How income splitting produces tax savings

Any tax-planning strategy has but a simple goal: to increase the amount of money left in one’s pocket. In the case of couples, whether they are married or living in a common-law arrangement (including same-sex couples), this could mean increasing the combined after-tax income of the couple. When the spouses are in different marginal tax brackets, there is an opportunity to increase the after-tax income of the couple. This exercise boils down to reducing the income taxed in the higher income earner’s hands while increasing the amount taxed in the lower earner’s hands. This is the essence of income splitting.

The problem for your clients is that Canada’s Income Tax Act is somewhat ambivalent on the subject. While income splitting is allowed for specific purposes, such as spousal registered retirement savings plans and pension income splitting, it’s discouraged under what are commonly known as the attribution rules. These are rules whereby investment income or capital gains arising from gifts or loans to spouses are taxed in the hands of the person doing the giving or lending rather than the recipient.

For example, money given to a spouse either as a gift or interest-free loan is then used to make investments. Under the attribution rules, the partner who provided the money in the first place must report any income, capital gains and/or losses from the investments. These attribution rules also apply to trusts set up for the benefit of a spouse. In addition, there are attribution rules that apply to gifts or interest-free loans made to minor children, as well as to trusts set up for their benefit. There is an important exception when dealing with attribution and minor children when capital gains and/or losses are not attributed back to the donor.

Below are some of the ways you can help your clients navigate the legal ambiguity around income splitting. I’m going to start with the best-known ways couples can do this and then suggest a couple of less obvious methods that can also produce tax savings. In the interest of focus, I will leave other strategies, such as splitting income with minor children, for another column.

Pension income splitting

Since 2007, married and common-law couples living in Canada have been able to transfer up to 50% of one spouse’s annual pension income to the other. No money actually changes hands, of course. It’s a question of doing a paper allocation on a tax return using Form T1032. The object is to reduce the taxable income of the partner in the higher marginal bracket and increase the taxable income of the spouse in the lower bracket. The benefit to the couple is lower overall taxes, and both may also receive a pension income tax credit.

Form T1032 also allows the withholding taxes deducted from the transferred pension income to be split on a pro rata basis. So, for example, if 40% of the pension income is transferred, 40% of the withholding taxes will also be transferred. The result is that one spouse avoids getting a large refund while the other has substantial taxes owing.

Spousal RRSPs

Although the benefits of a spousal RRSP have been diminished now that pension income splitting is on the scene, it remains a sound income splitting strategy. The way it works is fairly well known. The partner with the higher income makes contributions to an RRSP owned by a spouse — the beneficiary — and receives a tax deduction. Any withdrawals from the RRSP are usually taxed in the hands of the beneficiary, a tax-saving advantage because the partner who made the contributions in the first place will likely have a higher income at retirement.

Another advantage of the spousal RRSP is that it can effectively extend the amount of time a person can make contributions. While RRSP contributions are not allowed after the end of the year in which a holder turns 71, the partner who’s over 71 can still contribute to a spousal RRSP if the spouse is 71 or less.

Tax-free savings accounts

In previous columns, I’ve discussed how TFSAs can affect tax planning and how they compare with RRSPs and non-registered accounts. In this context, however, it’s worth noting that TFSAs are an effective way to transfer income and potential tax liability. For example, a spouse with higher income gives money to a partner for investment in a TFSA. Since the returns from the account are tax-free, the attribution rules do not apply. The only caveat with this new instrument is the fact that annual contributions to an individual account are capped at $5,000. Of course, over time, the TFSA’s effectiveness as a tax-planning tool will grow substantially.

Now, here are some less obvious strategies.

Market rate loans to spouses

If a higher income spouse lends money to a partner to purchase investments and charges interest on the loan that’s at least equal to the rate prescribed by the Canada Revenue Agency — currently 2% and set to reduce to a very low 1% effective April 1, 2009 — the attribution rules will not apply to the investment income or capital gains. And, obviously, it helps if the partner receiving the money earns a rate of return greater than the interest rate on the loan.

There are a few technicalities to observe, however. As noted, the interest rate on the loan must at least equal the prescribed rate that applies when the loan is made. What’s more, the rate can stay at this level even if the CRA’s prescribed rate subsequently increases. So if your clients are considering this strategy, they should wait until after April 1, 2009, to lock in the loan at 1%. This rate will stay in effect until June 30, 2009. The prescribed rate for the third quarter is unknown and will not be posted until June 2009. Finally, interest on the loan must be paid by January 30 of the year following the one in which it was made.

Couples should be careful to meet that interest payment target date. And to ensure that the loan passes scrutiny, they should put the arrangement in writing, complete with terms and conditions, and ensure that there’s a paper trail verifying interest payments.

Funding normal expenses

This is the final variation I’m going to suggest on the income splitting theme, and it has to do with how a couple divides its financial responsibilities. It makes sense for the higher income earner to pay for family expenses while the other partner invests most of his or her income. In this way, income from non-registered investments will be taxed in the hands of the lower income earner, reducing the couple’s overall tax burden.

Again, however, it’s important that the couple be able to support the arrangement. Ideally, the lower income spouse would have a separate account where income is deposited and then invested in his or her non-registered account. This should provide a thorough paper trail to support the fact that investments have been made using the lower income spouse’s money.

Finally, there is no need for these strategies to be used in isolation. For instance, if the higher income earning spouse expects to remain in a high income bracket, it may make sense for this spouse to contribute to both an individual and spousal RRSP, both spouses’ TFSAs and fund all of the family expenses, while the lower income earning spouse contributes to his/or her own RRSP (to the extent possible) and saves the rest in a non-registered plan. The objective of this strategy is to spend and save the same amounts as before but to allocate these expenditures in a more tax-efficient manner for both current and future tax savings.

Particularly in these recessionary times, people are going to want to retain as much of their income as possible. Any advice or reminders you can provide to clients on accepted forms of income splitting will undoubtedly be welcomed. As we’ve seen, there are several options. Your clients should be aware of them and take advantage of them if possible.