What is Income Splitting?
Income splitting is a tax strategy where a higher-income family member shifts income to a lower-income family member to reduce the family’s overall tax bill. Canada’s progressive tax system means higher income is taxed at higher rates, so spreading income out can lower the total tax paid. For example, two partners earning $100,000 each usually pay less tax combined than one partner earning $150,000 and the other $50,000.
While legal, income splitting is heavily regulated by the Canada Revenue Agency (CRA) using rules in the Income Tax Act (ITA) like the attribution rules, Tax on Split Income (TOSI), and the General Anti-Avoidance Rule (GAAR). These rules aim to prevent artificial arrangements designed solely to avoid tax. Getting it wrong can lead to the income being taxed back to the higher earner, plus interest and penalties. Understanding the balance between minimizing tax legally and avoiding disallowed strategies is key.
Understanding the Rules: Attribution and TOSI
Two main sets of rules limit income splitting:
The Attribution Rules
These rules generally prevent shifting investment income (like interest, dividends, rent) or capital gains from property gifted or loaned (at low/no interest) to a spouse or minor child. If the rules apply, the income or gain is taxed back to the person who made the gift or loan.
Spouse/Partner: Both income and capital gains usually attribute back.
Minor Child (under 18): Only income attributes back; capital gains are usually taxed to the child.
Adult Child (18+): Generally no attribution on gifts. Low/no-interest loans might see income (not gains) attributed back if tax reduction was a key purpose.
Exceptions (Attribution may NOT apply if):
Prescribed Rate Loan: Funds are loaned at the CRA’s prescribed interest rate (set quarterly when the loan starts), and the interest is paid by Jan 30th each year. Fair Market Value (FMV) Sale: Property is sold for its true value.
Income on Income: Income earned by reinvesting already attributed income is usually not attributed again (requires careful tracking). TFSA Contributions: Gifting funds for a spouse’s TFSA contribution doesn’t trigger attribution on income earned inside the TFSA. Business Income: Rules generally target investment income, not active business income.
Tax on Split Income (TOSI)
Expanded in 2018, TOSI targets “income sprinkling” from a private “related business” to family members (adults or minors) where the payment seems unreasonable for their contribution. If TOSI applies, the income (“split income”) is taxed at the highest federal rate (33%), with limited use of tax credits. Taxpayers use Form T1206.
Split income includes dividends, interest, or certain gains from a business where a relative is active or owns a significant stake.
Key Exclusions (TOSI may NOT apply if):
Excluded Business (Age 18+): Recipient works avg. 20+ hours/week currently or in any 5 prior years.
Excluded Shares (Age 25+): Recipient owns >=10% votes/value of certain non-service/non-professional corporations.
Reasonable Return (Age 25+): Amount is reasonable based on work, property, risk contributed.
Reasonable Return / Safe Harbour (Age 18-24): Amount is reasonable (stricter test) or a calculated return on their own contributed capital.
Spouse of Business Owner (Age 65+): Amount received by spouse if owner is 65+ and contributed meaningfully.
Other: Doesn’t apply to salaries/wages, certain capital gains (QSBCS), inheritance, separation payments.
TOSI focuses on the source (related business) and the recipient’s contribution, unlike attribution which focuses more on the type of income.
Legal Income Splitting Strategies
Despite the rules, several valid strategies exist:
Pension Income Splitting
Spouses/partners can allocate up to 50% of one partner’s “eligible pension income” to the other on their tax returns using Form T1032. No money actually changes hands.
Eligible Income: Depends on age. If 65+, includes RPP payments, RRIF/LIF withdrawals. If under 65, mostly just RPP lifetime annuities. RRSP withdrawals are generally not eligible, but RRIF withdrawals are (from age 65).
Ineligible Income: CPP, QPP, OAS, GIS, lump-sum RRSP withdrawals.
Benefits: Lowers family tax, can reduce OAS clawback for the higher earner, may allow both spouses to claim the $2,000 pension income tax credit. Converting RRSPS to RRIFs at 65 can enable splitting.
Spousal RRSPS
A higher-income spouse contributes to an RRSP owned by the lower-income spouse, using their own contribution room and claiming the deduction.
Withdrawals: Taxed to the owner spouse (annuitant), ideally at a lower rate in retirement.
Attribution Rule: Withdrawals within 3 years (current year + 2 prior) of a contribution may be taxed back to the contributor spouse. Use Form T2205 if this applies.
Benefits: Allows income splitting in retirement (even before age 65), can shift more than 50% of RRSP savings, helps manage OAS clawback.
Prescribed Rate Loans
Lend money to a lower-income spouse, adult child, or family trust at the CRA’s prescribed interest rate (or higher).
Mechanism: Borrower invests the funds. Net investment income (after paying loan interest) is taxed to the borrower.
Requirements: Must have a written loan agreement, use the rate set when the loan starts, and the borrower MUST pay the interest by Jan 30th of the following year. Missing an interest payment voids the strategy for that year and all future years. Benefit: Avoids attribution rules on the net investment income. The rate is locked in for the loan’s duration.
Paying Salaries to Family Members (For Business Owners)
Businesses can pay salaries to family members for actual work performed.
Tax Treatment: Salary is a deductible expense for the business and taxable income for the family member. Salaries are generally not subject to TOSI.
“Reasonableness” is Key: Salary must be reasonable compared to what you’d pay an unrelated person for the same job, considering duties, hours, skills, and market rates. Documentation: Essential to prove reasonableness (job description, timesheets, contract, proof of payment).
Consequences: Unreasonable amounts are not deductible by the business but still taxed to the recipient (double tax). Standard payroll rules apply (T4, withholdings).
Canada Pension Plan (CPP) Pension Sharing
Eligible spouses/partners (both 60+, receiving/applied for CPP) can apply to Service Canada to share their CPP retirement pensions.
Mechanism: Based on months lived together while contributing, Service Canada adjusts the actual monthly CPP payments – reducing the higher earner’s and increasing the lower earner’s. The total combined CPP paid doesn’t change. Process: Requires an application (Form ISP1002); not automatic.
Consideration: The complex calculation means it’s not always beneficial; assess potential impact before applying. Stops automatically on death, divorce, separation, etc.
Other Viable Strategies
Family Trusts: Fund with a prescribed rate loan to allocate investment income to beneficiaries. Requires professional setup.
TFSA Gifting: Give funds to spouse for their TFSA; growth inside is tax-free and avoids attribution. Paying Household Expenses: Higher-income spouse pays bills, freeing lower-income spouse’s earnings for investment in their own name (avoids attribution). Requires clear records. RESPs: Investment growth and grants taxed to student beneficiary upon withdrawal for education.
Gifting Assets to Adult Children: Shift future capital gains tax liability to adult children.
What’s Not Allowed
Avoid strategies that clearly violate the rules or are highly artificial:
Ignoring Attribution/TOSI: Gifting/lending property for passive income without meeting exceptions (like prescribed rate loan terms) or paying dividends subject to TOSI without meeting an exclusion will be challenged.
Unreasonable Salaries: Paying family members more than they are worth for their work will result in denied deductions and potential double tax.
Artificial Transactions & GAAR: Even if a strategy seems to follow the letter of the law, the General Anti-Avoidance Rule (GAAR) allows the CRA to deny tax benefits if the transaction is primarily tax-motivated and abuses the spirit or purpose of the Income Tax Act. Complex or contrived plans carry higher GAAR risk.
Key Considerations for Taxpayers
Document Everything: Keep detailed records for loans (agreements, proof of interest payment), salaries (job descriptions, timesheets, market comparisons), TOSI exclusions (hours logs), etc. The burden of proof is on you.
Know the Risks: Non-compliance can lead to reassessments, interest, and significant penalties (including gross negligence penalties). The CRA audits high-risk areas, including family business transactions. Consider the Voluntary Disclosures Program (VDP) for past errors.
Get Professional Advice: The rules are complex. Consult a qualified CPA or Tax Lawyer to choose the right strategy, structure it correctly, understand risks (including GAAR), and ensure compliance.
Consider Provincial Taxes: Savings depend on combined federal and provincial rates; rules can differ (e.g., Quebec pension splitting).
Review Regularly: Laws, rates, and family situations change. Review your strategies periodically with an advisor to ensure they remain effective and compliant. Be prepared for the administrative effort involved.
Conclusion
Income splitting offers real tax-saving potential in Canada through strategies like pension splitting, spousal RRSPs, prescribed rate loans, and reasonable salaries. However, these strategies operate within a framework of complex rules (Attribution, TOSI, GAAR) designed to prevent abuse. Success requires careful planning, meticulous documentation, and strict compliance.
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