Kiddie Tax Attribution Rules

The “kiddie tax” in section 120.4 of the Canadian Income Tax Act generally applies to income of a child under 18 attributable to dividends or shareholder appropriations from a private corporation designed to split income. The kiddie tax is not applicable to capital gains.

Prior to the so called “Kiddie Tax” rules, it was possible to split income between yourself and your children to reduce the overall tax liability. Business income could be paid out in dividends to shareholders, who were minors. Since these minors had little to no income, the tax liability of these dividends could be offset by certain tax credits.

The Kiddie Tax makes these dividends fully taxable. The Kiddie Tax in effect taxes certain unearned income of a child at the parent’s rate.

Shortly after the Kiddie Tax was introduced, tax planners developed structures to convert these dividends into capital gains since the Kiddie Tax did not apply to capital gains under the Income Tax Act.

New provisions were enacted under the Income Tax Act on June 6, 2011 to expand the scope of the Kiddie tax and some capital gains realized by minors will now be taxed at a higher rate than they once were, and even higher than most dividends. Split income will be expanded to include capital gains realized by, or included in the income of a minor from the disposition of shares of a corporation, if taxable dividends on the shares would have been subject to the tax on split income. Where capital gains are caught under this rule, they will be treated like dividends for tax purposes. Additionally, if you make a shareholder loan to a minor, it will immediately be taxed at this higher rate.

However, the new provisions do not apply to every situation: specifically excluded are the sales of shares listed on designated exchanges, shares of mutual fund corporations or “excluded amounts”. If you think that a minor has received income or realized a capital gain that is excluded from the higher tax, consult with a professional.

Trusts remain an effective planning tool to avoid the Kiddie Tax. Income earned in a Trust can flow through the Trust and be taxed in a minor’s hands at a lower rate than the parents provided that the minor will be in a lower tax bracket than the parent.

Parents may transfer an income generating asset to a Family Trust. A transfer of assets to a Family Trust is treated as a sale of the assets at their fair market value at the time of the transfer. Therefore, any gain between the cost of the asset and the sale price would be taxable to the transferring individual in the year the transfer was made. Because of this, it would be best to transfer an asset which costs a similar amount to its current fair market value, or to carry out a share freeze.

If the asset generates capital gains in the Trust, the amount would be taxed at the capital gains rate in the Trust, rather than the new higher rate imposed on Kiddie Tax transactions. This is because the asset is generating capital gains in a Trust, which is not subject to the Kiddie Tax just yet. The money in the trust could then be distributed to beneficiaries (minors) without additional tax.

If you are interested in splitting income with your children and have any questions regarding tax liabilities, give us a call to set up an initial consultation!