Rethink tax strategies

Since we’re all about tax this month, I’ve polled some of my colleagues to come up with a list of common tax-related blunders they’ve seen in relation to investment advisor assistance or recommendations.

Hopefully, you don’t spot any of your handiwork in this list, in which case you can use it as a reminder of things to look out for and have a handy reference of “what not to do.” It’s always important to know all the facts before you dispense advice and if there are any doubts, consult a tax specialist. So, here’s the list:

Own assets jointly with children to avoid probate or as a will substitute – This strategy can result in both tax and non-tax problems. On the tax side, transferring to joint ownership may be a disposition for tax purposes, which may trigger a taxable gain. If the property is a personal residence, a portion of the principal residence exemption may be lost if the child owns a home. On the non-tax side, after the transfer the property may be subject to risk from the child’s creditors; or a former spouse or partner in the case of a marital dispute.

Inappropriate uses of in-trust accounts – When using these accounts for income splitting with minors, take careful consideration of the investments. In cases where investments are concentrated in bonds or preferred shares, attribution will apply to the dividends and interest earned (defeating, in part, the income splitting objective). Generally, the investments should be growth securities that produce capital gains. Further, for income splitting to work, deposits to the in-trust account should be true gifts. That means the funds should not be used by your client – no withdrawals or transfers to RESPs.

Income splitting loan proceeds invested unwisely – To be effective, proceeds from income splitting loans should be invested in fixed-income instruments that produce a greater return than the interest rate on the loan; after all the benefit is the tax saved on the spread. Investment in growth equities, say a global equity fund, won’t necessarily produce that spread. Indeed, last year, such an investment would have produced significant capital losses. Not only is there no income splitting, but the capital loss may not be used until years later, if ever.

Incorrect adjusted-cost-base calculations – There are many ways to slip up here. Remember it’s average cost; and you must take into account, stock splits, spin offs, return of capital distributions (for income funds). And if stock option shares are owned along with purchased shares, there are special rules for determining ACB.

Pay your spouse and kids salaries – Although this can be an effective income splitting strategy for business owners, the people receiving the salaries must actually provide services, and amounts paid must be reasonable in relation to services rendered.

Name your estate as beneficiary of your RRSP or life insurance policy – This can cause the proceeds form part of the estate to be subject to probate and likely a delayed distribution. It’s generally more effective to make specific beneficiary designations within the contract.

Use a line of credit or another single debt source for both investment and personal purposes – When clients pay down on this debt, the payments reduce, pro-rata, both personal and investment debt. Clients need to pay personal debt first, because it’s more tax-effective.

Transfer the commuted value of a pension to an RRSP, as opposed opting to receive an early pension – This isn’t always poor advice, but advisors must keep in mind the early pension will be eligible for pension income splitting (which could result in significant tax savings), while the RRSP route will delay the pension income splitting until age 65.

Gena Katz, FCA, CFP, an executive director with Ernst & Young’s National Tax Practice in Toronto. Her column appears monthly in Advisor’s Edge.

Gena Katz

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