With top marginal tax rates over 50 per cent in seven out of ten provinces, the temptation to shift income from a higher-income family member to a lower-income spouse, partner or child has never been greater. Indeed, the spread between the top rate (over 53 per cent in Ontario) and the lowest rate (as low as 20 per cent in B.C. and Ontario) has created ripe opportunity for income splitting. But beware, because if you don't understand the complex rules surrounding what is and isn't allowed, you could find yourself caught by the attribution rules or, worse still, facing off against the tax man in court, a route one taxpayer recently tried.
Income splitting can be formally defined as transferring income from a family member to a lower-taxed family member to reduce the overall tax burden of the family. Since our tax system has graduated tax brackets, by having the income taxed in the lower-income earner's hands, the overall tax bill of the family can be reduced.
Our Income Tax Act has a variety of anti-avoidance rules meant to block attempts at income splitting. These are technically known as the attribution rules because they attribute the transferred income back to the original source, or the transferor.
Fortunately, there are several exceptions to the attributions rules that not only permit but, in some cases, encourage us to split income. For example, if you give your minor kids money to invest, any interest or dividends earned on those funds will attribute back to you, but not any future capital gains. On the other hand, if you gift funds to your spouse or partner for investment, all future income as well as capital gains will attribute back to you. If, rather than a gift, funds are loaned between spouses or partners at a minimum of the Canada Revenue Agency's prescribed rate (currently set at 2 per cent until at least the end of 2018), the attribution rules won't apply, provided the interest on the loan is actually paid by Jan. 30 of the following year.
But perhaps the easiest way to split income that actually involves no physical transfer of funds is the ability that spouses (or partners) have to split pension income. Pension income splitting can result in substantial tax savings if one spouse is in a lower tax bracket and it can also help preserve Old Age Security benefits, which might be clawed back if the recipient partner's income is above the clawback threshold ($75,910 for 2018). Pension income splitting may also allow doubling up on the $2,000 federal pension income amount if the second spouse doesn't have their own pension. It can even help preserve the age amount, which provides a non-refundable credit for taxpayers over age 65, but which is reduced once income is over $36,976 (federally).
Any pension income that qualifies for the federal pension income credit also qualifies to be split. Specifically, this would include annuity-type payments from an employer-sponsored registered pension plan, regardless of age, and also includes Registered Retirement Income Fund (RRIF) or Life Income Fund withdrawals, but only upon reaching age 65. (In Quebec, you must be at least 65 to split any of your pension income.) It does not, however, include RRSP withdrawals, which is why Moncton residents David and Deborah Way found themselves in Tax Court last month appealing their 2015 tax reassessments.
In 2015, Mr. Way made two lump sum withdrawals from his RRSP totaling $15,482. He did so without intending that these withdrawals be converted into an annuity or a RRIF. In their 2015 returns, Mr. and Mrs. Way jointly elected to split this total of $15,482, which was reported in their 2015 income returns as “pension income.” Each of the two spouses reported $7,741 (half of the $15,482) as income from an RRSP.
The CRA assessed the returns, denying the joint election to split the RRSP income on the basis that Mr. Way, in his 2015 taxation year, did not receive any “eligible pension income.” As a result, he was assessed the entire $15,482 RRSP withdrawal as income, and also was disallowed $1,161 of the age amount he had claimed in computing his non-refundable tax credits. To make matters worse, he was also denied the federal pension amount of $2,000 he had claimed for the same reason — he simply had no “eligible pension income” in 2015 because withdrawals from his RRSP itself do not constitute “pension income” as they were not payments from a pension life annuity or RRIF.
Surprisingly, however, Mr. Way was not in court to challenge these assessments. Rather he testified that he had prepared his and Mrs. Way's 2015 returns using a tax software program that was “certified by Canada Revenue Agency.” He testified that he “had accurately used this program but that the program was faulty because it led him to this error in preparing the two tax returns, and consequently his tax reassessment includes interest at a substantial rate going back to 2015.”
He was in court to seek damages from the software provider and/or the CRA, which certified the software, “arising from expenses he has incurred” (presumably the non-deductible arrears interest) from what he claimed was “faulty software.”
Unfortunately, as the judge sympathetically explained, the Tax Court “does not have jurisdiction for such claims…. In New Brunswick the New Brunswick Small Claims Court and the New Brunswick Court of Queen's Bench likely have the required jurisdiction for a claim of the nature Mr. Way says he wishes to pursue.”
Reached by phone this week, Mr. Way said he hasn't contacted the software company and, at least at this juncture, would not be taking his case any further as it “is not cost effective to pursue. The legal system is not very helpful for the little guy. You have to hire lawyers, spend time and aggravation.”
As for continuing to rely on tax software to prepare his own returns, Mr. Way said that after this experience, “I went back to an accountant and paid my $360.”