Wondering about income splitting strategies?

The Canada Revenue Agency (CRA) prescribed rate is at a low one percent, which has opened up the opportunity for some individuals to implement an income-splitting strategy with a spouse, common-law partner, (grand)children, or other family members. 

Income splitting is the transferring of income from a high-income family member (who pays tax at a high rate) to a lower-income family member (who pays tax at a lower rate). And since our tax system has graduated tax brackets, having some income taxed in the lower-income earner’s hands lowers the overall tax paid by the family.

There are various ideas going around about income-splitting, some of which you may have heard:

“Just pay them half of your salary, they don’t need to work in the business”

“You can transfer money to their (non-joint) bank account”

“Have assets transferred to their name”

“They can be shareholders and get paid dividends”

What’s legitimate income-splitting and what’s not?

You used to be able to pay shareholder family-members dividends, but that was essentially eliminated in January 2018, when the Canadian federal government instituted new income splitting rules designed to prevent income splitting using private corporations. Now you need proof that they contributed capital to the business. The return needs to be justified. TOSI (Tax on Split Income) rules are very complex and need to be addressed before any payments are made. For private corporations, they apply to dividend and interest income, but not salaries.

What would exclude me from TOSI’s income splitting rules? 

Other than an adult family member (25+) whose income represents a reasonable return on their investment, there are three exclusions:

  1. You will need to be able to prove that the adult family member has had a “regular, continuous, and substantial” stake in the business by working a minimum of 20 hours a week in the business for any previous five years of the business (doesn’t have to be consecutive). With the CRA peeking around, it’s good practice to always keep records of the hours that any family members work in your business.
  2. Another exclusion is if the family member (aged 25 years +) owns at least ten percent of the private corporation’s shares and votes directly (not through a trust), the corporation attains its income primarily from the sale of goods, and the corporation does not earn income directly or indirectly from another business owned by the corporation.
  3. The individual is over the age of 65.

What options are available for 2022 and beyond?

What can you do? There are always prescribed rate interest loans, where the higher-income individual ‘loans’ capital to lower tax bracket spouse or adult child. For minor children and grandchildren, a Family Trust can be used, but it does add more complexity and costs.

Ensure you have separate bank accounts to track money going in and any income generated. The interest amount on the loan must be paid back to the higher-income individual by the end of January the following year, and every year after that. The interest rate is determined by the CRA and adjusted each quarter. It’s currently at one percent. The interest rate carries forward from the date of the original loan for its lifetime, no matter what the new rate is. You must keep a very clear backup of the original loan and the interest payment each January or all is voided. That one percent interest amount is income for high payers and a deduction for the low payers. And all of the income from the investments is the lower payers’.

What can I invest in?

The borrowed money is used for the sole purpose of earning income from a business or property, thanks to the Income Tax Act. The property can also be stocks, bonds, ETFs, real estate, royalty-producing assets (such as books or music collections), mortgage lending, Bitcoin, and other crypto-assets. Your family member must have a reasonable expectation of earning income from the borrowed money.

What if I make a mistake?

Remember that the loan must bear interest, and missing just a single payment invalidates the loan. But what if you get divorced or one of you passes away? In one of those scenarios, the income from the investments is attributed back to the high payer’s income in each of those years, with interest amount on top of the new tax owed. That will get very expensive, and could do the exact opposite of what was intended.

Give me an example of income-splitting?

Let’s say that Jenny owns a successful design business with an income of at least $120,000 a year after she takes her annual dividend from the profits of the company. Her spouse Mark has very little income because he cares for their three small children full-time. Jennie has a non-registered investment in various ETFs which only adds to her income from the dividends they payout quarterly. The value is $80,000 once she transfers everything to cash.

After Jenny sells all of her investments (capital gains tax must be considered here), she then transfers the money to Mark’s bank account in one lump sum. Mark then repurchases the same ETFs (or something different if he wishes) in his own investment account. Since these ETFs pay out dividends, this becomes Mark’s investment income and is added to his tax return. They paid a total of six percent or $4800 ($80,000 x 6%=$4,800) in the first year. Mark makes sure to transfer one percent (or $800) of the original loan each and every January back to Jennie’s bank account.  

Jennie’s taxable income is reduced by $4000 (she gives up $4,800 in dividend payouts, but does get $800 in interest income from Mark) and Mark’s is increased by $4000 (He gets the $4,800 in dividends, but pays Jennie $800 in interest). Does that make sense?

Need more advice about income splitting rules?

Due to how complex the tax law rules are, we recommend getting advice from a tax pro before paying any dividends to your spouse or another adult family member. If you have questions about income-splitting as a creative entrepreneur, contact us.