Income splitting revisited

It is no secret that Canada’s tax system encourages clients to attempt to shift investment assets to lower-income family members. The potential benefits of doing this have increased over the past decade, with the highest marginal tax rate in most provinces now well above 50%. The federal government responded to the potential loss of tax revenues with the long-standing income attribution rules, which generally prevent taxpayers from income splitting with lower-taxed family members by attributing the income back to the taxpayer. 

This article briefly reviews the scope of the income attribution rules, highlights specific exceptions to the rules, and discusses how life insurance can be used to supplement other strategies. The income splitting rules that apply more specifically to business owners and related insurance planning opportunities will be discussed in a future article.

Income attribution rules

The “family” income attribution rules are aimed at preventing income splitting between spouses (including common-law spouses) and with minor children. They generally apply when a taxpayer transfers property (or makes a loan of property) to another family member. When the property transfer is to a spouse (directly or through a trust), any income/loss or capital gain/loss from the transferred or loaned property will be taxed in the hands of the transferor.

Similarly, when the transfer or loan is to a minor child (including a nephew or niece of the transferor), any income/loss from the property will be attributed to the transferor. However, in the case of minor children, capital gains/losses are not subject to attribution. In addition, attribution generally ceases to apply to children once they turn age 18.

It should be noted that when there is a transfer or loan to a trust for the benefit of a spouse/minor child, only such income or capital gains (for spouses) that is paid or payable to the respective family member will be taxable to the transferor. Otherwise, income and capital gains retained in a trust will be taxed to the trust at top marginal tax rates.

Main exceptions to the rules

There are several important exceptions to the income attribution rules including:

• contributions to a spousal RRSP
• gifts to a family member to contribute to a TFSA or first home savings account (FHSA)
• contributions to an RESP
• capital gains realized on transfers of property or loans to minor children (as noted above)

The exceptions relating to contributions to spousal RRSPs, TFSAs and FHSAs have built in contribution limits, age requirements and other criteria that must be satisfied. 

Another popular method of avoiding the attribution rules is making a prescribed rate loan to a spouse or minor child. Such loans must bear interest equal to the prescribed rate under the Income Tax Act, and such interest must be paid within 30 days after the end of the year. However, recent developments have made these lending arrangements less attractive. 

First, the prescribed rate on new loans has increased to 6% from 1% over the past two years, reducing the benefits of this strategy. Second, when a trust is being used to manage the property (typically for minor children), the new trust reporting rules create additional costs and complexity. And finally, proposed changes to the alternative minimum tax (AMT) could result in an AMT tax liability where a trust is the borrower of the funds. 

Life insurance arrangements

As a result of limitations applicable to the more “traditional” income splitting arrangements, clients may benefit from looking at other planning opportunities. Life insurance is one option that merits consideration for the following reasons:

• While contributions are not tax deductible, growth in the cash value of a permanent insurance policy is not subject to annual taxation provided it remains in the plan.
• There are a variety of ways to access the cash value of the insurance policy while the life insured is alive.
• The death benefit of the policy can be received by the beneficiary on a tax-free basis.
• Naming a family beneficiary of the life insurance policy can offer creditor protection to the policy and ensures the death benefit flows outside of the deceased’s estate.

It is also possible for a parent to establish and fund a life insurance policy on the life of a child and subsequently transfer that policy to their spouse or child on a rollover basis. For example, a high-income parent could acquire a permanent insurance policy on the life of a child and make additional deposits that grow over time. When the child reaches age 18 (or older), the policy can be transferred to that child without tax. The child can then access the funds in the policy without the transferring parent being subject to attribution on any policy gains. 

In addition, the parent can retain some control of the policy by being designated as an irrevocable beneficiary. Should policy values not be required immediately by the child, they will continue to grow tax-deferred and can be accessed by the child in the future. Ultimately, this policy could form the foundation of long-term insurance protection for that child’s family.

In summary, the income attribution rules must be considered when property is transferred between spouses or from a parent to a child. Fortunately, there are several important exceptions to the income attribution rules, which can be considered by your family clients. Life insurance is another important option that can be used to both supplement and enhance other income splitting strategies.

Kevin Wark

Insurance

Kevin Wark , LLB, CLU, TEP, is managing partner, Integrated Estate Solutions, and tax consultant, Conference for Advanced Life Underwriting. He’s also the author of The Essential Canadian Guide to Income Splitting.