Strategies for managing the tax bill on income-focused investments.
By Samantha Prasad, LL.B.
In the search for higher yield from investments, investors have turned to such things as monthly income funds and income trusts, structured notes, and capital class fund units, among others. But investment income almost inevitably attracts a tax bill. Here are some tips on how to cut the bill.
Income splitting once was a tried-and-true way of reducing tax on investment income. However, attribution rules and the so-called kiddie tax have pretty much put an end to income-splitting as a key strategy in this case. Luckily, we have other strategies available.
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’s funds 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.
Make sure that the lower-income spouse’s earnings and other independent capital are segmented in his or her own bank account and not commingled 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. And 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 your spouse pays you interest at the “prescribed rate” in effect at the time the loan is made (currently 1%).
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 fate 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 children’s 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.
In-trust accounts
Because of legal restrictions in setting up investment 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 would thwart capital gains splitting. But in a series of Technical Interpretations, the Canada Revenue Agency has indicated that this should not generally be the case.
Still, 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.
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 tool known as a “discretionary family trust” can help you to hedge your bets.
Getting professional advice
Finally, the tax strategies I’ve touched on in this article are fairly complex and some will require legal help to execute. These are not the do-it-yourself tactics of the kind that simply require filling in the appropriate line on your T1 return, so be sure to consult a qualified tax professional before attempting these maneuvers.
Courtesy Fundata Canada Inc. ©2014. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.
In the search for higher yield from investments, investors have turned to such things as monthly income funds and income trusts, structured notes, and capital class fund units, among others. But investment income almost inevitably attracts a tax bill. Here are some tips on how to cut the bill.
Income splitting once was a tried-and-true way of reducing tax on investment income. However, attribution rules and the so-called kiddie tax have pretty much put an end to income-splitting as a key strategy in this case. Luckily, we have other strategies available.
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’s funds 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.
Make sure that the lower-income spouse’s earnings and other independent capital are segmented in his or her own bank account and not commingled 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. And 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 your spouse pays you interest at the “prescribed rate” in effect at the time the loan is made (currently 1%).
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 fate 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 children’s 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.
In-trust accounts
Because of legal restrictions in setting up investment 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 would thwart capital gains splitting. But in a series of Technical Interpretations, the Canada Revenue Agency has indicated that this should not generally be the case.
Still, 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.
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 tool known as a “discretionary family trust” can help you to hedge your bets.
Getting professional advice
Finally, the tax strategies I’ve touched on in this article are fairly complex and some will require legal help to execute. These are not the do-it-yourself tactics of the kind that simply require filling in the appropriate line on your T1 return, so be sure to consult a qualified tax professional before attempting these maneuvers.
Courtesy Fundata Canada Inc. ©2014. Samantha Prasad, LL.B. is Tax Partner with Toronto law firm Minden Gross LLP. Portions of this article appeared in The TaxLetter, published by MPL Communications Ltd. Used with permission.
