The income tax rules were designed to ensure that members of a household cannot move income bearing assets around to minimize total household tax, and to ensure that salaries and dividends paid to family members must follow the same rules applied to arm’s length parties. These rules were enacted to ensure tax equity.
For example, some business owners paid high salaries to spouses or other family members to do work of little economic value. If a taxpayer paying the top 49 per cent tax rate can transfer $50,000 of employment income to a spouse with no other income, the household can save tax of at least $13,000. Therefore, if your business is paying a salary to a family member, ensure the salary is at market value, based on qualifications, experience, and work responsibilities. You should also ensure the terms of employment, pay frequency and method, and working conditions are as similar as possible to those of other arm’s length employees, and well documented. Otherwise, the Canada Revenue Agency (CRA) can disallow the deduction to the employer, and can even insist the family member still must pay the personal tax even though the employer gets no deduction – a double penalty.
This is one reason for paying dividends rather than salaries. Salaries to family members must be at market value, but there is no such test for dividends. So your spouse can buy a share in your PC at $1 then receive $100,000 in dividends the next day. If your children are included in your PC’s shareholders, ensure no dividends are paid to children out of your PC’s active business earnings until they turn 18. Children under 18 are subject to the “kiddie tax”, charged at the top personal tax rate.
Many dentists allow retained earnings to accumulate in their PC, waiting till their children turn 18, at which time they can be paid out at very low tax rates. Once your children turn 18, they can be added as nonvoting dividend-receiving shareholders, along with non-dentist spouses and your parents. This allows for significant income splitting, since a person with no other income can usually receive dividends of up to $35,000 a year with almost no personal tax.
The “attribution” rules prevent a wealthy spouse with investment assets from transferring these assets to a low-income spouse, so that investment income can instead be taxed to the spouse. Even if the ownership of these assets is legally changed into the name of the low-bracket spouse, the interest, dividends or capital gains they generate are “attributed” back to the high bracket transfer or spouse, who pays high-rate tax on it. There are several ways to plan around these rules, though these should only be implemented with the help of a professional tax adviser:
- Sell the assets to your spouse at fair market value. The CRA requires that the purchasing spouse must use their own personal funds (e.g., which they inherited, or were clearly earned independently).
- Move investment income over time to the low bracket spouse. The high-bracket spouse pays their salary and business earnings into a separate bank account, from which are paid all household costs (mortgage, property taxes, holidays, food, etc.). The low-bracket spouse’s salary or business earnings should go into an account solely in that spouse’s name, so that funds are built up over time which are clearly identifiable as that spouse’s property, and can be used to buy investment assets in that spouse’s name. This will allow for the investment income earned by the poorer spouse to be taxed at the lower tax rate.
- Lend money from the high-bracket spouse to the low-bracket spouse, who uses the loaned funds to invest. Interest must be paid on this inter-spousal loan at CRA’s approved rate (two per cent as of October 1, 2013), with interest paid at the latest by January 30 of the following year. This loan must be carefully documented, and both spouses must reflect this transaction on their personal tax returns, so professional advice is essential. If these investments earn, say, five per cent, the low bracket spouse will report net three per cent income taxable at a low rate, rather than this extra three per cent being taxed at 49 per cent on the high bracket spouse’s return.
Similar rules apply to transfers to children under 18, preventing parents from changing legal ownership of investments to their children’s names so the income can be taxed at the children’s low rates. There is an important exception: if you transfer assets to a child under 18, and the asset is then sold resulting in a taxable capital gain, that gain is taxed to the child, not the parent. (The parent pays tax on capital gains which arose before the transfer; the child pays tax on gains arising after the transfer.) However, legal advice is required in such transactions, to be sure of the rights of the child to the money received, and the parent’s obligations.
The rules covering transfers of wealth and assets between family members are very complex, and failure to follow them can be very expensive. Knowing the ins and outs of these complex rules can save you taxes and money.