Spouse and family income splitting

Navigating income attribution rules, including prescribed rate loans

Income splitting has been around for as long as the tax system itself. It’s a shift of income recognition from a high-rate taxpayer to someone at a lower tax rate. Most often it will involve a spouse/common-law partner (CLP), and can also work with children though less often when they are of minor age.

Importantly, income splitting is not illegal. It is however constrained by tax rules that scrutinize gifts and preferential loans between closely connected people. That being so, it’s sensible to review and understand the rules that could undo a planned action, prior to launching into the effort.

The motivation for income splitting

The premise of a progressive tax system is that those more financially capable are asked to bear a larger share of tax. For income tax, a higher rate of tax is imposed on income above each bracket threshold.

Presently there are five federal tax brackets, with rates progressing from 15% up to 33%. Each province has a similar structure, though the rates and number of brackets vary. When combined with federal rates, the top individual marginal tax rate is near or above 50%. Comparatively, the lowest combined rates are roughly in the 20-25% range, and may be close to zero once personal tax credits are applied.

Successful income splitting could cut that portion of a given family’s tax bill in half or better.

Attribution with a spouse/common-law partner

Attribution rules include both general and specific Income Tax Act provisions designed to plug holes where tax may leak. The base rule between an individual and a spouse/CLP is that any income, loss, capital gain or capital loss on loaned or transferred property will be attributed back to the transferor.

The rules don’t affect or change the legality of the transfer, including the legal right to the associated income or gain. Instead, they simply cause the transferor to pay the tax at his/her marginal tax rate.

The rules apply to direct transfers, as well as to indirect transfers and more complex scenarios, including:

- Transfer to a trust or corporation in which the recipient has a beneficial interest
- Loans without interest, or at interest below the prescribed rate (discussed further below)
- Loans through an intermediary to mask underlying routing of funds back to the recipient
- Third party loans advanced to the recipient, contingent on the guarantee of the high bracket person
- Re-advancing loans paying off an original loan from the same person to whom attribution applied
- Non-monetary loans, such as a loan of real estate or personal property
- Claiming an advantageous split of commingled funds, without any record of respective contributions
- Pre-relationship transfer or loan, with attribution beginning once a spouse/CLP relationship begins
- Substituted property acquired with proceeds of sale of original property that was subject to attribution

Attribution with a related minor child

Where a transfer or loan is made to a related minor child, attribution applies on income up to the year the child reaches age 18. Notably, there is no attribution of capital gains or capital losses, whether realized before or after the child reaches age 18, presenting a significant splitting opportunity. For these purposes, child includes a grandchild, sibling, niece or nephew of the individual or of a spouse/CLP.

Strategies that can avoid the attribution rules

The attribution rules can be circumvented with informed planning. The strategies described below refer to a spouse/CLP, but they work just as well when splitting with a child.

Prescribed rate loan

While a transfer to a spouse/CLP by way of gift is a problem, a properly documented and serviced loan that complies with the prescribed interest rate rules will escape attribution. The investment income will be taxed to the lower income borrowing spouse, less a deduction for the interest paid. On the other side, the lending spouse will have to include the interest in income.

While a formal written loan agreement is not mandatory, it’s prudent to have one to buttress the bona fides of the arrangement, should it be questioned in future by tax authorities. Apart from that,

- Interest payments must actually be made from borrower to lender, paid during the calendar year or no later than 30 days after year-end (January 30^th, not ‘end of January’).
- The lending spouse cannot be the source of the interest for the borrowing spouse, meaning it cannot be simply capitalized to the loan or be part of a revolving loan arrangement.
- The rate must be commercially reasonable, and be no less than the rate prescribed by tax regulations. That rate is set quarterly, calculated as the average yield of Government of Canada 3-month T-Bills auctioned in the first month of the preceding quarter, rounded up to the next whole percentage.
- The prescribed rate is 5% in the third and fourth quarters of 2024.
- Failure to comply with any of these rules makes the loan forever offside thereafter.

What makes this strategy particularly appealing is that the loan may remain outstanding indefinitely at the original interest rate, even if the prescribed rate rises in future. And if the prescribed rate falls, the current loan could be paid out, and a new loan established at the lowered prescribed rate.

Fair market value exchange

If a low bracket spouse gives an asset of fair market value (FMV) in exchange, attribution will not apply. However, if the FMV falls short, full attribution still applies. In other words, there is no pro-rata treatment, so the transfer from the high bracket spouse should be no more than the available asset’s FMV.

Examples may be an automobile, antiques or jewelry, as long as the ownership interest did not originate with the high bracket spouse, such as an earlier gift. An interest in a cottage or principal residence may also be possible, but those are more complicated due to land transfer tax (in some provinces), as well as tax on disposition and required tax elections to be made when filing tax returns for that year.

Income-on-income (also known as second/later generation income)

It is only the income on the original gift that is attributable. When that income is reinvested by the receiving spouse, the ongoing income-on-income is taxed to him/her. To prove this distinction if there is an audit (given that the onus is on the taxpayer), it may help to move income on the original investment into a separate account where it can be clearly tracked.

Business income

Generally, the attribution rules are intended to capture passive income from property. If the receiving spouse uses the transferred funds to generate business income, then attribution will not apply.

Alter ego and joint partner trusts

Privacy, probate minimization and more for those 65+

In estate planning, your Will is the central document for controlling what happens with your property at death. It could be argued though that having a Will alone could, in a sense, be too much management held in one place.

As odd as that may sound, a Will is a product – albeit a very important one – of you thinking through your own needs and those of the important people around you, and deciding how best to take care of them. That’s the estate planning process, and your Will’s role is to set out who is to receive the property you own when you die.

However, sometimes it may make sense to make changes so that select property does not flow through your Will, and therefore is not part of your formal estate. That is where alter ego and joint partner trusts can offer greater flexibility and control.

Mechanics of alter ego & joint partner trusts

Alter ego and joint partner trusts are inter vivos trusts, meaning they are set up while you are living.

You must be at least age 65 to set one up, with an alter ego trust for one person and a joint partner trust for a couple.

Commonly you will be both trustee and beneficiary, though you can also include one or more others as trustees with you. That will provide some flexibility should you become incapacitated while living, as discussed further on. Trustees have all the legal powers to buy, sell and manage the property that you have decided to transfer into the trust. As the beneficiary, during your life you are entitled (and actually required) to receive any income, and you have full use and enjoyment of the capital, just as you did before the trust was created.

You can name one or more residual beneficiaries. If it is an alter ego trust for yourself then those residual beneficiary rights will arise on your death. In the case of a joint partner trust, the survivor of the two of you will continue on as beneficiary on a first death, and then the entitlement of those residual beneficiaries will take effect on the survivor’s death. Commonly the residue would be paid out upon death of the primary beneficiary/ies, but it is also possible to draft it so that the trust will continue on for a period of time if you wish.

Income tax issues

These trusts may be used with any property you may own, but most often the focus is on real estate and non-registered investment accounts. With the exception of your principal residence, a property transfer usually triggers a taxation disposition.

Fortunately, you may roll capital property into these trusts at their cost base. Thereafter, income and capital gains realized in the trust are taxable to you (or both of you for a joint partner trust), in proportion to the assets you contributed.

At death, in the case of an alter ego trust (or at the second death with a joint partner trust), all remaining property is deemed to be disposed, with any resulting capital gain/loss is reported on the trust’s tax return. The trust’s capital gain/loss cannot be netted against capital gains/losses realized on your death by you personally. For this reason, you must carefully consider what initially goes into the trust and what you will continue to own personally, and carefully monitor all pending tax liabilities.

As an incapacity substitute, and for continuity of management

You should still have powers of attorney (POAs) for property and personal care drawn up in case you become incapable in future. Bear in mind though, that POAs can only deal with property that you own yourself, meaning that the named attorneys would not have legal power over the trust property.

With this in mind, whether it’s an alter ego or joint partner trust, you can name one or more co-trustees who can act with you now, act for your benefit later, and continue to act after your death as trustees for your residual beneficiaries. It is possible and common to name the same people as trustees and attorneys, or you may prefer to name different people as a way to spread out responsibility and oversight.

Estate liquidity, and time & cost savings of avoiding probate

On your death, the continuing trustees will have control of the trust assets without having to wait for a probate application. Not all provinces levy probate tax, and should not be a driving concern in your estate planning anyway. However, if the other features of these trusts serve your needs, then this cost saving is a bonus.

Privacy and insulation against estate litigation

Unlike a probated Will that can become part of a court file, trusts of this sort do not have to be made public. Apart from maintaining your privacy, this can be especially important if you or your beneficiaries are concerned about creditors. And even if those creditors pursue their claims, there are narrower means to attack a trust than may be available with a Will challenge.

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Spousal rollover … or not?

To defer, or prefer to incur

After a good long run, dad died midway through his 99^th year. Mom and we kids will miss him dearly – they actually called each other “dear” – but it was his time.

Mom is nearing the mid-90s herself. Customarily, everything would roll to her to get around the tax on deemed dispositions at death that would otherwise erode dad’s estate, of which mom is the sole beneficiary – But could we do better for her?

It’s one of those mantras of financial planning to arrange beneficiary designations and joint accounts to allow streamlined continuity to a spouse. Even so, it’s equally important to pause and consider whether to opt out, particularly for deaths early in the year. Dad died in January, so with only a couple weeks of income, there remains plenty of room to make use of his basic personal credit and low bracket tax rates.

Following are some steps we undertook, along with the odd snag along the way.

Pension rollover

To begin, notice was given to the administrator of the defined benefit pension that was their primary income source. As surviving spouse, mom will continue with a reduced pension, emphasizing the need to be tax-conscious with her other income sources. There won’t be any residual value when she dies, but with the two of them living well into their nineties, they got their fair actuarial share out of the deal.

RRIF on death

Mom handled the house when we were youngsters, followed by a lengthy run as a school trustee. Dad took early retirement at 60, then kept busy with teaching and consulting gigs into his 70s. Thus, despite having a dependable pension, both had moderate accumulation in registered retirement income funds (RRIFs), each naming the other as beneficiary. Their financial advisor (a friend to us all) readied the paperwork to roll dad’s RRIF to mom.

Acting under power of attorney (POA), we instead declined the receipt of the RRIF on mom’s behalf. Accordingly, the amount will be included in dad’s final year income, soaking up the remainder of his basic personal credit (i.e., at zero tax), with the rest tagged with the lowest bracket rate.

RRIF minimums

In their later years, we have been managing their finances under POA. This included instructing on taking the minimum RRIF withdrawal early in the year. That meeting was still in the upcoming calendar when dad died.

The RRIF minimum, based on the preceding year-end value, is required to be paid in the following calendar year. Per CRA and the administrator’s practice, as it had not been paid before dad’s death, that portion had to be paid and taxed to mom as the named beneficiary (though again as noted above, the bulk had been declined, to be taxed in dad’s final year).

TFSA rollover

One great thing about a TFSA rolling to a spouse is that it continues to be a TFSA, without requiring or using up the receiving spouse’s TFSA room. Notably, unused TFSA room does not roll to a spouse, nor to anyone else for that matter. Fortunately, mom and dad were consistent TFSA contributors, with the combined amounts now being with mom, except for the lost room for dad’s final year due to the contributions not having yet been made.

(Not) naming beneficiaries under POA

For registered accounts in Ontario (and most common law provinces), attorneys under POA cannot initiate or change beneficiary designations. However, many financial institutions will carry over an existing designation on an incoming registered plan, which was helpful as we were consolidating their financial holdings when their faculties had significantly declined.

Unfortunately, dad had one small TFSA without a designation. As we could do nothing about it, probate was inevitable for dad’s estate. On the bright side, it bolstered our decision to allow the RRIF to fall into the estate, with the projected income tax savings well exceeding the nominal bump in probate tax.

Joint non-registered account

The proceeds from their home sale years ago went into mom and dad’s joint non-registered investment account. That’s helped service their later accommodations, while also appreciating nicely. Probate was bypassed at dad’s death, with mom continuing as sole legal and beneficial owner by right of survivorship.

By default, capital property rolls at adjusted cost base (ACB) to a spouse on death. This applies when held through a joint account as in this case, or if dad had an account under his name alone that was then migrated to mom as estate beneficiary (as long as the individual securities in the account were not sold in the process).

Alternatively, dad’s estate can elect out of the automatic rollover, on a per-property basis. This will allow us to optimize for mom’s future needs by choosing which securities to rollover, and which to have taxed on dad’s final return. As mom could conceivably blow right past dad, the century mark and beyond … that extra financial flexibility will be welcome comfort for her as she moves into this next chapter.