There are two reasons why income splitting in Canada can reduce the family’s tax burden:
1. Canada’s tax system is based on graduated tax rates; and
2. Everyone in Canada has a tax-free basic exemption amount.
A graduated tax rate system basically means that the tax rate increases as taxable income increases.. Furthermore, each Canadian resident can earn approximately $7,800 to $11,000 (varies by province) of taxable income every year tax-free due to the basic personal tax credit. As a result of these two factors, if income can be shifted from a high-income parent to a low-income spouse or child, then the family can realize tax savings up to $11,000 per year (varies by province). If there are four members in a family, then family tax savings of up to $44,000 per year can be realized. Due to this amount of potential annual tax savings, families earning a high income should strongly consider family income-splitting strategies.
In order to prevent abusive income-splitting arrangements, the Income Tax Act has income attribution rules. These rules will attribute certain types of taxable income back to the high-income family member that actually supplied the capital for investment, thus achieving no tax savings.
For business owners, you can split income by paying reasonable salaries to lower-income family members based on the services they perform. However, if a low-income spouse or child is not actually working in the family business or their services are minimal, then paying them a salary or bonus that is in excess of the services rendered simply for income-splitting purposes is not permitted.
If you own a Canadian corporation, there are a number of creative strategies to split income with family members. One such strategy, typically done in combination with an estate freeze, is called “dividend sprinkling.” Although there are some attribution rules to consider, this strategy involves paying dividends from the corporation to adult children and spouse shareholders based on the growth of the corporation after the estate freeze. If the spouse or adult children had no other income, then approximately $$8,000 – $49,000 of tax-free dividends (varies based on province) could be paid to them from the corporation every year if structured properly.
A common investment income-splitting strategy with a low-income spouse is the prescribed rate loan strategy. A high-income spouse loans capital to a low-income spouse for investment at the CRA-prescribed interest rate (which is currently 1%). All future investment income will be taxed to the low-income spouse, provided the low-income spouse pays the high-income spouse interest annually. The high-income spouse must declare the interest on the loan.
Gifting funds to minor children and earning capital gains on the funds is still an effective income-splitting strategy that many high-income parents with low-income children should consider. A child with no other income can earn approximately $15,000 – $22,000 of capital gains every year tax-free (varies by province) due to their basic personal exemption. If you are concerned about gifting monies to your child outright, then consider loaning the funds to a family trust on an interest-free basis. This will accomplish the same capital gain income-splitting benefit as an outright gift if the trust and loan are set up properly, and you can call back the loan principal any time.
This article is supplied by Troy Peart, a Wealth Advisor with RBC Dominion Securities Inc. Member CIPF. This article is for information purposes only. Please consult with a tax advisor before taking any action based on information in this article. Troy Peart can be contacted at firstname.lastname@example.org or (604)665-0895.