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The stories, unfortunately, are likely all true. The Canadian tax system uses progressive tax rates". This means that your tax rate increases as your income increases, at least until you hit the top rate. For example, if you earn $20,000 per year, the tax taken on the next dollar of income you earn is likely around 22 cents (in Ontario). Compare this to approximately 48 cents on the next dollar if you are in the top tax bracket. Progressive tax rates have created an entire industry of professionals looking for ways to reduce taxable income, and therefore the tax bill. One of the most popular methods is called "Income Splitting".
The concept of income splitting is simple - shift income from one family member who is in a high tax bracket, to another family member (a spouse or child) who is in a lower tax bracket. The result of effective income splitting is an increase in family "after-tax" income. Let's use an example. Say Melanie's annual taxable income is $60,000 while her husband only works part-time and makes $10,000 per year. In a province where the provincial rate is 50%, the family tax bill is approximately $21,400. Subtract this from the total family income of $70,000 and this leaves $48,600 after-tax. If Melanie can shift some of her income to her husband, the family would definitely be better off financially. Let's say that a large portion of her income is interest from a GIC, and she is able to transfer the GIC to her husband such that the $70,000 family income is split evenly between them. The family tax bill now drops to $18,000, leaving $52,000 available as spending money. The family now has an additional $3,400 of disposable income.
Not exactly. There are many tax rules that limit one's ability to "shift" income among family members. These are called the "Attribution Rules". These rules are complicated and should be reviewed with your tax advisor. There are, however, some simple and legitimate means of income splitting. Understanding what is or is not allowed is the first step towards good tax planning.
These rules generally apply whenever there is a transfer of property (this includes money) between spouses or their children and grandchildren under the age of 18 (a "related minor child"). Similar rules may apply where family loans are made at less than market rates of interest. Here's how it works:
With proper planning, there are ways around the attribution rules.
The interest on the loan must be included in the higher-income spouse's tax return but can be deducted by the lower-income spouse. Also, any interest must be paid within 30 days of each calendar year in which the loan is outstanding.
Some Examples The following examples demonstrate how some thoughtful, up-front planning can put more money into a family's pocket.
Let's assume that a married couple, Mr. and Mrs. H, earn $80,000 and $10,000 respectively and live in Ontario. Mr. H has $100,000 to invest. He wants to invest the $ 100,000 in an Income Fund that is expected to pay $ 10,000 in income in 1999: $2,000 in interest, $3,000 in dividends and $5,000 in capital gains. Now let's look at two possible situations. In situation A, Mr. H invests the $ 100,000 in the Income Fund. In situation B, he lends the $ 100,000 to Mrs. H who then invests it in the Income Fund. Situation A: The family tax situation is as follows: Note: This information is for illustration only. Tax rates are not current for 2001
Mr. and Mrs. H owe a total of $33,854 in tax. Situation B: Mr. H lends his wife $100,000 at Revenue Canada's current prescribed rate of interest (4%). Mrs. H purchases the income fund. Note: This information is for illustration only. Tax rates are not current for 2001
On a total family income of $99,500 (the same as in situation A), the tax liability has dropped to $32,558. Note that the interest paid by Mrs. H can be deducted on her return but must be included on Mr. H's. The attribution rules won't apply in 1999 as long as the interest is paid by January 30, 2000. Mr. and Mrs. H have reduced their tax bill by $1,296 ($33,854 in Situation A vs. $32,558 in Situation B). While this does not appear significant, this saving will continue annually given the same facts and assumptions. An annual saving of $1,296, compounded at 10 per cent will amount to $22,720 in 10 years and $81,651 in 20 years. Not bad for a simple tax plan!
Rob and Anna just got married. Anna is a doctor and is in the top tax bracket in her province. Her tax rate is approximately 50%. Rob is unemployed. Anna owns $200,000 in investments which she recently purchased that earn approximately $20,000 per year in income. Rob owns a cottage they use every weekend. The cottage is also worth approximately $200,000. One way to reduce their tax bill would be to shift the income-earning asset from Anna to Rob. Although Rob would have to include the $20,000 in investment income on his tax return he is in a much lower tax bracket.
Anna could purchase Rob's cottage at its market value by either (1) transferring her investments to Rob at market value or (2) selling them and using the cash to pay for the cottage. Rob could then be in a position to purchase the same investments with the cash. The end result would be that Anna owns a personal asset, while Rob, the lower income earner, owns the income-earning asset. Of course, as with any example, there is a bit of over-simplification here. However, the message is clear: use the earning and savings of the higher income earning spouse to purchase personal goods and services, while using the lower income spouse's earnings and savings for investment purposes. Before these types of decisions are made however, all factors need to be considered. For example, will either Rob or Anna incur a tax liability by selling their assets? Is there land transfer tax on the cottage? Are there selling fees for the investments? Are there any family law considerations? Notice: Clarington Mutual Funds nor Fiscal Agents Financial Services Group are not engaged in rendering accounting, legal or other professional services or advice. The comments in this Tax Tip are not intended, nor should they be relied upon, to replace specific professional advice.
© 1997, Fiscal Agents
Money Management Newsletter
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