Munro: When New Years’ resolutions include divorce

I was skiing over the holidays with a friend who happens to be a lawyer specializing in family law. When I casually asked about her business she told me the holiday season is often the calm before the storm. It turns out many couples put troubled marriages on hold through December. Then, they ring in the New Year by taking off their rings and commencing with divorce proceedings.

Separation breeds anxiety all around, for parting couples and their families as well as their lawyers. The stress also affects financial advisors, who suddenly find they’re helping clients unravel investment strategies they’ve worked long and hard to construct. As a financial advisor, your role isn’t to serve as marriage counselors – even though it may seem that way sometimes – but advisors can be enormously helpful when marriages end. An advisor can help to smooth this undeniably difficult process by providing often critical advice. This includes helping soon-to-be-single clients determine their net worth, reset broad financial goals and priorities, develop budgets, and, importantly, generate new investment plans.

What follows are some of the tax issues your clients are almost certain to face in the event of a marriage breakdown. You can help make them aware of these basics with the vital caveat that you always direct them to seek independent legal and tax advice before making any final decisions.

Child support payments

The spouse who is likely to be the one paying child support under a separation agreement should know that those payments cannot be deducted from income. Furthermore, the spouse receiving the money will not have to include it in income. This has been the case since May 1, 1997 when the federal Child Support Guidelines came in to effect. Prior to that time, support payments could be taxed as income to recipient and deducted from income by paying parent. Note these old rules are grandfathered for agreements reached prior to May 1, 1997.

Spousal support payments

Unlike child support payments, spousal support payments are generally included as taxable income to the recipient and deducted from taxable income by the paying spouse. It isn’t automatic, however, and clients should know that several criteria must be met to achieve this outcome. One criterion is that the payment must be periodic, that is, made on a regular basis.

Lump sum payments

Lump sum payments provide another twist. By definition, they’re not periodic and so are not deductible in the manner of spousal support payments. Generally, lump sum payments are not taxed as income to the recipient, nor are they deducted from income by the paying spouse. An exception to this rule is when a lump sum payment is made to cover arrears of periodic spousal support payments, in which case the rules governing spousal support payments may apply.

Attribution rules

The attribution rules apply to spouses, not former spouses, so when a marriage breaks down, the attribution rules no longer apply.

Capital property transfers

When property is transferred as part of a settlement agreement, it is done at the adjusted cost base of the property. This isn’t necessarily to the advantage of the former spouse who receives the property because it can result in a larger than expected tax bill when the recipient ultimately disposes of the property. To get around this possibility, former spouses can agree to make any property transfers at fair market value. This way, a capital gain or loss is triggered at the time of the transfer, thereby dealing with tax issues up front.

RRSP transfers

When couples are parting, each can make transfers from an RRSP or RRIF to the other’s plan without having to pay taxes. There are two qualifiers however; a transfer must be due to the breakdown of the marriage, and it must be part of any settlement agreement.

TFSA transfers

The rule here is the same as for RRSP transfers. Any amounts being transferred from one ex-spouse’s TFSA to the other’s will maintain tax-exempt status. What your clients will need to remember in this event is that the spouse or partner doing the transferring won’t regain contribution room. On the other hand, the transfer won’t diminish the contribution room of the partner receiving the funds.

Canada Pension Plan / Quebec Pension Plan credits

Since January 1, 1978, divorcing or separating couples have been able to split their accumulated CPP or QPP “pension credits,” or the contributions they paid over the years on pensionable earnings. The effect here is to even out the pension credits between couples during the time they were together, whether they were married or in a common law relationship. The obvious benefit here is for the partner who either had a lower income or did not work at all. Conversely, the higher earning partner will lose credits. The precise rules governing pension credit splitting have been revised and expanded several times since 1978, so the exact application to your clients would depend on professional advice.

Wills

It seems obvious but separating clients should remember to update their wills. Equally, the tax-free and tax-efficient spousal rollovers that pertained while a couple was together will no longer apply.

Legal fees

As my lawyer friend noted, at least one member of a dissolved marriage will get a minor break. Legal costs incurred to establish or enforce a right to child or spousal support, or to obtain an increase in child or spousal support, are deductible from income. This provision has been in effect since October, 2002. Prior to that time, different rules applied.

Your clients will need professional help

Undoubtedly, a divorce or separation is an immensely stressful, emotionally-charged and complicated process. It presents advisors with opportunities to support their clients in new and meaningful ways during a particularly difficult time in their lives. By providing some basic information, the advisor can help shed light on some of the important issues that clients should be aware of as they begin this process. Advisors can also make sure their clients are steered toward the appropriate specialists to get the detailed advice necessary for post-marital stability and prosperity.

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Michelle Munro is director, tax planning, for Fidelity Investments Canada.

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While the information provided in this email and any attachments may be intended to highlight various tax planning issues, it is general in nature. This information should not be relied upon or construed as tax advice. Readers should consult with their own advisors, lawyers and tax planning professionals for advice before employing any specific tax or investing strategy.

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