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Income Splitting
Income splitting is the reallocation of income among family members to reduce the total amount of tax paid by the family unit. The shifting of income from a family member in a high tax bracket to one in a lower tax bracket will result in greater after-tax income retained by the family.
The use of income splitting with family members is recognized as an acceptable tax planning method, although the use of these strategies are restricted by the income attribution rules.
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Attribution Rules
Under the income attribution rules, income earned on capital that has been transferred as a loan or gift to family members may be "attributed" or taxed in the hands of the individual that gifted the capital.
For example: If Mrs. Smith were to gift capital to either Mr. Smith or their minor children, any income (except for business income; or capital gains/losses recognized by the children) would be taxed back or attributed to Mrs. Smith.
If income splitting is achieved by transferring property to a family member, the accumulated capital gains or losses must be recognized as of the date of transfer and declared on the transferor's tax return. However, a capital loss cannot be recognized at the date of transfer for property transferred to a spouse due to the superficial loss rules.
Although the income attribution rules restrict the number of income splitting opportunities available, there are still a number of effective ways of splitting income with family members.
Income Splitting Methods
Note: To ensure the desired results are achieved, income splitting methods should be discussed with a tax advisor prior to implementation.
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Income Splitting With Your Spouse
1. Invest The Earnings Of The Lower Income Spouse
To establish investment capital in the hands of the lower income spouse, their employment earnings should be kept separate from the family's finances and invested in their name. This will allow the investment income earned to be taxed at the spouse's lower tax rate. The earnings of the higher income spouse should then be used to pay all living expenses for the family as well as the family's tax liabilities.
2. Contribute To A Spousal RSP
One objective of income splitting is to equate each spouse's income in retirement. In order to ensure equal retirement income, make RSP contributions to the spouse with the lower expected retirement income.
In the future, when the funds are withdrawn from the spousal RSP, the income will be taxed in the hands of the spouse. Income attribution to the RSP contributor will not occur provided a spousal contribution to any spousal plan did not occur in the year of the withdrawal or the previous two years. Minimum RIF withdrawals are also not subject to the attribution rules.
3. Loans To A Spouse Used To Finance A Business
Business income is not attributable, therefore any business income earned will not be taxed in the hands of the spouse that provided the capital.
4. Pay Your Spouse A Salary
For individuals who own a business, it is possible to pay a salary for the work the spouse performs. The amount of salary paid to a spouse must be reasonable in relation to the duties they perform. This will put income into the hands of the lower income spouse, which will be taxed at their lower rate. Also, this will allow your spouse the opportunity to contribute to the Canada or Quebec pension plan and to their own RSP.
5. Income On Income
Although the income earned on property transferred to a spouse is attributed back to the transferring spouse, this income does become the recipient spouse's capital for reinvestment.
The income earned on the reinvested capital will be taxed in the recipient spouse's hands, hence the term "income on income." The income earned on the original loan capital will continue to be attributed (taxed) back to the lending spouse.
Over a number of years this method can result in the accumulation of substantial capital in the hands of the lower income earning spouse.
For example: Mrs. Smith gifts $100,000 to Mr. Smith, the lower income spouse, who invests the capital at 10% (interest and dividend income). Each year $10,000 of income is taxed in Mrs. Smith's hands, but becomes Mr. Smith's capital for reinvestment.
Note: If the income received on the capital transferred by gift or loan is in the form of a stock dividend or realized capital gain, the future income earned on the stock dividend or capital gain is still attributable to the transferring spouse.
6. Prescribed Rate Loan
When the higher income spouse loans money to the lower income spouse at an interest rate at least equal to the Canada Customs and Revenue Agency's (CCRA) prescribed rate for these loans, income attribution can be avoided. This means that all of the income and capital gains earned by investing the borrowed funds will be taxed in the hands of the spouse who borrowed the money. The higher income spouse must declare the interest received on the loan but this income should be less than the amount of income earned by the lower income spouse.
In order for this strategy to work, a formal written loan agreement must be in place and payments of interest must be made each year or by January 30 of following year. If the interest payments are not made within this time limit, attribution will apply for current and all future years and this income splitting strategy will no longer work.
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Income Splitting With Your Children
Age 18 and Over
Since the income earned on capital transferred as a gift to adult children is not attributed back to the giftor, any outright gift will achieve family income splitting. Low interest or no-interest loans to adult children result in the attribution of income on the loaned capital back to the loaning family member. Only the capital gains/losses earned on the loaned capital will not be attributed to the loaning family member.
Under Age 18
Since the income earned on capital transferred as a loan or gift is attributable to the transferring family member, with the exception of capital gains and losses, income splitting opportunities are restricted to the following strategies:
Child Tax Benefit
A parent may gift the monthly Child Tax Benefit payment to a minor child for their investment. Income earned on the gifted payments is taxed in the hands of the minor child.
Growth Stocks
Since capital growth recognized on capital transferred as a gift or a loan is taxed in the child's hands, the purchase of growth-oriented investments will avoid attribution.
Other Opportunities
If a parent owns a business and employs their children in that business the income earned on the children's invested salary is not attributable to the parent. The use of the "income on income" strategy (discussed in the spousal income splitting section) can also be used with minor children to accumulate capital in their hands.
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