In the search for yield, investors have turned to such things as monthly income funds and income trusts, structured notes, and capital class units. But again, cash in your hand means investment income that must be reported in your tax return.
Investment income splitting has always been a long, traditional way to minimize tax on investment income. However, the attribution rules and the kiddies’ tax have more than curtailed this avenue. Happily, there are a number of key strategies which can allow you to trump CRA at its own game.
Making the Most of Independent Capital. Make sure that the lower-income spouse invests his or her own capital, while the higher-income spouse’s capital is used for day-to-day living expenses.
Examples of independent capital can include just about anything that doesn’t come from the higher-income spouse, e.g., a gift or inheritance from a parent, or earnings from a job.
You can maximize a spouse’s independent capital in a number of ways. For example, use the higher-income spouse for personal expenditures, which can even include paying the lower-income spouse’s taxes.
Likewise, if a parent of one of the spouses is thinking of giving some money to the family, it’s better tax planning if the gift is made to the lower-bracket spouse.
Tax Tip – Make sure that the lower-income spouse’s earnings and other independent capital are segmented in his or her own bank account and not comingled with money that comes from the higher-income spouse, such as joint accounts and the like.
That way, there should be no question about who pays the tax on the income. Make sure that these “pure” accounts continue to “track.” For example, a separate “pure” brokerage account in the sole name of the lower-income spouse should be opened for the investments.
The Loan Maneuver. The Income Tax Act also allows a spouse to pay tax on investment income (and capital gains) if the investment is funded by a loan from you, provided that the spouse pays you interest at the “prescribed rate” in effect at the time the loan is made.
In order to qualify for this tax break, the interest on the loan for each year must be paid no later than January 30 after the year end.
Otherwise, the attribution rules will apply and the profits will be taxable in your hands, not your spouse’s. Furthermore, if you miss even one deadline, the attribution rules will apply on the particular investment forever after.
Note: Once you make the prescribed loan, the interest rate can be locked in (based on the prescribed rate in effect at the time) even if interest rates go up.
Capital Gains Splitting. As the attribution rules potentially apply to children (and grandchildren), they generally state that income from an investment is taxed in the hands of the funding parent while the child is a minor.
However, the attribution rules do not apply to kids’ capital gains.
That means if a parent funds an investment in an account for a child (either by way of gift or loan), the attribution rules do not apply to capital gains, even though they do apply to interest, dividends, and the like until the year in which the child (or grandchild) turns 18.
This important exception to the attribution rules will apply even if you do nothing more than put some money in the child’s name to make an investment.
There is, however, one complication. Because there are legal restrictions for accounts in the name of minors, many financial institutions require investment accounts for those under legal age to be set up in the name of a parent. These are called “in-trust” or “in-trust for” accounts.
A number of years ago, there had been some confusion as to whether these accounts will thwart capital gains splitting. But in a series of Technical Interpretations, CRA has indicated that this should not generally be the case.
Having said this, larger-scale investors should seriously consider documenting these in-trust accounts. In fact, in many cases, it may make sense to set up a formal trust.
Remember, a separate in-trust account should be set up for each child – and the investments in the account really belong to the child, not you.
So a formal trust may make sense if you’re uncomfortable with this.
For example, if you may change your mind in the future as to which child should benefit from the investments, a powerful financial planning weapon known as a “discretionary family trust” can help you to hedge your bets.
The Taxletter, MPL Communications Inc.
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