Income splitting is simply moving income from an individual in a higher tax bracket to someone in a lower tax bracket to reduce overall tax liability. The problem with many families is that one spouse is the primary income earner and reducing the family’s tax burden is a difficult challenge.
 
An example of income splitting is where Robert earns $100,000 per year and Judy earns $15,000. Robert earns $1,000 interest income. Since his marginal tax rate is 42% he paid approximately $420 on that income. If that same investment were held by Judy, whose marginal tax rate is only, 20% she would pay just $200 on that same investment.
 
In theory it sounds easy: transfer assets to a family member in a lower marginal tax bracket. But the Income Tax Act contains attribution rules designed to make this more difficult. Under the attribution rules the Canada Revenue Agency (CRA) doesn’t much care whose name is on the account. It’s more interested in whose money is in the account. If you don’t know the rules you, not the person you’re trying to split the income with, may be taxed on all the income. Therefore knowing exactly what the attribution rules are is important:
 
Your spouse: If you attempt to split income with your spouse by gifting assets or through no-interest or low interest loans, all investment income including dividends, interest and capital gains will be taxed in your hands. There are special rules for transferring assets between spouses. To take advantage of income splitting strategies it is necessary to transfer the assets at fair market value, which might leave you with a potential tax liability.
 
Your minor children: If assets are transferred to a minor child either by gifting or no-interest or low interest loan, you will be taxed on the dividends and interest, but not the capital gains. Capital gains will generally be taxed in the hands of the minor child. For the attribution rules a minor child includes a child, grandchild, niece or nephew under the age of 18.
 
Your adult child: A gift of assets or money to an adult child will not give rise to income for capital gains under the attribution rules. But in the case of a loan you have to be careful. If CRA concludes that the loan was specifically to reduce or avoid tax, any income or capital gains could be attributed back to the parent lending the money.
 
Be aware that if you transfer assets that have appreciated in value to your family members in order to income split you have more than just the attribution rules to worry about. When you give up beneficial ownership of an asset you are deemed to have disposed of it at fair market value. This means that any resulting capital gain will have to be reported and tax paid on it. With cash, no capital gain is recognized and the attribution rules have to be considered.
 
Although the attribution rules are quite rigorous there are strategies that can be employed to legally accomplish income splitting. In Part II of this article, we will review some of these strategies.
 
April 16, 2008