Income splitting rules are collectively known as the attribution rules in Canada. The attribution rules are designed to prevent the transfer of property from one related individual to another.
If certain conditions are not met, the income associated with holding or disposing of property transferred is said to be attributed back to the taxpayer. For the purposes of this article the income attribution rules will be referred to as the income splitting rules.
Income Splitting by Individuals
The income splitting rules apply when income is transferred to a spouse or common law partner or to an individual to whom they do not deal at arms length. The income splitting rules also apply income transferred to children or grandchildren under 18 years of age as well as to nieces and nephews.
It is important to note that the income splitting rules may treat income from property different from income from capital gains. Income from property such as interest, dividends, rent, or royalties that is transferred will be taxed in the hands of the person transferring the property regardless of whether the property was transferred to a spouse or other related minor under the age of 18 years. On the other hand, the income splitting rules related to capital gains are applied differently for spouses than for minors under the age of 18 years.
Income Splitting Between Spouses
If property is transferred to a spouse, then the Income Tax Act considers the transfer to have occurred at the original cost of the transferring spouse and no capital gain for tax purposes is incurred. All income from the property is taxed in the hands of the transferring spouse. When the property is subsequently sold by the spouse receiving the property, the gain would be taxed in the hands of the spouse transferring the property.
Property that is transferred to a spouse at fair market value and where the spouse pays for the property does not fall within the income splitting rules. Any capital gain or loss resulting from the sale is included in the selling spouses’ income and the selling price becomes the adjusted cost base for purchasing spouse.
A loan may be extended to help the spouse purchase the property, provided the loan is documented with repayment terms and the interest is the rate prescribed by the CRA. The “interest” on the loan must be paid within 30 days of the end of the year otherwise the transaction is not valid and the income is taxed in the hands of the selling spouse. The interest is taxable in the hands of the selling spouse and deductible in the hands of the purchasing spouse.
Income Splitting With a Related Business
If property is transferred to earn business income the business income is not taxed in the hands of the person transferring the property. However, if the property is transferred to a spouse any capital gain would be taxed in the hands of the transferring spouse when the business is sold by the receiving spouse. Consult a financial professional when considering property transfers between family members and a business.
Income Splitting With Children
If property is transferred to a related minor under the age of 18, the transfer is deemed to have taken place at fair market value of the property and any gain is taxed in the hands of the person transferring the property. Any subsequent gains are taxed in the hands of the related minor.
While the property is transferred, the income earned from the property transferred would be taxable in the transferring person’s hands until the child reached the age of 18. However, if the transfer occurs at arms length, and the minor acquires the property using their own funds, then the income from the property would then be taxable in the minors’ hands.
Property that is transferred to a related minor at fair market value and where the related minor pays for the property with their own funds does not fall within the income splitting rules. Similarly, a loan may be extended to help the minor purchase the property provided the loan is documented with repayment terms and the interest is the rate prescribed by the CRA.
Low or interest free loans made to related persons under the age of 18 for the purpose of acquiring income earning property can also result the income from the property taxed in the hands of the party lending the funds. Most commonly attribution would arise if a low or interest free loan was made to a child to acquire investment property. On the other hand, if the loan was given to acquire a principle residence, then the rules do not apply and there are no tax consequences unless there is a change in use of the property.
“Kiddie Tax” or Tax on Split Income
The tax on split income was introduced to reduce the benefits from certain transactions. The top marginal tax rate is applied to all dividends and other shareholder benefits of unlisted Canadian or foreign private corporations, income from trusts, or income from partnerships that are owned by a relative. This income will also not be eligible for deductions or tax credits (other than the dividend tax credit). There are a number of pitfalls that can result from these types of arrangements and professional advice should be sought.
Secondary Income
When the income splitting rules apply, they impact only the primary income from the transfer of income. Income earned from reinvestment is not subject to the attribution rules. For example, if $1,000 of interest were attributed back, any subsequent interest earned from reinvesting the $1,000 would not.
Other General Anti-Avoidance Provisions Related to Income Splitting
- If a spouse or minor child has an existing commercial rate loan, a new loan or interest free loan cannot be substituted.
- The Income tax Act does not permit funds to be lent to an unrelated third party who then lends the funds to the spouse or related minor.
- A loan guarantee cannot be used to avoid the income splitting rules. A higher income spouse cannot avoid the rules by providing a loan guarantee on a low rate or interest free loan to a spouse.
- There are a variety of rules in the Canadian Income tax act designed to prevent income splitting through a trust or corporation.
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Assume a non-resident couple where the non-working spouse takes ownership of money that is earned while non-resident. Would attribtuion rules apply on the income after becoming residents in the future. Seems most Canadians ignore it and there hasn’t been any tax court cases that I can find.
The attribution rules under the Income Tax Act, subsection 74.2(1) do not apply if the transferor was not a resident of Canada. However, at the point the where the transferor becomes a resident of Canada, the attribution rules may apply. The facts are generally outlined in a 1999 technical interpretation bulletin. If you have access to CRA technical interpretation bulletins, the document number is 1999-0013435 (E).
Hello, Tax Guy:
For the income split, I have a question about how it works: assume that my annual income of $100k, my spause stays home without income. I lend her $50k for investment. When filling tax return form, should I claim my income as $50k + the interest from my lending money to my spause, or I still have to report $100k?
Thanks for your help.
Regards,
Joe
@ Joe:
If your spouse invests the money you have lent, then the tax will be on the investment income and not the loan. In your example above, you make $100k and lend $50k to your spouse, you still pay tax on $100,000.
If you lent your spouse $50,000 and took back a promissory note with a stated interest rate at the prescribed rate, then you must declare the interest you receive from your spouse from the note (x% of $50k). Your spouse invests the $50,000 and is taxed on the investment income from that $50k and will also be able to deduct the interest paid to you.