INCOME SPLITTING AND ATRIBUTION
1. Advantages of Income Splitting
Canada's system of taxation is based on progressive rates of tax. There are currently four basic rates of federal tax that apply at different levels of income thresholds. What follows are the 2017 federal rates of tax:
- up to $43,953 15%
- $43,954 to $87,907 22%
- $87908 to $136,270 26%
- $136,271 and over 29%
Each province levies its own rate of tax based on percentage of federal tax. Therefore, it is advantageous for family members to level the income earned by the family unit among the various members so that as much of the income as possible is taxed at lower rates. The purpose of income splitting is to shift income from the family member who is taxed at the highest rates to the family members who have less income and are taxed at the lower rates. The overall family tax bill is minimized.
2. Roadblocks to Income Splitting - the Attribution Rules.
Canada Revenue Agency does not like income splitting for obvious reasons. It reduces the amount of tax collected. Rules have been incorporated into Income Tax Act to prevent family members from shifting income among themselves. These rules in most cases attribute income back to the family member from whom it originated, hence the term "attribution rules".
(a) Transfers and Loans to Spouses
If an individual has transferred or loaned property to a spouse or to someone who has since become a spouse, any income or loss from the property for the year will be attributed back to the transferor or lender and taxed in his or her hands rather than in the hands of the spouse who received the transfer or loan. This rule is stated very broadly and catches any transfers or loans made "directly or indirectly, by means of a trust or by any other means whatever ...". There is a further rule which attributes any capital gains or loss to the transferor or lender where there has been either a transfer or loan between spouses. There was a time when it was thought that if one reinvested the capital gains any further growth would be free of attribution. However, in Interpretation Bulletin IT-511R, Canada Revenue Agency has taken the position that all gains are subject to attribution if they can be traced back to property acquired through a transfer or loan between spouses. This change in their administrative position is effective for property acquired by a spouse after December 30, 1987. This is not the case with income earned from property (i.e. interest, dividends, rents or royalties) acquired from a transfer or loan. The income which has been subject to attribution can then be reinvested and income generated from the reinvested income will not be subject to attribution.
(b) Transfers and Loans to Minors
There is a specific rule which applies to transfers or loans to a person who is under the age of 18 and who is either not at arm's length or is a niece or nephew of the transferor/lender. This rule covers transfers or loans to children, grandchildren or great-grandchildren as well as nieces and nephews. The net has been cast very widely and just as with the rule between spouses, it is phrased to cover any transfer or loan made "directly or indirectly, by means of a trust or by any other means whatever" either "to or for the benefit of a person who was under 18 years of age". Unlike the rule which applies to spouses, it may be possible to avoid attribution or capital gains where there has been a transfer or loan to a minor.
(c) Transfers and Loans to a Family Trust
Even though the basic attribution rules which apply to transfers and loans to spouses, and minor children are worded to capture income splitting attempts through the use of trusts, there is a specific rule which addresses transfers and loans to trusts. This rule attributes income back to an individual who has loaned or transferred property to a trust "either directly or indirectly, by means of a trust, or by any other means whatever, to a trust" in which another individual is a "designated person" in respect of the transferor/lender. The term "designated person" means the spouse of the individual and anyone who is under 18 who does not deal at arm's length with the individual and includes a niece or nephew who is under 18. Attribution will only apply to income allocated to a beneficiary of the trust who is a designated person. If income is not allocated to a designated person during the year, attribution will not apply. Since income earned by an inter vivos trust which has not been allocated to a beneficiary is taxed at the top rate, this attribution rule is a major obstacle to income splitting through family trusts. The only way to avoid attribution would be to retain the income in the trust or allocate it to a beneficiary who is not a designated person. If there are beneficiaries who are 18 or over and who have little or no other sources of income, income splitting can be achieved by allocating all of the trust income to those beneficiaries.
(d) Transfers and Loans to Corporations
(i) Purpose Test
A special rule applies to income splitting attempts which make use of corporations. This rule has a unique feature in that it will only apply if it can be shown that the transfer or loan was made to the corporation for the purpose of reducing the income of the transferor/lender and to benefit a designated person who is a "specified shareholder" of the corporation. A "specified shareholder" is a taxpayer who owns, directly or indirectly, not less than 10% of the issued shares of any class of the corporation. A taxpayer is deemed to own shares of a corporation owned at that time by a person with whom the taxpayer does not deal at arm's length. If a trust holds shares of the corporation, each beneficiary is deemed to own all of the shares held by the trust. Therefore, if the trust holds 10% or more of the shares of a corporation and at least one of the beneficiaries of the trust is either a spouse, child, grandchild, great grandchild, niece or nephew of the transferor/lender the corporate attribution rules could apply. Unlike the other rules described above, the circumstances surrounding the transaction must indicate an income splitting purpose.
(ii) Small Business Corporation Exemption
This rule has another unique feature. There is a specific exemption if the transfer or loan was made to a corporation that was a small business corporation at all times during the year. Attribution is applied at the end of each calendar year. Therefore, if an individual made a transfer or loan to a corporation which had shareholders that qualified as designated persons in respect of the transferor/lender, and the purpose test was met, attribution would not apply if it could be shown that the corporation qualified at all times during that calendar year as a small business corporation
(iii) Definition of a "Small Business Corporation"
The definition of a small business corporation ("SBC") for this purpose means a corporation that was a Canadian controlled private corporation throughout the year which used substantially all of its assets in carrying on an active business in Canada. The phrase "substantially all" refers to the fair market value of the corporation's assets and is interpreted by Canada Revenue Agency to mean 90% or more of the fair market value of the assets. A corporation will also meet the definition of an SBC if substantially all of its assets consist of shares of another SBC, provided the first-named corporation controls the SBC or owns more than 10% of the issued share capital of the SBC with full voting rights and provided the shares represent more than 10% of the fair market value of the issued shares of the SBC.
(iv) Corporate Attribution — Potential for Double Tax
The corporate attribution rules are particularly onerous because they can apply even where no income is generated from the transfer or loan or where no income is ever paid to a designated person during the year. The rule operates simply by virtue of a transfer or loan to a corporation for which the individual received as a consideration either shares or debt of the corporation, and provided the purpose test is met. Once attribution applies, the transferor/ lender is deemed to have received interest in the year which is calculated by applying Canada Revenue Agency's prescribed rate applicable from time to time on an amount equal to the fair market value of the property transferred or loaned to the corporation. This deemed interest is reduced if the transferor/lender actually received dividends on shares taken back in exchange for the transfer, or charged and received interest on the loan. This creates the potential for double tax since tax is paid by the transferor/lender on income which is not received and tax will be paid by the corporation on income actually generated by the transferred or loaned property.
(e) Transfers and Loans to Non-Arm's Length Persons
The other category of loans to watch out for are loans to adult children or to other non-arm's length persons where no interest is charged or a rate of interest is charged which is below the Canada Revenue Agency prescribed rate in effect when the loan was made. Any income earned from property which can be traced back to such a loan will be attributed to the lender. It is not enough to simply charge the Canada Revenue Agency prescribed rate. It is also necessary that the full amount of interest owing be paid each year within 30 days after year end. If this deadline for paying interest is not met, the loan will be offside permanently and will attract attribution even if interest is paid on time in subsequent years.' Like the corporate attribution rule, this rule only comes into play if the main purpose of the loan is to reduce the tax of the lender and cause the income from the property acquired to be included in the income of the borrower.