Author Segal LLP

Divide and Conquer

The Canadian tax system taxes individual, rather than family, incomes. That means that if you’re married, or living in common law, you might want to consider a transfer of income to a lower-earning spouse or children.

Known as income splitting, this tactic can significantly trim your tax burden because the income transferred is taxed at the marginal rate of the lower-income family member.

However, from the government’s perspective, income splitting means less revenue. So tax authorities put up some obstacles called attribution rules. Under these provisions of the Income Tax Act, certain income earned by related parties is attributed back to the person who made the transfer.

Nevertheless, there are legal ways to split income. Here are five methods that might help you save on federal taxes:

lores_canada_money_coins_currency_cash_dollars_close-up_mbGifts to a spouse. If you provide any gifts or interest-free loans to your lower-income spouse, dividends, capital gains or interest earned will be attributed back to you. However, if your spouse reinvests the investment income, the money earned on those investments is taxed at your spouse’s lower rate.Transfers to children. All income derived from gifts to an adult child are taxed at the child’s rate rather than yours. With an interest-free loan, and under attribution rules, income earned on the funds will be taxed in your hands, just as it would have been if you had not made the loan. However, the income then becomes their property and can be reinvested without further attribution.

Trusts. Starting Jan. 1, 2016, graduated tax rates will apply to testamentary trusts for the first 36 months. After that it is taxed at the highest marginal rate except where there is a disable beneficiary. The rules are complex. Consult with your accountant.

Retirement plan transfers. Income derived from a contribution to a spouse’s Registered Retirement Savings Plan (RRSP) is not attributable to you if the money stays in the plan for at least two years. The point of making contributions to a spousal plan is to provide tax relief at retirement. Spouses with equal RRSP funds when they retire will likely pay less in total tax.

Pension Splitting. Anyone who is eligible for the Pension Income Tax Credit can transfer as much as 50 per cent of the qualifying income to the tax return of a lower-income spouse or common-law partner. This is generally allows a greater portion of family income to be taxed at a lower rate and generates a higher level of after-tax income.

Registered Education Savings Plan. You receive no tax deduction at the time of your contribution to the plan and all income earned within the plan is reinvested tax-free. When the plan starts paying out for the education of children or grandchildren, the money withdrawn is taxable to the student, who is likely to be in a low marginal bracket.

Caution: Provincial rules vary in terms of tax rates and the ability of minors to enter into contract agreements. Attribution rules are complicated, so consult with your accountant before you start splitting your income.

Be Aware: U.S. and Canada Share Border Crossing Information

Canadian business travelers who spend a lot of time south of the border should be aware of Canada Revenue Agency’s (CRA) efforts to crack down on tax evaders.

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Critical Residency Issues

U.S. tax residency is based not just on U.S. Citizenship and green card status but also physical presence in the U.S.

Physical presence generally includes time you physically spend in the country, including days spent on business trips or attending conferences.

Under U.S. tax law one of the determinants of residency is the substantial presence test. Many mistakenly believe that they are safe as long as they spend fewer than 183 days away in one year.

In reality the test is much more complicated: You are considered a resident of the U.S. for tax purposes if you are physically present on at least 31 days during the current year, and 183 days during the three-year period that includes the current year and the two preceding years, counting:

  • All the days you were present in the current year;
  • 1/3 of the days you were present in the first year before the current year, and
  • 1/6 of the days you were present in the second year before the current year.

Days spent in the U.S. because you are ill and unable to leave do not count.

If you are caught in this calculation you will be required to file a U.S. tax return reporting your world income, as well as a Canadian tax return. An exemption is available if you can establish a closer connection to Canada than to the U.S.

To claim closer connection exemption you must file Closer Connection Exemption Statement (IRS form 8840) each year on or before June 15 of the following year. If you don’t file this form you may lose the exemption.

Canada and the U.S share immigration entry and exit dates under the Entry/Exit Initiative of the Perimeter Security and Economic Competitiveness Action Plan. This information will help the IRS determine the number of days a Canadian spends in the U.S. This could result in Canadian business travelers having to pay U.S. taxes.

U.S. tax residency generally is based on physical presence in the country for any reason ranging from shopping excursions and holidays to business trips. Many Canadians are not aware that entering the U.S. for business on behalf of a Canadian employer or to attend conferences will count toward U.S. tax residency status. (See right-hand box.)

The increased risk of being liable for U.S. taxes significantly boosts the chances that Canadians may face an IRS audit. As well, travelers may have to file U.S. foreign compliance disclosures and report all their Canadian holdings ranging from bank accounts to ownership holdings in Canadian corporations or partnerships.

In addition to this increased scrutiny, the CRA plans to boost efforts to track down tax evaders who use aggressive tax strategies to hide money in tax havens or make questionable claims related to business travel.

In reality, there is nothing illegal about lowering the amount of taxes you owe, provided the methods used are legal. But when tax planning reduces taxes in a way that is not consistent with legal rules and regulations, the methods are considered to be tax avoidance. The CRA interpretation of tax avoidance includes transactions that:

  • Contravene specific anti-avoidance provisions, and
  • Reduce or eliminate tax through means that comply with the letter of the law but violate its spirit and intent.

This differs from tax evasion, which typically involves deliberately ignoring a specific part of the law. For example, those participating in tax evasion may under-report taxable receipts or claim expenses that are non-deductible or overstated. They might also attempt to evade taxes by willfully refusing to comply with legislated reporting requirements.

Tax evasion, unlike tax avoidance, can involve criminal prosecution.

Of course not all tax shelters are used to evade taxes. Under theIncome Tax Act, tax shelters generally include either a gifting arrangement or the acquisition of property where the tax benefits and deductions will equal or exceed the net costs of entering into the arrangement. A gifting arrangement involving limited recourse debt related to the gift is also considered a tax shelter. Generally a limited recourse debt is one where the borrower is not at risk for the repayment.

Tax-shelter promoters must have an identification number and provide the CRA with a list of investors or participants, including their names, social insurance numbers, and other prescribed information. This identification number allows the CRA to track the arrangements and the participants. All tax shelters are reviewed and, if they are considered potentially abusive, they are audited.

Of particular concern to the CRA, and arrangements you should avoid, are mass marketed gifting tax shelter arrangements. These are made for the primary purpose of avoiding taxes. They include schemes where taxpayers receive a charitable donation receipt with a higher value than what they paid. This can typically be four or five times their out of pocket cost. The CRA audits every mass-marketed tax shelter arrangement and no arrangement has been found to comply with the Income Tax Act.

If you have questions, consult with your adviser.

Testamentary Trusts and Taxes

lores_testamentary_trust_kkTestamentary trusts, unlike inter vivos trusts, are formed by wills and executed when an individual dies.

A trust is a legal structure that allows you to separate the control and management of an asset from its ownership. Trusts involve relationships between three different parties:

  • The settler, who sets up the trust, contributes the first assets and sets the instructions on how to manage the trust and who will benefit from it;
  • The trustee, who controls and manages the assets; and
  • The beneficiaries, who benefit from the assets.

The transfer of the assets to the trust is known as the trust settlement.

Trusts can be either:

1. Discretionary, where the trustees decide who will receive the distribution from the trust, or
2. Non-discretionary, where the distribution is made according to the trust agreement.

Testamentary Trusts

A testamentary trust is a trust or estate that is generally created on the day a person dies. The terms of the trust are established either by the will of the deceased or by provincial or territorial court order.

Testamentary trusts do not include any trust created by anyone other than the deceased or a trust created after November 12, 1981, if any property was contributed to it other than by an individual as a consequence of the person’s death.

If the assets are not distributed to the beneficiaries according to the terms of the will, the testamentary trust may become an inter vivos trust.

Advantages

Income splitting: Despite the kiddie tax rule, you can still split interest income received from arm’s-length parties and certain other forms of income with a minor.

Taxes: Currently the income of a testamentary trust is taxed at marginal rates so it has significant advantages if the beneficiaries are already taxed at high marginal tax rates. Income splitting between the trust and beneficiaries allows the beneficiaries to reduce taxes significantly.

Beginning in 2016, flat top taxation is scheduled for estates in taxation years that end more than 36 months after death and all grandfathered inter vivos trusts and testamentary trusts created by will. There is an exception aimed at ensuring graduated-rate taxation that continues to apply to trusts with disabled beneficiaries. In addition there are several other exemptions, including the:

  • Elimination of the exemption from the calendar year as a taxation year requirement: The new rules provide that existing testamentary trusts and estates that have existed for longer than 36 months, and that have off-calendar year-ends will have a deemed year-end as of December 31, 2015.
  • Elimination of the exemption from tax installment requirement.
  • Charitable donations treatment: For 2016 and subsequent years there will be more flexibility to the tax treatment of charitable donations made in the context of death after 2015. Donations made by will, and those made by Registered Retirement Savings Plans, Registered Retirement Income Fund, Tax Free Savings Accounts or life insurance policies will no longer be deemed to be made by the individual immediately before the individual’s death.

Instead, these donations will be deemed to have been made by the individual’s estate at the time the property actually transferred to the qualified donee within 36 months after death. The trustees can choose the year in which the donation was made so it can be the year of death, an earlier taxation year or the individual’s last two taxation years. The current annual limit will continue to apply.

Only one testamentary trust (even if there are several mentioned in the will) and usually the estate itself is the only trust eligible for graduated rate estate treatment for the 36 months.

Setting up trusts can be complicated so be sure discuss your needs with your accountant.

Getting Married this Summer? Talk Money

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The invitations are sent, the reception hall is booked, the flowers are ordered — and your nerves are probably frayed.

Planning a wedding leaves little time for anything else, but consider this: A prenuptial agreement (also called a domestic contract or a marriage contract) may be as critical a negotiation as the price of food at the reception. Talking about finances may seem pessimistic because it presumes the possibility of a divorce.

A Form of Insurance

Look at it this way: People don’t buy a home assuming it’ll fall apart, but they buy homeowners insurance. Safe drivers buy auto insurance and healthy people have health and life insurance. It just makes sense. Prenups protect both spouses.

One way to ease the potential discomfort of broaching the subject is to say that your accountant or legal counsel insists you include the agreement as part of your financial and estate plan.

So what exactly is a prenup? It’s simply a legal agreement that outlines how you’ll divide your assets in the event of a divorce. And it isn’t just for wealthy people. They work for everyone.

Even couples who live together but aren’t married should consider a cohabitation agreement. If you do marry, you can convert it to a prenup. Some couples arrange postnuptial agreements, which accomplish the same thing but are signed after the marriage — in some cases, years later. In order for these agreements to be recognized legally, both sides should have independent counsel.

Blending Your Finances

Financial disagreements are one of the leading causes of marital problems. So, it’s important to consult with your tax adviser, banker and legal counsel before you tie the knot to get a handle on your financial, tax and estate planning strategies as a joint household. Here’s a checklist of important steps to consider:

1. Candidly discuss joint finances. For example, how much debt is each of you bringing to the marriage? What about savings? How is your credit rating? The older you are, the more (good and bad) financial baggage you’re likely to have.

2. Decide on joint or separate bank accounts — or both. Your banker can walk you through what will be needed to combine checking, savings and money market accounts.

Even if you decide to maintain separate accounts, it’s often helpful to have at least one joint account to pay for shared expenses, such as the costs of a mortgage or rent, household expenses and childcare. This account is meant strictly for your combined needs, and it allows you both to keep track of how you’re spending money.

A joint account can also help avoid trouble and delays in case of death. If a spouse or common-law partner dies and there are separate accounts, the survivor could be excluded from the account until the estate goes through probate. That could take months.

3. Coordinate employee benefits. You might save money by eliminating duplicate health care or life insurance coverage. And don’t forget to change beneficiary designations on retirement plans.

4. Update deeds, wills and power of attorney documents. An attorney can also discuss the full array of estate planning tools, such as various trusts, that might be relevant once you’re married.

5. Plan financial goals as a couple. Create an annual budget, as well as a contingency plan in case a spouse gets laid off or becomes disabled. Make sure you have several months’ income saved as an emergency cash reserve. Designate who’ll be responsible for paying the bills and reconciling the checkbook.

Also look beyond your current financial situation. For example, discuss what you envision your retirement will look like, and whether current retirement account contributions are sufficient to achieve your long-term goals.

6. Review beneficiaries and the amount of life insurance policies. As your marriage progresses and if you have children, remember to update the beneficiaries of the policy as well as retirement accounts. These assets will be distributed to your named beneficiaries, regardless of the terms of your estate planning documents. Coordinate designations with your estate plans. Review how much life insurance you hold. Do you need more to ensure that any children are treated fairly and equally?

7. Check property titles. Jointly owned property automatically passes to the co-owner.

Remarriage Issues

People who have been previously married bring additional financial issues to the table, especially if they have children from a previous marriage or are required to pay alimony, child support or insurance premiums under the terms of a divorce settlement agreement. Consider these questions when blending your finances:

  • Do you have business debts or obligations with your former spouse?
  • Are you required to keep a former spouse on your insurance?
  • Does a former spouse have a claim on your employer-sponsored retirement account?
  • If you’re entitled to assets from a former spouse, for example, an inheritance or other financial interest, will your remarriage end that entitlement?
  • Is your former spouse still a beneficiary in your will?

If you already remarried and have no prenup, consider a postnup to accomplish the same goals. Without proper planning, it’s possible that a family home or family business could pass to your new spouse and eventually to his or her children, rather than your own. A properly drafted prenup/postnup — as well as a change in your will — can help ensure your wishes are carried out.

Talk to the Kids

If you or your spouse are stepparents, discuss plans for your estate with one another and your children and stepchildren. You don’t want your children to think that your spouse has unfairly influenced you or that you don’t care about them. Be open and honest about your estate plans to prevent disagreements and misunderstandings after your death.

An RRSP No-No: Don’t Make Early Withdrawals

050516_Thinkstock_502643282_lores_KKA large number of Canadians are prematurely dipping into their Registered Retirement Savings Plans (RRSPs).

A recent poll conducted by Pollara for Bank of Montreal (BMO) showed that 34% of Canadians have withdrawn money from their RRSPs before retirement. According to the survey, the average withdrawal totaled nearly $16,000. A third of the borrowers have paid back the money, but 25% say they don’t expect to ever pay it back.

The top reasons for these premature withdrawals ranged from buying a home (25%) to paying off debt (21%), covering living expenses (21%) and paying the costs related to emergencies such as car accidents or house floods (15%).

Major Consequences

“It’s clear that some Canadians have had to [withdraw funds early] in order to meet short-term needs,” said Chris Buttigieg, senior manager of wealth planning strategy at BMO. The problem is there are significant tax and financial consequences for early withdrawals.

Of those who withdrew funds from their RRSPs, 84% did it as a last resort, according to the survey. Many said they were worried about the consequences, which include:

  • Loss of retirement income (79%),
  • Tax on the money withdrawn (77%),
  • Inability to save effectively for retirement (77%), and
  • Loss of future contribution room (62%).

The main advantage of an RRSP is tax deferral. The money in the plan can grow and isn’t taxed until it’s withdrawn. Another advantage is the tax deduction. Your taxable income is reduced by the amount you contribute up to a limit. The idea is that the money will be taxed when you retire and your income and marginal tax rate will be lower than during your peak earning years when you can claim tax deductions.

Your RRSP has an added benefit of allowing you to carry forward unused contribution room indefinitely.

Regional Breakdown

This chart breaks down the withdrawals by region:

Region
% Who Withdrew
Average Withdrawal
% Who Repaid Top Reason
National 34 $15,908 33 Buying a home
Atlantic 40 $8,509  34 Living expenses
Quebec 30 $12,622 42 Buying a home
Ontario 35 $17,092 30 Living Expenses
Alberta 32 $16,538 35 Buying a home
B.C. 33 $16,538 28 Buying a home

Most savers didn’t need a crystal ball to realize there would be consequences. Most said they knew it wasn’t a good idea to withdraw money from their RRSPs before retirement, because taking money out prematurely can have significant tax and financial penalties.

First, there are withholding taxes. Your financial institution will hold back taxes on the amount you take out and pay them to the government on your behalf.

On top of that, you’ll have to report the amount you take out on your tax return as income. At that time, you may have to pay more tax on the money in addition to the withholding tax paid earlier.

Lost Contribution Room

Once you’ve withdrawn the money, you lose the contribution room of those funds permanently. If you take out $10,000, you’ll never be allowed to re-contribute it, which reduces the potential value of your total RRSP at retirement. Once the money is out, you have to start over again to save it and you lose the compounding growth that you could have gotten if it had stayed in.

Two exceptions are withdrawing funds and investing in the first-time Home Buyers’ Plan, which allows you to withdraw certain amounts from your RRSP to buy your first home, and the Lifelong Learning Plan, which allows you to take out money to go back to school. Both plans don’t involve withholding tax but require you to repay the money within a certain time. If you fail to repay the money, or any part of it, the amount is added to your income and taxed.

While paying off debt is one of the reasons some people dip into their RRSP early, an alternative to consider is to make the contribution and use your tax refund to pay the debt. You could also discuss with your adviser if it makes sense to consolidate your debt with a loan where you have just one payment at a much lower interest rate than you pay on all your other debts combined.

Another option to consider is a line of credit. A personal line of credit lets you borrow a specific amount, but you aren’t charged interest until you use the money. The interest rate on a line of credit is generally lower than most credit cards, so one strategy is to open a line of credit with a low interest rate to pay off those high-interest debts.

Other Possibilities

There are additional ways to help prepare you financially for retirement such as pre-retirement investment strategies, critical illness insurance and, of course, Tax-Free Savings Accounts (TFSAs). The registered accounts allow you to save as much as $5,500 a year.

Unused contribution room can be carried forward indefinitely. TFSAs allow you to earn money in the accounts and withdraw it tax-free. Just be careful to follow the repayment rules closely. If your contributions exceed the limit, you could be subject to a 1% penalty tax on the highest excess amount in the month of the contribution.

Your financial adviser can help you determine the right strategies and investments for both the years before you retire and after you stop working.