Canada’s income tax system uses the individual as a tax unit, rather than a spousal unit or family unit. In other words, each individual in a family is subject to tax on his or her income, because the income is not pooled with other family members.
Our income tax system also employs graduated or progressive tax rates. This means that as your income increases, the marginal tax rate on your income can increase. For example, in 2018 your first $46,605 of taxable income is subject to a 15% federal tax rate, whereas your taxable income exceeding $205,842 is subject to a 33% rate. Taxable income between those thresholds is subject to three other rates (20.5%, 26%, and 29%), again depending on your level of taxable income. On top of that, each province levies progressive provincial income tax and those rates vary depending on the province.
As a result of the individual tax unit and the progressive tax rates, if a high-income individual can shift income to a lower income individual, there will be an overall savings in tax. For example, if you are a parent in the highest tax bracket and you can shift some of your income to your spouse or minor child in a low tax bracket, you will obviously save tax.
Of course, the government is aware of this, and the Income Tax Act contains various "income attribution" rules that can apply when you transfer property that is used tor investment purposes to your spouse (or common-law partner) or minor children. The main rules are summarized below.
Loans or transfers to spouse
If you lend or transfer property to your spouse (or common-law partner), then income or loss from the property is attributed to you and included in your income rather than your spouse’s income. Income from property includes items such as interest, dividends, royalties and rent. A similar rule can apply to attribute taxable capital gains (or allowable capital losses) from your spouse’s dispositions of the property or substituted property.
Fortunately, as discussed below, there are various exceptions to both rules.
There is also a “substituted property” rule, which means that attribution can continue even if your spouse sells or converts the lent or transferred property and uses the proceeds to acquire another property. For example, if you give your spouse cash and she uses the cash to purchase mutual funds, the income from the funds will be attributed back to you. Furthermore, if she sells the funds and uses the proceeds to buy another income-producing property, the attribution rules can continue to apply to the income or gain from that other property.
The income attribution rule stops if you divorce or are living "separate and apart" by reason of the breakdown of your marriage (or common-law relationship). The capital gains attribution ceases after divorce, but stops during your separation only if you and your spouse make a joint election with your tax returns.
Loans or transfers to minor children
A similar rule applies if you lend or transfer property to your child, grandchild, great grandchild, sibling, niece or nephew (including in-law relationship) under 19, or to any other child under 18 with whom you do not deal at arm's length.
As with the spousal attribution rule, income or loss from the property or property substituted for that property is attributed back to you.
This income attribution does not apply throughout the year in which the minor child turns 18 years or in later years.
Furthermore, the attribution rules do not apply to capital gains realized by minor children. For example, if you purchase publicly-listed common shares or equity mutual funds for your minor children, any taxable capital gains from the property will be included in their income and will not be subject to attribution. So you can legitimately split capital gains with your minor children.
There is one notable case where capital gains splitting is not advantageous: if the minor disposes of shares in a private corporation to you (or any non-arm’s length person), the gains will normally be subject to the Tax on Split Income (the so-called "kiddie tax") at the highest marginal rate of tax. This tax has been substantially extended as of 2018.
Exceptions
Fortunately, there are various exceptions where the attribution rules do not apply.
• The rules do not apply to income from business. Therefore, you can give or lend property to your spouse or minor children to earn income from their business and the income will not be attributed to you.
• As noted, the rules do not normally apply to capital gains of minor children. Therefore, you can split capital gains with children. However, attribution can apply if you transfer qualified farm or fishing property to your child under the tax-deferred “rollover” provisions of the Income Tax Act. There is also the potential kiddie tax issue discussed above.
• The rules do not apply if you lend money to your spouse or minor child at the prescribed rate of interest at the time of the loan, as long as they pay the interest each year or by January 30 of the following year. The prescribed rate is currently 2% (see below under “Prescribed Interest Rates”).
For example, if you lend money to your spouse and charge 2% annual interest and he uses the funds to purchase an investment that pays an annual return of 6%, the attribution rules will not apply. Your spouse will include the 4% net return in income (the 6% gross return minus the 2% interest paid to you). You will include the 2% interest received by you. However, if your spouse misses the January 30 deadline for even one annual interest payment, this exception from attribution ceases to apply.
Interestingly, this exception can apply regardless of the length of the term of loan. So the loan can remain outstanding for 10 or 20 years or longer, and still qualify for the exception, as long as your spouse pays the interest on time for each year.
• The attribution rules do not apply if you receive at least fair market value consideration for the property. Similar to the lending exception above, if the consideration is debt, you must charge at least the prescribed rate of interest, and they must pay you the interest each year or by January 30 of the following year. Also, in the case of your spouse, if you transfer property under this exception you must elect out of the tax-free “rollover” on the transfer, which is otherwise available for transfers between spouses. This means that the transfer of the property will normally take place at fair market value, which could generate a capital gain for you if the value exceeds your cost of the property. So for transfers to your spouse, you will normally want to use property with little or no accrued gain.
• The rules do not apply to reinvested income (secondary income). Thus, if you transfer property to your spouse or minor child and they reinvest the income earned on the property, the income earned on the reinvested income is not subject to attribution.
• The rules do not apply to transfers of property to children 18 years of age or older. However, in the case of loans, there is an attribution rule that can apply if you lend money to a child (minor or adult) or another non-arm’s length person and one of the main reasons is to reduce your tax payable. As above, there is an exception to this attribution rule if you charge at least the prescribed rate of interest on the loan.
• Since the attribution rules do not apply if the lent or transferred property generates no income or capital gains, you can give your spouse and children cash to pay personal expenses, and that will not attract any attribution rules. As a planning point, you could pay your spouse’s personal expenses (including his or her income tax payable) and common household expenses, thus freeing up your spouse’s own income to invest in income-earning property. The attribution rules will not apply.
• Since income or capital gains from a tax-free savings account (TFSA) are not included in income, you can put cash into your spouse’s or adult child’s TFSA and there will be no attribution on any subsequent income. Similarly, if you contribute to your spouse’s registered retirement savings plan (RRSP), there is no attribution when the funds and income are withdrawn by your spouse, generally as long as the withdrawal does not take place in the calendar year during which the contribution is made or the next two calendar years.
• If you receive the Canada Child Benefit in respect of your children, the benefit can be invested and the income or gains from the investment are exempt from attribution.
• You can split eligible pension income (e.g. income from your registered pension plan, annuity income from your registered retirement savings plan, and income from your registered retirement income fund) with your spouse or common-law partner. Normally, you can split up to 50% of that pension income per year. If you are under 65 years of age, the pension split is somewhat more restricted relative to the case once you are 65 years or older.
