Understanding Income Splitting in Canada:
Tax Saving Strategies

To try to even the tax landscape for all Canadians, the federal government introduced new legislation in 2018 to limit income-splitting opportunities.

There are still ways to legally reduce your household tax burden, but if you don't understand how Tax on Split Income (TOSI) rules function, your tax planning may fall apart and end up doing more harm than good.

Thankfully, today's focus is to help you avoid these costly mistakes.

How does income splitting work in Canada?

Income splitting comes in many forms, but the common thread is that it's a tax savings strategy between immediate family members. Under Canada's progressive tax system, the higher your income, the higher your marginal tax rate—unless, of course, you allocated a portion of your earnings to family members in a lower tax bracket to lower your household's overall tax obligations.

The Income Tax Act’s attribution rules—a law that traces income transfers back to the original source—are relatively strict, but there are still some perfectly legal methods to help improve your tax situation.

Pension income splitting

Age—the magic number being 65—and income source play a leading role when it comes to pension income splitting eligibility. Below, we’ve listed a handful of examples, but a complete list can be found on the Government of Canada website.

*Note: These are only eligible if received as a result of the death of a spouse

Remember—you and your spouse or partner must make a joint election to split pension income using form T1032.

Strategically allocating your pension income is a balancing act: if one's income is reduced, the other's is increased by the same amount. The immediate benefit is to utilize lower tax brackets, but always consider how it could impact certain income-tested credits and benefits based on one person's net income, such as OAS and CPP. Programs like the GST/HST credit and Child Tax Benefit, among others that consider combined income, shouldn't be impacted in most cases.

Spousal or common-law RRSPs (RRIFs)

If you think you’ll have a higher income than your partner during retirement, contributing to a spousal registered retirement savings plan (RRSP) could be worthwhile. Though you'll be the one making the contribution, your partner will own the plan as an annuitant. In other words, you’ll reduce your taxable income this year, and the eventual withdrawals will be taxed in the hands of the lower earner.

There are some limitations, however. If your spouse or partner were to make a withdrawal within three years of a contribution, the income would be attributed to you in most cases. As always, tax-efficient strategies require ample time to plan and execute.

In our earlier example, we saw that RRIF income is eligible for pension splitting, and you can convert a portion of your RRSP to facilitate this approach. So, have spousal RRSPs become redundant? 

No, they haven’t. Firstly, withdrawals from a spousal RRIF funded by standard RRSP contributions are typically only eligible for pension splitting once the annuitant spouse turns 65. Secondly, while spousal RRSPs allow the entire withdrawal to be taxed by the annuitant—subject to the 3-year rule—this is different from the pension splitting election, which applies to eligible pension income received by one spouse and is limited to 50%.

Spousal or common-law partner loans

If you were to lend money to your significant other at the prescribed interest rate—dictated by the CRA—you can use the interest payments as an income-splitting tool. This strategy hasn't been as popular lately, given that rates are quite steep, but it may come back into favour if interest rates fall far enough. To see any real benefits, your investment returns must be higher than the underlying rate of the loan.

In the following scenario, we assume a loan of $500,000 with a 1% prescribed rate was used to build an investment portfolio generating 5% annually, and all savings are reinvested. The lender's marginal tax rate is 45%, and the recipient's is 25%—the difference in take-home income is shocking.

Interest must be paid by January 30th the year after the loan was officially made. We'd also recommend getting a promissory note and a loan agreement to outline the terms and ensure they're enforceable. If this strategy sounds appealing to you, consult a legal expert and investment manager to maximize its security and value. Additionally, proper documentation and record-keeping are vital for being able to prove CRA compliance. Non-compliance with attribution rules can have severe consequences.

Loans to children

The concept of spousal loans can be applied to your children as well, but there are some caveats to keep in mind. It may not be wise to lend them money directly, but you can utilize a properly structured family trust to designate them as beneficiaries, have a trustee invest on their behalf, and pay out the net investment income. For post-secondary students with little to no taxable income to speak of and plenty of claimable tax credits, there's a chance they may even earn tax-free investment income.

If interest rates are the reason the above strategy has become less popular, they're also the leading cause for why this next one is gaining traction—Canada is quickly becoming one of the least affordable housing markets in the world. With more and more young adults turning to their parents for help to get ahead, we can appreciate that attribution rules generally don't apply to income earned on funds gifted to non-spouse relatives 18 years of age or older.

Under the right conditions, this can lead to a positive tax outcome if they use the money to purchase a home to live in. At the eventual point of sale, the child, as the owner and occupant, may be able to claim the principal residence exemption to avoid tax liabilities on the gain, provided the property qualifies as their principal residence. If the house is treated as a rental unit to generate income, the principal residence exemption becomes less reliable. It’s important to weigh the pros and cons of both before making any decisions to avoid any unforeseen tax attributions.

Utilizing a TFSA

TFSAs are already tax-advantaged accounts. While contributions are non-deductible, investment growth and returns are generally tax-free, even at the point of withdrawal. This benefit can be compounded through income splitting—if a family member has contribution room but not the money to take advantage of it, you can gift them the funds needed to top up their TFSA. While invested, they'll be able to enjoy tax-free investment returns, and those gains won't be attributed back to you.

Foot the bills

In most relationships, one person earns more than the other. Let's use John and Lisa as a hypothetical example—after tax, they earn $60,000 and $90,000 a year, respectively. Their combined household expenses are $60,000.

If they were to split their bills right down the middle, John would be left with $30,000, while Lisa would have double that. Her surplus cash could be funnelled into her investment portfolio, but as the higher earner, it would be more beneficial for John to invest thanks to his lower marginal tax rate.

And here's the surprisingly simple but effective strategy—let Lisa pay for the household expenses while John invests for their family's future. From a tax perspective, there's no real reason to share costs equally.

You'll want to keep detailed records in case the CRA asks how John, who makes significantly less than Lisa, can afford to invest and that the account isn’t being inadvertently controlled by the higher-earner. Having separate bank accounts can help keep a cleaner paper trail, but it's important to balance the benefits of joint accounts (accessibility, survivorship rights, etc.) with potential tax savings.

The "kiddie tax" and private corporations

TOSI laws previously applied to anyone under the age of 18, and the recipient would be taxed at the highest marginal rate (33%) regardless of their total income. 

While TOSI laws previously applied primarily to children under 18, the new ruling has a much broader reach and can now apply to adults receiving certain types of income ('split income'), including interest, dividends, or capital gains on shares from a related business, provided that income meets the specific definition and conditions outlined in the TOSI rules.

From employing your children to using excluded shares, there are some exemptions, thankfully. The rulings are complex and nuanced, but you can read more here on specific cases and how they may impact your tax situation as an individual or corporation.

Do you qualify for income splitting in Canada?

For Canadians hoping to optimize their after-tax earnings, the new TOSI exemptions are both complicated and subject to future potential modifications. This article would quickly become a book if we outlined every possible scenario, but that was never its intention.

Today's discussion took aim at reminding the reader that enriching yourself can come in one of two forms:

1. Earning more income

2. Saving more on taxes

On the plus side, you don't need to figure it out on your own—that's what your Family Wealth Advisor is for.