TaxMatters@EY – April 2021

Alan Roth, Toronto

Income splitting is a beneficial tax planning tool if you are taxed at the top or an otherwise high marginal income tax rate and your spouse or common-law partner or other family members are subject to tax at lower rates. To the extent that your income can be spread among other family members with lower rates, you can reduce your family’s overall tax burden. This sort of planning is particularly attractive when you have limited sources of income such as in retirement.

But the Income Tax Act (the Act) restricts or prevents income splitting in many situations. For example, if you lend or transfer property — directly, indirectly or through a trust — to your spouse or partner or a relative under the age of 18, any income or loss from the property is attributed to you and taxed in your hands under the attribution rules, with certain exceptions.¹ In addition, the broadening of the tax on split income rules for 2018 and later taxation years limits income splitting arrangements that use private corporations to benefit from the lower personal tax rates of certain family members of all ages who are direct or indirect shareholders of the corporation, or who are related family members of direct or indirect shareholders.

For details on the revised tax on split income rules, see the February 2018, February 2020, and November 2020 issues of TaxMatters@EY.

There are, however, certain income splitting techniques that are permitted under the Act, including some that target retirement income such as pension income splitting, spousal registered retirement savings plans (spousal RRSPs), and the splitting of Canada Pension Plan (CPP) benefits.

Pension income splitting

If you receive pension income that qualifies for the $2,000 pension income tax credit, you may be able to elect to transfer up to half of it to your spouse or partner. This is a notional transfer, so there is no actual transfer of cash. It’s only an allocation of pension income for tax purposes. There is also no maximum dollar amount that may be split.

Income eligible for splitting

Different types of pension income may be eligible for splitting, depending on your age. As noted below, the types of eligible pension income that may be split if you are under the age of 65 are very limited:

• If you are under 65: Eligible pension income is limited to qualified pension income, which includes annuity payments from a registered pension plan (RPP) and certain other payments received as a result of the death of your spouse or partner (e.g., a survivor pension annuity).²
• If you are 65 or older: Eligible payments include those described above (including the RSIB payments described in footnote 2), plus annuity payments from an RRSP or a deferred profit-sharing plan (DPSP), registered retirement income fund (RRIF) payments, payments out of or under a pooled registered pension plan (PRPP), and certain qualifying amounts distributed from a retirement compensation arrangement.³ Pension income for this purpose does not include old age security (OAS), CPP or Québec pension plan (QPP) benefits, death benefits, retiring allowances, RRSP withdrawals (other than annuity payments), amounts from a RRIF that are transferred to an RRSP, a RRIF or an annuity, or payments out of a salary deferral arrangement or employee benefit plan.

A foreign pension annuity may qualify for income splitting. However, neither the portion that is tax exempt due to a tax treaty with the foreign country nor income from a US individual retirement account (IRA) qualifies.

Although pension income splitting is typically used by spouses or partners to allocate pension income from the higher-income individual to the lower-income individual, the rules may also be used to allocate eligible pension income from a lower-income individual to a higher-income individual. In a scenario outlined in a recent Canada Revenue Agency (CRA) technical interpretation,⁴ two spouses preferred the latter method of allocation because it would reduce the fees incurred for the lower-income spouse to live in a retirement home (which were based on the spouse’s net income for income tax purposes).

How to split eligible pension income

To split eligible pension income, you and your spouse or partner must make a joint election by completing Form T1032, Joint Election to Split Pension Income, and file the election with both income tax returns for the year the pension income is being split. If the returns are e-filed, you should keep a signed copy in your files. To be eligible, you and your spouse or partner must be a Canadian resident at the end of that year and cannot, as a result of a breakdown in the marriage or partnership, be living separate and apart from each other at the end of the year and for a period of 90 days or more that began in the year.

When you make the election, the pension income allocated to the spouse or partner is deducted in calculating net income on the transferor’s income tax return and added in calculating net income in the transferee’s return. The transferred income will retain its character as either pension income or qualifying pension income (for those under 65) in the transferee’s return.

When income tax has been withheld from pension income that is being split, you should allocate the tax withheld in the same proportion as you report the related income.

You have to make the pension income splitting election on an annual basis. Each year, you and your spouse or partner should decide if you want to split eligible pension income and how much you want to split (up to a maximum of 50% of eligible pension income). Each annual election is independent and is based on the eligible pension income received in that taxation year.

The CRA may allow an election to split pension income to be filed late under certain circumstances. A request to extend the time for making, revoking or amending a joint election may be made at any time within three calendar years of the filing due date for the income tax return for the taxation year to which the election relates. If such a request is made within the three-year deadline but after the transferee’s normal reassessment period has expired, the CRA will accept the election only if it does not result in an increase in the transferee’s tax payable or if it results in a refund to the transferee.⁵

Relief is discretionary and will be given only where the applicant is resident in Canada at the time of the request (or if the individual is deceased, the applicant was resident in Canada prior to his or her death) and demonstrates that the failure to file the election on time was beyond the individual’s control and would cause unintended tax consequences.

Benefits of pension income splitting

Pension income splitting can produce significant tax savings for couples. The extent will depend on a number of factors, including

• The use of lower marginal income tax rates on the split income diverted to the lower-income earning transferee spouse or partner
• The ability to double up on the basic and pension income tax credits
• Increases in OAS retention and the amount of the available age credit because of reduced income to the transferor
• A potential reduction in the amount of required income tax instalments to the transferor

Note that the amount of income tax instalments payable by each spouse or partner may be affected due to an increase in income tax payable for the transferee and a decrease in income tax payable for the transferor as a result of the pension income split.

Example

Leslie and Susan are both retired, over the age of 65, and resident in Ontario.

Leslie was subject to tax at the highest marginal personal income tax rate for the 2020 taxation year since he received a considerable amount of income from a non-registered portfolio of investments, registered pension plan benefits and from required withdrawals from his RRIFs. He also received CPP and OAS benefits (although all his OAS benefits were clawed back due to his high net income).

Susan’s income consisted solely of CPP (maximum retirement amount) and OAS benefits totaling approximately $21,500 for 2020.⁶

Both Leslie and Susan began receiving CPP benefits at the age of 65.

Leslie wishes to split the maximum permitted amount of his eligible pension income with Susan for the 2020 taxation year. For 2020, his eligible pension income consisted only of his registered pension plan benefits and RRIF withdrawals, which totaled $138,000 that year. Leslie and Susan elect to split 50% of that amount (the maximum percentage they could elect under the pension income spitting rules), or $69,000, by jointly filing Form T1032 with their income tax returns.

Leslie’s taxable income is reduced by $69,000, the amount of eligible pension income transferred to Susan. Since this income would have otherwise been taxed in Leslie’s hands at the highest marginal income tax rate, Leslie will realize tax savings of $36,935 ($69,000 x 53.53%, the highest combined federal-Ontario marginal income tax rate on ordinary income in 2020⁷).

Susan’s taxable income is increased by $69,000, the amount of eligible pension income allocated to her, for total taxable income of $90,500 in 2020.The additional $69,000 of income is subject to federal and Ontario income tax of $18,259, considerably less than what Leslie would have had to pay without pension income splitting since Susan is subject to much lower marginal tax rates.

In addition, both Leslie and Susan may claim the $2,000 pension income tax credit on their respective returns. Without the joint election, only Leslie could claim this credit, since only he would have pension income eligible for this credit. Susan’s combined federal and Ontario pension credit is approximately $375.⁸ Therefore, Leslie and Susan’s combined net tax saving before any clawback of Susan’s OAS benefits is $19,051 (36,935 - 18,259 + 375).⁹ This net tax savings amount will be reduced by a clawback of $1,717 in Susan’s 2020 OAS benefits.¹⁰

Leslie may also consider tax planning, such as the use of a prescribed rate loan, to generate tax savings in respect of the investment income earned on his investment portfolio. For further information for this type of planning, see Putting a prescribed rate loan in place, in Managing Your Personal Taxes 2020-21, Chapter 9, Families. Also check out EY’s helpful online tax calculators and rates.

Spousal RRSPs

A spousal RRSP is a plan to which you contribute, but your spouse or partner receives the annuities. A contribution you make to a spousal RRSP does not affect your spouse’s or partner’s RRSP deduction limit for the year, but your total deductible contributions to your and a spousal RRSP may not exceed your own deduction limit.

Contributions to a spousal plan become the property of your spouse or partner. In most cases, the withdrawn funds are taxable in the hands of the beneficiary, presumably the lower-income spouse or partner if planned properly. However, exercise caution — funds withdrawn within three taxation years of any contribution to the plan will be attributable to you and taxed in your hands instead of your spouse’s or partner’s.¹¹ If this occurs, your spouse or partner will still be required to include the full amount of the withdrawn amount in their income. However, the spouse or partner will also be able to claim a deduction equal to the amount included in your income as a result of the attribution to prevent double taxation.

Benefits of spousal RRSPs

Spousal RRSPs may be used as an income splitting tool. A high-income earning spouse or partner can obtain the tax benefit of making deductible contributions to a spousal plan at a high tax rate. In other words, the income deducted in the computation of the contributing spouse or partner’s taxable income as a result of the spousal RRSP contribution would otherwise be taxed at a high marginal income tax rate. After a three-year non-contribution period, the low- or no-income earning spouse can withdraw the funds and pay little or no tax. This planning may be particularly advantageous in providing additional family funding when a lower income earning spouse or partner takes time off work or starts a business that isn’t expected to earn profits for a number of years.

Unlike pension income splitting, spousal RRSPs may be used as an income splitting tool well before retirement. As noted above, only eligible pension income can be split and, in the case of RRSP or RRIF income, this means the transferor must be at least 65 years old.

If you have earned income (including employment income, director fees, business income, royalties or rental profits) after you turn 71 (the age when your RRSP matures and must be collapsed), and you have a younger spouse or partner, you may continue to make contributions to a spousal RRSP until the end of the year your spouse or partner turns 71. This strategy allows for a prolonged deferral of tax in relation to amounts contributed.

Spousal RRSPs can allow more flexibility than pension income splitting, although the two options may work well together. Pension income splitting is limited to one-half of the recipient’s eligible pension income. By using a spousal RRSP, a person can effectively direct any amount of RRSP or RRIF income to a spouse or partner. This strategy can be beneficial when the higher-income-earning spouse continues to work or has other significant income in their retirement years.

Pension income splitting is not a physical split of money; it’s only an allocation of pension income for tax purposes. Therefore, the recipient spouse or partner is not accumulating capital. By using spousal RRSPs, the RRSP income becomes capital to the recipient and may be invested to earn additional income (not necessarily pension income). This could include tax-deferred investment income earned within the RRSP or, after the funds are withdrawn from the RRSP as pension income, they could be reinvested elsewhere, such as a TFSA or non-registered investments.

While spousal RRSPs offer benefits, it doesn’t mean they should be used instead of pension income splitting. Depending on your personal situation, spousal RRSPs and pension income splitting can be combined to produce the most effective financial and tax results.

Splitting CPP

Although CPP is not pension income that is eligible for purposes of the pension income splitting rules, couples are able to split or share CPP benefits. As with pension income splitting, CPP benefits sharing may result in overall income tax savings.

CPP sharing is available by application (Form ISP1002, Application for Canada Pension Plan Pension Sharing of Retirement Pension(s)), to spouses or partners who are both at least 60 years of age and living together, where one or both are either receiving or applying for CPP benefits. CPP benefits must be split equally and the cash payments are actually “split.”

If you are already sharing CPP benefits and no longer wish to do so, you will need to complete and file the Cancellation of Pension Sharing form (ISP1014).

CPP benefit sharing may also cease upon the divorce of a couple, or the death of one of the spouses or partners, or in the month the spouse or partner who has never paid into the CPP begins contributing to the plan. In the event a couple separates, CPP benefit sharing ceases in the 12th month following the month in which the spouses or partners start to live separate and apart.

If you are not currently splitting your CPP income and you are considering doing so, visit www.canada.ca/en/services/benefits/publicpensions/cpp/share-cpp.html for further details. Québec Pension Plan benefits may also be split between spouses or partners. Further information is available at https://www.rrq.gouv.qc.ca/en/retraite/retraite_a_deux/impact_fiscal/Pages/division_rr.aspx.

Conclusion

Income splitting techniques with retirement or other types of income may be beneficial, but care must be taken so that such planning is onside at all times with the tax rules. For additional guidance on structuring such planning, consult your EY tax advisor.

Winnie Szeto, Toronto; Gael Melville, Vancouver

In this case, the taxpayer brought an application before the Federal Court (FC) for judicial review after the CRA twice denied her request for a waiver of the tax and penalties that arose as a result of her making contributions to her tax-free savings account as a nonresident. The FC concluded that the CRA was unreasonable in denying her request. As a result, the CRA’s decision was set aside and the matter was returned for redetermination by a different CRA official.

The TFSA rules

A tax-free savings account (TFSA) allows an individual to set money aside for any purpose on a tax-free basis. Income and gains earned in the account are generally tax free, even when they are withdrawn. However, there are rules as to how much an individual can contribute and who can contribute to a TFSA.

An individual who exceeds their TFSA contribution limit is liable for a penalty tax on the excess amount until it is withdrawn.

A nonresident is generally not eligible to contribute to a TFSA and does not accrue any additional TFSA contribution room while they are nonresident. A penalty tax applies to contributions that are made while the individual is nonresident. An individual who runs afoul of the rules may request that the Minister of National Revenue waive or cancel their liability arising from excess or nonresident TFSA contributions if they can demonstrate that the liability arose as a result of a reasonable error and they promptly withdraw the excess amount and the income attributable to that excess amount from the TFSA.

Facts

In 2009, the taxpayer, a Canadian resident, overcontributed to her TFSA. The following year, the CRA informed her of the overcontribution and charged her a penalty tax on the excess contribution, which she promptly paid.

In 2010, the taxpayer left Canada and eventually settled in New York. Between 2010 and 2018, she continued to contribute small amounts to her TFSA each year, but in 2014 she contributed just over $30,000. Prior to her 2014 contribution, the taxpayer’s Canadian bank incorrectly informed her that she was still eligible to contribute to her TFSA even though she was no longer a Canadian resident.

When the taxpayer realized in 2018 that her bank had given her incorrect advice, she quickly emptied and closed her TFSA. She then submitted a letter to the Minister seeking a waiver of the penalty tax on her excess contributions due to being a nonresident for the 2010 to 2018 taxation years on the basis that she had made a reasonable error. In this request, she explained that she did not know that she was ineligible to contribute to her TFSA as a nonresident and that her bank had given her incorrect advice.

The CRA denied this request on the basis that the taxpayer had continued to make excess TFSA contributions as a nonresident from 2010 onwards, even after the CRA had notified her of her excess TFSA contributions in 2009. The CRA assessed the taxpayer for tax, penalties and interest totalling over $27,000. The FC judge remarked that this effectively wiped out the taxpayer’s retirement savings.

The taxpayer then sought a second, independent review of the first decision. In the second request, the taxpayer focused on her 2014 to 2017 taxation years because almost all of the tax, penalties and interest liability related to those years. Once again, the taxpayer argued that her liability in those years arose as a result of a reasonable error. She also argued that the basis for the CRA’s first decision was flawed because her excess contributions in 2009 were not related to her nonresident excess contributions in 2014 to 2017. She submitted that she paid the 2009 overcontribution liability and that matter was closed.

The CRA denied the taxpayer’s second request on the same basis as the first — that is, that the taxpayer continued to make excess and nonresident contributions to her TFSA even after she was notified by the CRA about her excess TFSA contribution in 2009.

The taxpayer then brought an application before the FC to challenge the CRA’s second decision.

Standard of review

The FC judge first noted that the CRA’s refusal to waive taxes and penalties must be reviewed on a standard of reasonableness.¹ In other words, was it reasonable for the CRA to deny the appellant’s request to waive taxes and penalties?

The FC judge also noted that a reasonable decision is transparent, intelligible and justified in relation to the relevant facts and law. The party challenging the decision — the taxpayer in this case — has the burden of demonstrating that the decision was unreasonable.

Taxpayer’s argument

At the hearing, the taxpayer reiterated her argument that her excess and nonresident contributions to her TFSA in 2010 to 2018 arose as a result of a reasonable error. She submitted that the CRA was unreasonable in denying her second request because the basis for the denial was flawed.

The taxpayer argued that the liability for her excess and nonresident contributions from 2010 to 2018 arose as a result of her nonresident status, and that she did not “continue” to make excess and nonresident contributions to her TFSA after being informed of an excess contribution in 2009.

She further argued that there was no rational connection between the excess contribution she made in 2009 and the excess and nonresident contributions she made in 2010 to 2018.

Finally, she submitted that the CRA’s second decision simply repeated the same basis for refusal as the first and it did not address her argument that the basis for the first decision was flawed.

Decision of the Federal Court

After considering several previous FC cases² that involved the Minister’s refusal to waive liability for excess TFSA contributions, the FC judge agreed with the taxpayer that the CRA’s decision to deny her request for relief was unreasonable. The FC judge found it was unreasonable for the CRA to suggest that the taxpayer “continued” to make excess contributions after being warned.

According to the FC judge, the taxpayer’s 2009 overcontribution resulted from a different error than her subsequent excess contributions. Specifically, the taxpayer made the later excess contributions because she mistakenly believed that her contribution room continued to increase while she was nonresident. Therefore, the taxpayer did not repeat a previous mistake that the CRA had already warned her about.

The CRA argued that in addition to the taxpayer’s 2009 excess contribution, its second decision was also based on other factors, such as the CRA directing the taxpayer to their website and Guide RC4466, Tax-free Savings Account (TFSA), for additional information on TFSAs, which included information on the rules for nonresidents. The CRA also argued that the taxpayer was aware that her nonresident status was relevant because she specifically asked her bank about her TFSA eligibility at the time of her 2014 contribution.

The FC judge did not accept the CRA’s arguments and was of the view that the sole basis for the CRA’s second decision was that the taxpayer had repeated a mistake that the CRA had previously warned her about.

Based on the above, the FC judge decided in favour of the taxpayer, stating that the CRA’s decision to deny the taxpayer relief from the tax liability that arose from her excess and nonresident TFSA contributions was unreasonable because it was not transparent, intelligible or justified.

Lessons learned

Individuals need to familiarize themselves with the TFSA rules and must understand that tax penalties will result from excess and nonresident contributions. Although the Income Tax Act allows an individual to request a waiver of these penalties, such a waiver is at the Minister’s discretion, and the CRA’s own guidance on granting relief (which was referred to in the judgment) indicates that an individual may generally only receive relief once.

The FC judge ruled in favour of the taxpayer in this case, but that outcome was not a given. For example, relief was denied in the recent Jiang and Weldegebriel cases. Also, it should be noted that the remedy granted in this case was to send the matter back for redetermination; the CRA could reach the same decision, so the taxpayer may not be better off.

Generally, individuals should exercise caution when contributing to TFSAs or any other plan and should seek professional tax advice as appropriate. Professional advice may be particularly important when there is a significant change in an individual’s personal circumstances, such as becoming a nonresident of Canada.

Tax Alerts – Canada

Tax Alert 2021 No. 06 – Yukon budget 2021‑22

Tax Alert 2021 No. 07 – Prince Edward Island budget 2021–22

Tax Alert 2021 No. 08 – New Brunswick budget 2021‑22

Tax Alert 2021 No. 09 – Ontario budget 2021‑22

Tax Alert 2021 No. 10 – Highlights Quebec budget 2021‑22

Tax Alert 2021 No. 11 – Quebec budget 2021-22

Tax Alert 2021 No. 12 – Nova Scotia budget 2021‑22

Tax Alert 2021 No. 13 – CRA outlines potential changes to RSU sourcing methodology
In Internal Interpretation 2019-0832211I7(E) Cross-border Restricted Share Units, the CRA introduces a new methodology for sourcing restricted share unit (RSU) benefits that it refers to as the “Hybrid Methodology.”