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Ways to Preserve Family Capital

We can plan to shift income, capital, and other taxes to lower earners in the family in a variety of ways. Every family investment planning strategy follows the same basic pattern: first review results for each individual in the family, then the results for the family must be considered. Discuss the following with your tax advisor:

• Identify current marginal tax rates for all family members.
• Identify taxable income sources realized during the year by each member of the family.
• Identify anticipated marginal tax rates for each different income source earned.
• Discuss ways to capitalize on personal tax-free zones, differences in types of income earned, the tax brackets to which income is subject to tax, and the related marginal tax rates.

Where income that would be tax currently at a high marginal rate (example, fully taxable payments from a Registered Retirement Savings Plan) can be deferred until a later year when the marginal tax rate would be lower. The tax advantages can be significant, particularly when you view that opportunity within the context of the family unit. Where the amounts can be split between family members, results can often be even better.

Income sources that can be split

Recently governments have been moving towards family income splitting in very limited circumstances. For example, in 2007 it became possible for those who receive certain pension benefits to transfer up to 50% of that income to a spouse if that is to their tax advantage. This will usually provide for tax savings as pensioners take advantage of the progressivity of tax brackets and rates. It is also possible for business owners to split the revenues they earn by hiring their spouse or children in the business, if they otherwise would have hired a stranger to perform the role. The family member must be qualified to perform the role and actually do so, for reasonable compensation similar to what would be paid to a stranger. In this case, the amounts paid are deductible to the business owner and taxable in the hands of the family member.

This is great tax planning, as it opens up tax advantaged investment opportunities for the family members by creating "room" for contributions to Registered Retirement Savings Plans (RRSPs) and in the case of adults, contributions to the Canada Pension Plan (CPP), and Tax-Free Savings Account (TFSA).

Certain employed commission sales agents may also split income by hiring a family member as an assistant, however the fact that this assistance is required and paid for by the agent must be a condition of their contract of employment.

When it comes to splitting investment income the rules are more complicated, as described below. Passive income from investments is reported each calendar year and, with the exception of rental income, will not create RRSP contribution room. The primary categories of investment income are:

• Interest: This income is reported in full in the year received, or in the case of compounding investments, in the year accrued.
• Dividends from Canadian Corporations: Paid out after-tax profits of a corporation, the actual amounts received are "grossed up" on the tax return, thereby increasing a taxpayer's net income. You'll see this on your T-slip as the "taxable" amount. This gross-up can have an effect on the size of refundable or non-refundable tax credits. However, the dividend is offset by a dividend tax credit which reduces federal taxes and, in the end, gives most investors better tax results than interest earnings. Dividends from Canadian Controlled Private Corporations are subject to different gross-up and dividend tax credit rates from those of public corporations, because of the way the corporations are taxed. This system integrates the personal and corporate tax systems in an attempt to avoid double taxation.
• Rents: This income is reported on a "net profit basis" and is generally nil, as many taxpayers like to reduce their rental income by claiming a deduction called Capital Cost Allowance based on the value of their building. This may however cause a tax problem in the future, if buildings appreciate over time.
• Royalties: This income is reported in full, but certain resource properties may be subject to more advantageous tax treatment.

It is important to understand how you might earn these types of income from your investments. If you are still unclear about these terms speak to your advisors so that you can match investment products to income sources.

Notice that capital gains earned on the sale of income producing assets, such as publicly traded shares or a rental property, are not included in this list of investment income sources. A capital gain occurs when an income producing asset is sold for more than its "adjusted cost base." That's your original acquisition value or price plus certain additions or deductions. Only one half of any capital gains are taxable, after you reduce them by any capital losses incurred during the year. This source is in a category by itself.

Circumventing attribution rules

When assets are transferred to family members, special rules exist to deny the opportunity of income splitting. In effect, any earnings from the transferred property are attributed back to the transferor. Here are the rules:

• Property transferred between spouses is subject to attribution: If the higher earner transfers property to the lower earner for investment purposes, resulting income from the investment is taxed in the hands of the transferor. Exceptions include:
  • Tax-Free Savings Account contributions.
  • Registered Disability Savings Plan (RDSP) contributions.
  • Spousal RRSP contributions.
  • Income resulting from transactions in which bona fide "inter-spousal" loans are drawn up to transfer the capital and interest is actually paid to the lender at least once a year during the year or within 30 days after the year end.
  • Profits resulting from investments in a business, as described above.
  • Transfers resulting from marriage breakdown.
  • Income on property after it is inherited.
• Property transferred to minor children: Income in the form of dividends and interest will be attributed back to the transferor, however capital gains will be taxed in the hands of the minor. In addition, a "tax on split income" will be applied if minors receive dividends from private corporations owned by their parents. This "kiddie tax" also applies to income paid to minors from a trust or partnership, and cancels the advantage of income splitting. Other exceptions to the Attribution Rules on transfers of capital to minors include:
  • Contributions to TFSAs, RRSPs and RESPs.
  • Any income earned on the investment of Child Tax Benefits or Universal Child Care Benefits in an account held in trust for the child.
  • Employment income actually earned by a child working in a parent's business.
• Property transferred to adult children: There are no restrictions on the type of property that can be transferred to adult children, and all resulting income will be taxed in their hands except if the tax department believes the main reason for the loan was to reduce or avoid taxes by including the income on the adult child's return. The rules will not apply if:
  • Amounts transferred are used for non-taxable investments: in a TFSA, principal residence, in the costs of education, car purchases, and so on.
  • Contributions are made to the child's RRSP, RESP or RDSP.
  • A bona fide investment loan is drawn up, with interest actually paid at least once a year within 30 days after year-end, similar to inter-spousal loans.
  • Transferred funds are used to start the child's business.

Recent tough times may provide a golden opportunity to transfer assets - like the family cottage - to adult children, given low market values. This should be discussed with your tax and legal advisors.