“”second generation” income is not attributed back to the original transferor.”
The Income Tax Act contains many rules that are designed to eliminate the ability for a taxpayer in a high tax bracket (typically paying 45-50% tax on each dollar of taxable income over about $128,000) to shift income to a lower-bracket taxpayer (who might be paying from 0%-30%). This process of shifting income is called “income splitting”. The rules to prevent income splitting include anti-avoidance and attribution rules. Anti-avoidance rules are added to specific sections of the Act as perceived abuses are highlighted, and there is also a general anti-avoidance rule (GAAR) that tax planners must always consider.
Attribution rules are not added or changed as frequently as anti-avoidance rules, but they are no less important. Most attribution rules treat the income earned by the low-bracket taxpayer to be that of the high-bracket taxpayer who transferred or loaned the property. The most common attribution rules apply when a taxpayer transfers property (including money), directly or indirectly, to the taxpayer’s spouse, or to a related child, niece or nephew who is under 18. The attribution rules will generally deem all income earned on the property to be the transferor’s income for tax purposes. Note that where property is transferred to minors, capital gains earned on the property are not attributed back to the transferor. Capital gains are attributed to spouses unless the property is transferred in a way that avoids the attribution rules.
It is generally well-known that both property income and capital gains will be attributed back if the transfer is between spouses, and that only the income will be attributed if the transfer is to a minor. However, there are some exceptions that are worth remembering. Business income (watch for Kiddie Tax) and “second generation” income (income on the income that was already attributed) are not attributed back to the original transferor. For example, if a parent buys a bond for a minor child, the interest on the bond will be treated as the parent’s income. However, the interest earned on reinvestment of the bond interest will not be attributed and will be treated as the child’s income. While this may seem like an insignificant plan, when you factor in the current low interest rate environment, the age of the minor child and the amount that can be earned on the reinvested interest as rates increase, the plan can be simple and financially rewarding.
This concept can be used in more complicated scenarios as well. For example, many operating companies are owned by a family trust with spouses and minor children as beneficiaries. When this type of corporation has excess cash it can pay a dividend to the trust. The business owner is likely in the same tax bracket as the trust (both high rates) so the tax on the dividend may be relatively comparable. If the dividend is earned by a trust, however, the income can be left in the trust to earn second-generation income that can be distributed to the spouse or minor beneficiaries who may pay a lower rate of tax.
Even with anti-avoidance and attribution rules to contend with, taxpayers can continue to split income if the circumstances and financial benefit are favourable. However, no planning of this nature should be undertaken without professional advice.
TAX TIP OF THE WEEK is provided as a free service to clients and friends of the Tax Specialist Group member firms. The Tax Specialist Group is a national affiliation of firms who specialize in providing tax consulting services to other professionals, businesses and high net worth individuals on Canadian and international tax matters and tax disputes.
The material provided in Tax Tip of the Week is believed to be accurate and reliable as of the date it is written. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Neither the Tax Specialist Group nor any member firm can accept any liability for the tax consequences that may result from acting based on the contents hereof.