasize the purpose for which the child received the funds, i.e., funding an education, house purchase etc. It may be argued that any tax benefit is ancillary to the main purpose of the loan.

Next Update – Income splitting strategies that are acceptable to the tax department

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