Tax Attribution Rules: A Response to Income Splitting

The Tax Attribution Rules: A Response to Income Splitting—A Canadian Tax Lawyer’s Guide

 

Introduction – Tax Attribution Rules

The Canadian system taxes individuals progressively. High-income earners are subject to a higher marginal tax rate; low-income earners incur a lower marginal tax rate. A family could therefore lower its overall tax burden by shifting income away from high-tax family members and toward low-tax family members.

The attribution rules prevent taxpayers from reducing taxes by shifting investment income to family members. Without these rules, a taxpayer could subject his or her investment income to a lower tax rate by transferring the income-earning property to a low-income spouse or child.

Mechanically, all attribution rules function in the same basic way: if an individual transfers or loans a property to certain related parties, the income or loss from that property remains that of the individual.

This article provides a summary of the tax-attribution rules in the Canadian tax system.

Attributed Income from Property Transferred or Loaned to a Spouse or Related Minor: Section 74.1

Income Tax Act subsection 74.1(1) deems the income or loss from a property that an individual transferred or loaned to his or her spouse to be that of the individual and not of his or her spouse. (To be clear, a “spouse” includes a common-law partner.)

To illustrate, you give your spouse shares in a public corporation. The shares then pay out a $100 dividend. Under subsection 74.1(1), you—not your spouse—must include the $100 dividend as income.

Subsection 74.1(2) imposes a similar rule where an individual transfers property to a related minor—that is, a person under 18 years of age, and who either deals with the transferor on a non-arm’s-length basis or is the transferor’s niece or nephew.

Attributed Capital Gain from Property Transferred or Loaned to a Spouse: Section 74.2

Under section 74.2 of the Income Tax Act, if an individual transfers or loans a property to a spouse, and the spouse subsequently sells that property to a third party, the resulting capital gain or capital loss is that of the individual and not his or her spouse.

For instance, you give your spouse your portfolio shares, and she sells them on the market at a $100 loss. Under section 74.2, you—not your spouse—incurred the capital loss.

As mentioned in the section below covering exceptions and exclusions, this attribution rule doesn’t apply when a taxpayer transfers property to a related minor. So, if you transfer or lend a capital property to a related minor, who subsequently disposes of that property, the resulting gain or loss isn’t attributed to you.

“Substituted Property” & Paying Off Investment Loans

The attribution rules under sections 74.1 and 74.2 continue to apply if the transferee spouse or related minor acquires a “substituted property.” For instance, you give your spouse $100 cash, and she or he uses that money to buy public shares. Your spouse has “substituted” the cash for the shares. So, if she or he earns dividends on those shares or realizes a capital gain when selling them, that income is deemed to be yours and not hers or his. Moreover, this pattern continues for every subsequent substituted property unless another rule ousts the applicable attribution rule. So, you transfer $100 cash to your spouse; he or she uses that money to buy shares. The shares pay a $2 dividend. He or she then sells the shares for $150 and uses that amount to purchase units in a mutual fund. The fund pays a $5 distribution. Not only are you deemed to receive the $2 dividend and the $50 capital gain, but also you’re deemed to receive the $5 distribution. Your spouse substituted your initial transfer of $100 in cash for shares, which she then substituted for $150 in cash, which she finally substituted for units in the mutual fund.

In other words, even a cash gift can trigger the attribution rules. The Income Tax Act defines “property” in very broad terms. Indeed, the Act’s definition of “property” includes “money.” Moreover, the attribution rules apply not only to the initially transferred or lent “property” but also to the “property substituted therefor.” So, although money by itself cannot yield income or capital gains, once that money is used to purchase an income-generating property or a capital property, the resulting income or capital gain will be attributed.

Similarly, under subsection 74.1(3), if you pay off your spouse’s or a related minor’s investment loan, the proportionate amount of the spouse’s or minor’s investment income is attributed to you. For example, your spouse took out a bank loan of $100,000 and used it to purchase shares. You give your spouse $80,000, which she uses to repay her loan. From then to the end of the year, your spouse’s shares pay dividends of $10,000. Subsection 74.1(3) deems $8,000 of those dividends—i.e., 80,000/100,000 x 10,000—to be your income and not that of your spouse.

Attribution of Income from Property Transferred to a Trust Benefitting a Spouse or Related Minor

The attribution rules under sections 74.1 and 74.2 both expressly apply where an individual indirectly transfers or loans property to a spouse or related minor—that is, through the use of a trust.

In particular, where an individual transfers or lends property to a trust benefitting a spouse or a related minor, then that individual is deemed to receive:

• any income from the transferred or loaned property that the trust distributes to the spouse or related minor, and
• any capital gain that the trust, upon disposing of the property, distributes to the spouse.

As above, the attributed amount is taxable in the hands of the transferor, not the beneficiary.

Notably, the income or capital gain is attributed to the transferor only if the trust distributes that amount to the relevant beneficiary. Amounts taxed at the trust level aren’t subject to the attribution rules. By extension, losses cannot be attributed to the transferor because a trust cannot distribute its losses to its beneficiaries.

To supplement the rules in sections 74.1 and 74.2, section 74.3 provides a formula for calculating the attributed amount where the trust either received property from more than one individual or distributed income to several beneficiaries.

Exceptions and Exclusions

Section 74.5 provides for various exceptions to the attribution rules in sections 74.1 and 74.2.

If an individual transferred a property to a spouse or a related minor, the attribution rules don’t apply if

• the individual received fair-market-value consideration in exchange for the property;
• where the consideration was a debt, the individual received a market-rate interest payment within 30-days after the end of both the year in which the transfer occurred and each subsequent year; and
• where the individual transferred the property to a spouse, the individual elected out of subsection 73(1)’s spousal-rollover rule. Moreover, an individual running a business and paying wages to a spouse or a related minor will not trigger the attribution rules.

Likewise, if an individual lent property to a spouse or a related minor, the attribution rules don’t apply if that individual received a market-rate interest payment within 30-days after the end of both the year in which the loan occurred and each subsequent year.

In addition, the attribution rules don’t apply when parties divorce or dissolve a common-law relationship. Yet couples not yet divorced but living apart due to marriage breakdown are still subject to the capital-gain attribution rule unless they jointly elect otherwise.

Furthermore, the attribution rules simply exclude certain sorts of income. Some examples include:

• income earned from the child tax benefit under section 122.61
• business income
• second-generation investment income or income from re-invested income—e.g., income from reinvested dividends paid on transferred shares (Not to be confused with reinvested capital gains, which result in “substituted property.”)
• capital gains (and losses) when a related minor disposes of property that you initially transferred to the minor
• income on holdings in a spouse’s RRSP or TFSA—in other words, you may contribute to your spouse’s RRSP or TFSA without triggering the attribution rules

Finally, the attribution rules cease to apply when either the transferor or the transferee dies,the transferor becomes a non-resident of Canada for tax purposes, or, in the case of a transfer to a related minor, the transferee reaches 18 years of age.

Specialized Attribution Rules

The Income Tax Act also contains more specialized attribution rules applying to diverted payments, income-splitting with minors, holding corporations, and revocable trusts.

For an explanation of these specialized rules, see here.

Attribution Tax Tips

Despite these attribution rules, some income-splitting strategies still remain viable—e.g., contributing to a spouse’s Registered Retirement Savings Plan (RRSP) or Tax-Free Savings Account (TFSA).

If you unknowingly triggered an attribution rule, you may have underreported your taxable income. To avoid problems with the Canada Revenue Agency, contact one of our expert Canadian tax lawyers for advice on the remedies available, such as the Voluntary Disclosures Program.

If ignored, the attribution rules can undermine an assortment of tax-planning structures, such as estate freezes or family trusts. Moreover, when you trigger an attribution rule, your spouse or related minor, as the case may be, is jointly and severally liable for your tax on the attributed amount. Do yourself and your loved ones a favor and discuss proper tax planning with one of our experienced Canadian tax lawyers.