Avoiding the attribution rules to maximize family investment income

A common tax planning strategy is to reduce family taxes by transferring investment income from the higher income earner to the lower income spouse and their children. The tax department’s rules to prevent this tactic are known as the attribution rules.

The attribution rules restrict transfers and loans to spouses and children under the age of 18. They state that if an individual transfers or loans property, either directly or indirectly, by any means, to a spouse or certain individuals under the age of 18, any income will be that of the person who made the transfer.

The attribution rules restrict transfers and loans made ‘either directly or indirectly’ and ‘by any other means whatsoever’. This would appear to be a comprehensive approach to restrict income splitting among family members. Despite these rules, there are still numerous ‘loopholes’ and opportunities to implement an effective income splitting strategy. These include:

Business Income – The attribution rules apply to the transfer of property and not to business income. If a husband transfers money to his spouse to start her own business, the income generated to the business would not be attributed to the husband. Thus, if a high-income individual is considering an entrepreneurial opportunity, consideration may be given using the spouse’s money for the initial capitalization of the business. Future dividends could be paid to the lower income spouse without being impacted by the attribution rules.

Transfers at Fair Market Value – The attribution rules do not apply if property is transferred to a spouse and the transferor receives the fair market value of the asset in return. This is a common technique to avoid the attribution rules.

Loan with Interest – If a loan is involved in the transaction and the spouse who received the property pays an arm’s length interest rate, the attribution rules will not apply. Given that the prescribed rates of interest that are set quarterly by the government are currently below the dividend yield of a number of blue chip Canadian companies, this is an attractive tax planning opportunity in a low interest rate environment. For example, if the prescribed rate of interest were 3% and a Canadian stock paid a 4% dividend, it may be prudent to borrow the funds to acquire such a stock.

Income on Income – If property is transferred to a spouse or minor, the income generated on the property is attributed to the individual that made the transfer. However, any investment income generated on the original investment income is not attributed back. For example, if a spouse transferred $10,000 to her husband and he earned a 10% return; the $1,000 of investment income would be attributed to the wife. If the $1,000 of investment income were reinvested at 10%, the $100 of investment income would be taxable to the husband, rather than the wife.

Transfers of Capital Gains to a Minor – If property is transferred to a spouse, any resulting income or capital gain is attributed to the individual that made the transfer. However, if an asset were transferred to a minor, any income that is generated would be attributed to the transferring parent, but not the capital gains realized on the eventual sale of the asset. A tax planning strategy to consider is transferring shares of growth companies to your children.

Transfers to a Child over the Age of 17 – The attribution rules apply to children, grandchildren, nieces and nephews under the age of 18. Once the child reaches 18, the attribution rules no longer apply. However, there is an anti-avoidance rule that applies to transfers of property to non-arm’s length individuals if the transaction were motivated by tax reasons. To implement this strategy it is important to emphasize the purpose for which the child received the funds, i.e. funding an education, house purchase, etc. It may be argued that any tax benefit in ancillary to the main purpose of the loan.

Family Budgeting – The simplest and most effective technique to split family income cannot be restricted by the tax department, as it involves the preparation of a family budget. In order to implement this strategy, the spouses must be in different tax brackets. Assume the husband’s annual income is $85,000 and the wife works part-time and her take home pay is $10,000. The responsibility for paying specific expenses varies by family, but it is not uncommon for higher income spouses to use their excess funds for investment purposes. If the husband currently invests $10,000 per annum from his salary and the wife uses her part-time earnings for household and personal expenses, an income splitting opportunity exists. The lower income spouse could invest the $10,000 from her earnings and the higher income spouse would pay for the expenditures that were formerly made by his wife. The strategy would result in the investments being owned by the wife and the investment income would be taxed at her lower marginal tax rate.