Income-Splitting Opportunities with Corporate Class Funds
By Evelyn Jacks
It is every person’s legal right and duty to arrange their affairs
to pay the least amount of tax legally possible. In planning investment
strategies, therefore, taxpayers can and should structure their resulting
income and profits in a tax-efficient manner.
Just as tax return preparation is most effective when all of a family’s
returns are prepared at the same time, financial advisors can promote
tax efficiency within the family by structuring income-splitting opportunities
between high income earners and their minor children, spouses and other
Income splitting removes assets and income from tax exposure at the highest
marginal rates to the lowest, resulting in significantly more after-tax
dollars for the family. As a result, individuals keep more of the first
dollar invested, avoid high marginal taxes levied on the highest-income
earner, and also create more wealth by limiting clawbacks of social benefits
like the Old Age Security and refundable and non-refundable tax credits.
Special rules called the Attribution Rules must be observed in income
splitting. However, effective strategies can built around these rules.
Avoiding the Attribution Rules with Corporate Class Funds
It is generally not possible to transfer income to a spouse, common-law
partner or minor child without triggering the Attribution Rules, which
require that the resulting income be reported by the transferor, unless
certain exceptions are met. For example, attribution can be avoided by
making spousal RRSP contributions, or when properly documented inter-spousal
loans are in place for other income from property – interest or
dividends for example – or capital gains or losses. For minors,
Attribution Rules apply to interest or dividend income earned by transferred
funds, but not capital gains or losses.
By using corporate class funds as an investment solution, more tax-efficient
income for the whole family can be result. This is because of the structure
of corporate class funds, which provides:
- The ability to defer capital gains taxes on disposal of the funds
themselves (as transfers between funds within the corporate class do not
trigger a taxable event).
- Minimal annual taxable distributions, resulting from activities
of the fund manager, as they are paid as dividends and capital gains income
- The ability to convert highly taxed interest income into capital
gains. (Income-oriented corporate class funds retain interest income within
the fund rather than paying regular distributions. Investors seeking income
can set up an automatic withdrawal plan, and the withdrawals are taxed
as capital gains.)
Transfers to a Spouse
Under the Attribution Rules, capital transferred to a spouse will result
in the taxation of the associated income and capital gains in the transferor’s
hands. This includes situations where a spouse guarantees the repayment
of a loan, for investment purposes, made to the other spouse. This can
be avoided when the higher earner draws up a bona fide investment loan
between the spouses for the transfer of the money. Here are the requirements:
- Draw up a formal demand note outlining terms of the repayment.
- Pay interest at the Canada Revenue Agency’s prescribed
rate each year at least by January 30 following the end of the tax year.
- Ensure that the higher-income earner reports interest paid by
the lower earner as income.
- Resulting income and capital gains would then be properly reported
by lower-income earner and taxed at lower marginal rates.
If the lower-income spouse uses the transferred funds to invest in corporate
class funds, then the strategy becomes even more successful. That’s
because, as noted above, corporate class funds tend to generate tax-efficient
capital gains income (only 50% of the gain is added to taxable income),
they have minimal annual distributions and they allow capital gains to
be deferred when dispositions occur between fund classes.
Transfers and loans to minors
Where property is transferred or loaned either directly or indirectly
to a person who is under 18 and who does not deal with the transferor
at arm’s length or who is the niece or nephew of the transferor,
the income or loss resulting from such property – interest, dividends,
rents or royalties – is reported by the transferor until the transferee
becomes 18 years of age. However, capital gains or losses that result
from the transferred property are deemed to be the income of the minor.
When corporate class funds are selected as an investment by an adult
for a minor, income attribution is avoided when the funds generate capital
gains dividends as income or capital gains on later disposition. The child’s
portfolio therefore also benefits from significant tax-efficient growth
opportunities while the adult successfully transfers capital to the child.
Example: Mary and Jack have a child, Susan, to whom they have transferred
$25,000. This money is invested in corporate class funds. Susan will report
resulting capital gains and capital gains dividends, rendering them non-taxable
if total income is under the basic personal amount.
Consider the following in planning income for minors:
- Assuming no other income, up to $16,296 in taxable capital gains
can be generated as income in the hands of the child before tax is payable
- Corporate class funds may also be an appropriate investment vehicle
for income and assets properly attributed to and held in the child’s
own name, including:
- Gifts and birthday money from other adult relatives.
- Earnings from full or part-time jobs.
- Benefits from life insurance policies in which the child was named
as the beneficiary.
- Disability or survivors’ benefits from parents qualifying
under the Canada Pension Plan paid directly to the child.
- Reinvestment of income – such as interest and dividends
- first attributed back to the adult from transferred funds. This
second-generation income can now be reinvested on an attribution-free
basis by the child.
- Such capital previously transferred by the adult and subject to
Attribution Rules, which becomes the child’s own-source capital
upon attaining age 18.
Exceptions to the Attribution Rules
Tax-efficient investing strategies also include these exceptions to the
- Transfers for fair market consideration. The Attribution Rules
will not apply to any income, gain or loss from transferred property if
at the time of transfer, the equivalent of fair market value was actually
paid by transferee from his or her own sources.
- Transfers to adult children. Income resulting from assets transferred
to an adult child (over 18) will, in general, not be subject to attribution.
However, when income splitting is the main reason for an investment loan
to an adult child, the income will be attributed back to the transferor,
unless the loan is a bona fide loan with interest payable as described
above, by January 30 of the year following the end of the calendar year.
- Attribution and Marriage Breakdown. If spouses are living apart
due to relationship breakdown, they can jointly elect to have attribution
rules not apply to the period in which they were living apart. Spouses
can also choose not to have this section apply, with the result that any
property sold in the time the spouses were living apart will be taxed
in the hands of the transferor. If corporate class funds are sold under
this scenario, the parties will keep more of the investment because of
the advantageous tax treatment of resulting capital gains.
Those taxpayers who make tax-efficient investing a priority have the
unique opportunity to reinvest or use more of the first dollar that is
earned, regardless of the life-cycle of the investor. Corporate class
funds provide an investment alternative for the whole family that may
be appropriate for income-splitting activities with minors and spouses
or common-law partners. The tax advantages of the structure of this product
can result in better overall returns during the course of the investment,
or upon disposition. Advisors and their clients may therefore be able
to meet wealth accumulation goals more quickly and accurately over time.
Evelyn Jacks is the author of 30 best-selling books on the subject
of personal income taxation, and the President of Knowledge Bureau, Inc.,
Canada’s leading professional education publisher in the tax and
financial services industry, specializing in delivering courseware and
information services to knowledge-based practices. For more information
call toll free 1-866-953-4769 or visit www.knowledgebureau.com.
This article is written to be of a general nature and neither the
author, her company, employees, subcontractors or others associated with
The Knowledge Bureau can take responsibility for any results, positive
or negative, taken by any persons. While the author received a fee to
write this article, she is not in the business of providing advice on
investment products and is not registered and licensed to do so, nor does
the author have any compensatory relationship, or beneficial ownership
regarding the sale of investment products discussed herein.