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David Konning

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There are two reasons why income splitting is so important in Canada to reduce the family's tax burden:

1. Canada's tax system is based on graduated tax rates

2. Everyone in Canada has a tax-free basic exemption amount

A graduated tax rate system basically means that there is a higher marginal tax rate on taxable income as income increases. Furthermore, each Canadian resident can earn about $10,000 (varies by province) of taxable income every year tax-free due to the basic personal tax credit. As a result of these two factors, if income can be shifted from a high-income parent to a low-income spouse or child, then the family can realize tax savings up to $15,000 per year (varies by province). Due to this amount of potential annual tax savings, families earning a high income should strongly consider family income-splitting strategies.

In order to prevent abusive income-splitting arrangements, the Income Tax Act has income attribution rules. These rules will attribute taxable income back to the high-income family member that actually supplied the capital for investment, thus achieving no tax savings.

For business owners, you can split income by paying reasonable salaries to lower-income family members based on the services they perform. However, if a low-income spouse or child is not actually working in the family business or their services are minimal, then paying them a salary or bonus that is in excess of the services rendered simply for income-splitting purposes is not permitted.

If you own a Canadian corporation, there are a number of creative strategies to split income with family members. One such strategy, typically done in combination with an estate freeze, is called "dividend sprinkling". Although there are some attribution rules to consider, this strategy involves paying dividends from the corporation to adult children and spouse shareholders based on the growth of the corporation after the estate freeze.

A common investment income-splitting strategy with a low-income spouse is the prescribed rate loan strategy. A high-income spouse loans capital to a low-income spouse for investment at the CRA-prescribed interest rate. All future investment income will be taxed to the low-income spouse. However, the high-income spouse must declare the interest on the loan.

Gifting funds to minor children and earning capital gains on the funds is still an effective income-splitting strategy that many high-income parents with low-income children should consider. A child with no other income can earn approximately $15,000 - $20,000 of capital gains every year tax-free (varies by province) due to their basic personal exemption. The capital gain income can then be used for various expenses for the child's benefit such as private school, camps and lessons. If you are concerned about gifting monies to your child, then consider loaning the funds to a family trust on an interest-free basis. This will accomplish the same capital gain income-splitting benefit as an outright gift if the trust and loan are set up properly, and you can call back the loan principal any time.

Please contact me if you have any questions or wish further information on any of these points.

* David Konning is an investment and retirement planner at Royal Bank. He can be reached at David.Konning@rbc.com or at 856-0406

The material in this Newsletter is intended as a general source of information only, and should not be construed as offering specific tax, legal, financial or investment advice. Every effort has been made to ensure that the material is correct at time of publication, but we cannot guarantee its accuracy or completeness. Interest rates, market conditions, tax rulings and other investment factors are subject to rapid change. Individuals should consult with their personal tax advisor, accountant, or legal professional before taking any action based upon the information contained in this Newsletter.

Financial planning services and investment advice are provided by Royal Mutual Funds Inc., a member company under RBC Wealth Management. Royal Mutual Funds Inc., RBC Asset Management Inc., Royal Bank of Canada, Royal Trust Corporation of Canada and The Royal Trust Company are separate corporate entities, which are affiliated. Royal Mutual Funds Inc. is licensed as a financial services firm in the province of Quebec