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Issues Arising on Divorce
Balaji Katlai and Hugh Neilson*
Introduction
There are few announcements more disturbing for an advisor to receive from a client than “We’re getting divorced.” The breakdown of a relationship creates sufficient personal upheaval that it is patently unreasonable to throw in the myriad legal and tax implications that also result. Unfortunately, we do not have any options in this regard, and as the professional advisors to the parties, we must advise them as best we can so that they can continue with their separate lives. The tax provisions applicable to matrimonial breakup are numerous and complex, and most practitioners come into contact with them only on rare occasions. Add the potential animosity
* Balaji Katlai and Hugh Neilson, CPA, CGA works with Kingston Ross Pasnak LLP in Edmonton. Hugh Neilson, FCPA, FCA, TEP works with Kingston Ross Pasnak LLP/Video Tax News Inc. in Edmonton. The paper which follows owes a debt to many previous presentations, both by one of the co-authors and by others. Much of the content is derived (and updated) from a 2009 presentation at the 2009 CICA National Conference on Income Tax. While updated and reorganized for this Conference, much of the legislation and jurisprudence remains unchanged over the intervening years. The author wishes to acknowledge Thomas B. Devaney, FCPA, FCA and Michel F. Audy, CPA, CA, CFP, TEP for their historical contributions to the materials used in preparing this presentation.
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between the parties agreement, and you have a recipe for a very unpleasant and difficult professional engagement.
The legal issues are numerous, and the tax concerns are no less abundant. This paper will address some of the tax matters of relatively common occurrence. It does not attempt to discuss esoteric or unusual matters in great (if any) detail, but attempts to provide the practitioner with an overview of the tax implications of matrimonial matters. It also incorporates a focus on the additional challenges of private business and corporate assets of the relationship.
The courts have been less than sympathetic to family law practitioners who make errors in the complex taxation issues which arise and can be expected to be no more friendly towards accountants and tax advisors who make similar errors. Many family law practitioners are careful to advise their clients, in writing, that they are not offering any assurance on income tax matters. This opens the door to the client obtaining expert advice, or requesting their counsel do so, in this area. It may also reduce the family law practitioner’s liability exposure. Of course, that liability has to go somewhere, and it most commonly falls to the income tax advisor to bear the brunt of any eventual legal action.
Similarly, it is important that the tax advisor recognize that their contributions to the process must be made in the context of potentially complex emotional, financial and family law matters.
Tax issues are a significant factor in most family law matters. If there is a property settlement or spousal support, both parties must be aware of the tax implications, so that the resulting bargain is
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entered into knowing full well the consequences. If the parties do not understand these tax results, they may, at best, be unhappy with the outcome. At worst, they may consider taking action against the advisors who did not provide them with what they now consider to be appropriate advice.
The tax rules that apply to Family Law are complex and pervasive (and some say perverse). As was stated by Judge Bell, of the Tax Court of Canada (TCC) in the case of Dunfield:1
The legislation in this area of tax law was, before the 1997 amendments, complex and bewildering to those unfortunately clutched by its talons. Now, it is almost incomprehensible. Planned legislative abstruseness could not have ascended the Olympian heights scaled by both the substantive and implementing provisions respecting the income inclusion and deduction of maintenance payments. The Minister, for some unexplained reason, decided to and did, reassess the Appellant disallowing the deduction claimed in 1998 without having reassessed Davies to include the $3,600 in her income. Assuming that Davies would be reassessed to remove the payments from her income if the Appellant loses this appeal, this appears to have been done with no increase to the fiscus but because of an ungenerous approach to the application of rules while ignoring the reparation steps taken. Thousands of taxpayers are affected by this maze of legislative pitfalls. Many of them, for economic reasons, are obliged to represent themselves in court. What hope do they have of making any sense of these provisions where lawyers and
1 Dunfield vs. The Queen, 4 CTC 2518, 55 DTC 3774, 2001 CanLII 940
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judges are driven to the wall in their attempts to understand and apply them? The agonies of domestic combatant strife are debilitating and depressing. No one in that position needs a torpefying journey through this legislative labyrinth.
General Matters
Although our paper focuses on tax issues commonly arising in a relationship breakdown, the parties’ other tax issues often come to the forefront in the course of a matrimonial dispute, so virtually any tax issue may be engaged.
Even judges do not agree on how the Income Tax Act (the Act) is to be interpreted in these areas, and have sometimes arrived at contradictory results on exactly the same fact scenario. Nonetheless, we must do our best with these matters and hope that, most of the time, we get it right.
Throughout this paper, we will use the term order or agreement, or similar as a shortcut to the longer and more definitive legal wording. The actual wording in the Act, additionally, varies slightly in certain sections, but is generally in the form of “pursuant to a decree, order or judgment of a competent tribunal or pursuant to a written separation agreement.” Where the exact wording is important, you may wish to review the applicable section.
We use the term “settlement agreement” to refer to any of the property division, child or spousal support, custody or other agreement entered into by the parties to the marriage or common law relationship. As well, in certain contexts this term can also include the Court Order(s) or Consent Order(s) obtained as part of the Family Law procedures.
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Unless otherwise stated, all section references in the paper refer to the Act. The Canada Revenue Agency (CRA).
Except where otherwise indicated, this paper assumes that we have a “normal” arrangement with both spouses living in Canada, and being in receipt of ordinary income sources. If that is not the case, the results can be significantly different. Consider, for example. situations where the payer of spousal support has income which was not taxable, for example significant workers compensation board (WCB) pensions, a non-resident earning his income free of tax to any country, or an Indian living on and earning income from a reserve. In each of these cases, the deduction of spousal support would not provide any tax benefits, however the recipient would still be taxable in Canada.
Except where otherwise indicated by the context, the term “spouse” includes a common-law partner.2
SECTION 1: PROPERTY DIVISION
It should first be noted that while a married relationship can have three phases (married, separated, divorced), the common law relationship only has two (common-law partners or not common-law partners). As well, the termination of a marriage requires that the parties obtain a decree nisi,
2 As defined in Subsection 248(1)
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however, for income tax purposes, the termination of a common-law relationship only requires that they cease to cohabit in a conjugal relationship for a continuous period of 90 days. Consequently, a common law relationship can cease, and the tax rules apply (or cease to apply), much more quickly than with a formal marriage, in a manner outside the control of the parties
1.1 Division of Property
General rules:
In most cases, property transferred between spouses, or former spouses in settlement of rights arising out of marriage, can transfer on a rollover basis (that is, the transferor is deemed to have sold the asset, and the recipient is deemed to have acquired it, at its Adjusted Cost Base (ACB), Undepreciated Capital Cost (UCC) or other income tax cost). The transfer of capital property takes place at income tax cost automatically,3although the parties can elect out of this treatment, resulting in a transfer at fair market value (FMV).
Some assets, however, are more problematic. There is no provision for the transfer of assets held as inventory, so such assets must transfer at their fair value for income tax purposes. Transfers of inventory held in a traditional business are uncommon, since you would expect that the recipient would already be the owner of the proprietorship, or that one party would be transferring the shares
3 Subsection 73(1)
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of a corporation (or an interest in the partnership) which operates the business, both of which are eligible for rollover.
More challenging are assets held with the intention of resale at a profit, since the these are also “inventory” of an adventure in the nature of trade.4 This issue can easily be encountered where a couple has acquired land, not to use it personally or in a business, but intending to sell at a profit once values have increased. Additionally, it is not uncommon for individuals to acquired speculative investments, such as start-up companies in the resource, research or tech sectors, which CRA may consider to be an “adventure in the nature of trade.” More recently, we have seen individuals undertake investments in cryptocurrency, with similar uncertainty as to classification. Such assets cannot be transferred on a tax deferred basis.
In addition to the inability to roll over the assets, these situations often create disagreements with respect to the valuation of these speculative investments, as they are often not matured to the point of providing any assurance as to the realizable value. Where the property is held jointly, it is normally not difficult to divide this “inventory” into two separate names,5and this can be accomplished on a tax deferred basis. Where this is not the case, our experience is that one solution is for the property settlement agreement to require the title holder to pay to the other spouse the agreed percentage of the after tax receipts on the asset. Items such as contributions to cash calls, who decides when to sell, etc., should also be considered in the agreement. The desire to share in the future value of such property, or the hesitancy to pay taxes on a transfer, must be weighed
4 See definition of business; Subsection 248(1)
5 Partition of property; see Subsections 248(20) to (23)
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against the impact of retaining a joint investment. In some cases, the relationship between the parties makes any joint holding impractical, and some other approach essential.
In addition, only direct transfers between spouses/former spouses are covered by these provisions. It is not uncommon for parties to consider themselves to “own” assets that are in fact owned by a corporation, trust or partnership. Where a couple holds assets in a corporation, the transfer of such assets from the corporation to an individual always requires a transfer at fair value, with the resultant tax consequences. If the assets are in a partnership, it may be possible to transfer them at no immediate tax cost, however this is not a simple process. Trusts, fortunately, are usually more easily dealt with; however it is important to ensure that the proper procedures are adhered to.
The transfer of personal assets can be done prior or subsequent to divorce: the rules are the same. Consequently, there is usually no requirement that these transfers occur prior to the decree nisi.
A common practical issue with respect to asset transfers is whether the recipient spouse is aware of the tax cost of the assets acquired. If there is any uncertainty, it may be advisable for the agreement to provide that the transferor will supply the cost records to the recipient. Where the cost may not be obvious (e.g. income trusts where capital has been returned, investments in partnerships, shares which have had a chequered history, identical assets acquired over a number of years at different prices, farm land which has had ACB reductions due to various capital receipts), these records should be reviewed by the recipient’s advisors to confirm the validity of the cost amount. It may even be prudent to have the transferor “guarantee” the ACB, with the parties agreeing in advance as to who bears the additional tax costs if CRA disagrees and reassesses
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the recipient for further taxes. Since this tax cost was likely built into the property settlement, any additional tax should likely be borne on the same basis.
Transfers at FMV
Where the parties agree,6assets can be transferred at FMV. This can be advantageous if the transferring spouse has capital losses carried forward, has low income, can utilize the Capital Gains Exemption, etc.
It should be noted, however, that an intermediate value cannot be chosen. The transfer is either at ACB (UCC for depreciable assets) or at FMV. Where there are identical assets (shares are a common example), it may be possible to elect to transfer a certain number of these assets at FMV, with the remainder automatically rolling over at ACB, effectively allowing you to get much closer to your desired proceeds, as each share is a separate property.
However, if there is only one asset, such as a rental property, it is an all or nothing election.
As well, an election to transfer at FMV risks CRA arguing that the FMV is something different from the amount agreed to between the parties. If CRA’s number is higher than the parties (which is a common result), there may be additional taxes owing that were not anticipated in the planning or the settlement agreement. In addition, the transferring spouse may feel that he or she did not
6 Technically, where the transferor elects that Subsection 73(1) not apply
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receive adequate consideration for that asset in the overall settlement (inasmuch as CRA has determined that the asset was worth more than had been asserted, as well as generating an additional tax liability). This can lead to attempts to re-open the settlement, or claims against the advisors.
Capital Gains Exemption
Where the assets to be transferred include shares of a qualified small business corporation, or eligible farm property, utilization of the transferor’s Capital Gains Exemption (CGE – also known as Capital Gains Deduction)7 may be beneficial. By electing to transfer the asset at FMV, the recipient receives the asset at a higher tax cost, even though the transferor avoids the income taxes otherwise payable by claiming the CGE.
Utilization of the CGE is, however, often an issue in that the transferor generally bears all of the costs and risks, while the recipient obtains the benefit of the higher cost base. Costs include possible Alternative Minimum Tax (AMT) liability,8“old age security (OAS) clawback,”9loss of income based benefits such as the GST/HST credit,10 Canada Child Benefit,11 Guaranteed Income
7 Section 110.6
8 Sections 127.5 through 127.55
9 Section 180.2
10 Section 122.5
11 Sections 122.6 through 122.63
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Supplements12 and provincial income-tested benefits, commonly provided to senior citizens or families with minor children. Risks include the possibility that the asset does not actually qualify for the CGE (resulting in full taxation), that the claim is not available to the extent expected (prior utilization, Cumulative Net Investment Loss problems or prior Allowable Business Investment Loss claims), or that the value exceeds the estimate (resulting in proceeds that may not be sheltered by the CGE)!
Where it is possible, consideration could be given to structuring the transaction such that the risks rest with the person benefiting from the planning. In all cases, ensuring that the settlement agreement addresses this matter and deals with any resulting income tax liability or other costs is prudent practice. It should be remembered, however, that CRA will likely see this agreement at some point, either if it is registered with them, or if they request to see it to confirm the deductibility of the amounts claimed by the payer on his or her personal tax return.13 Consequently, the wording must be sufficiently clear to ensure that the parties know who will eventually bear any such costs, but not drafted in a manner that points CRA towards an area that they may wish to audit. Even when successfully defended, a CRA audit increases costs and anxieties, and often resurrects matters the parties would rather have put behind them. Responsibility for these costs may also merit inclusion in the agreement.
12 Provided for in the OAS
13 This is a common request for deductible support payments, and sometimes claims for dependent children
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Where one spouse has transferred an asset to the other, prior to or during marriage, for inadequate or no consideration, the recipient spouse is liable for any taxes owing by the transferor at the time of transfer, up to the “benefit” received on the transfer.14 Transfers made pursuant to a court order or written separation agreement while the parties “were separated and living apart as a result of the breakdown of their marriage” enjoy an exception.15
It should be noted that, even if there are no taxes outstanding at the time the asset is transferred, this liability may still apply if the transferor is subsequently re-assessed for taxes. It is therefore advisable that any final agreement deal with this matter, and that the parties clearly agree as to who is liable for any taxes assessed against the parties. A practical issue here is what value does an indemnification have? Before CRA utilizes this provision, they generally exhaust their collection procedures against the actual taxpayer. The tax debtor’s indemnification may have little value if he or she is insolvent or bankrupt!
The “separation” exception does not apply if there is no court order or written separation agreement. Payments towards the non-debtor spouse’s household expenses, payments intended for child or the spousal support, paying off the non-debtor’s VISA or other liability, etc., could theoretically trigger this liability if there is no order or agreement. Additionally, if the debtor
14 Section 160
15 Section 160(4)
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spouse transfers a car, some cash, some furniture, etc., outside of any such order or agreement, the recipient may have a contingent liability to CRA. Finally, of course, it is quite possible that assets were transferred between the spouses over the years of their marriage.
Where assets will be transferred before the final agreement is entered into, it may be advisable to have a short written separation agreement that deals with these assets. There is no requirement that all matrimonial matters be dealt with in one agreement. Consequently, the recipient would be well advised to ensure that there is a separate agreement that deals with transfers of assets. Each such agreement should, at a minimum, state that the parties agree to live separate and apart, and then deal with the specific subject matter.
Attribution
Normally, assets transferred between spouses result in attribution of income16 and capital gains.17 That is, the spouse who originally paid for the asset must report all income and gains arising from the property, even if legal ownership is transferred to the other spouse. Where the parties are separated due to marital breakdown, attribution of income ceases,18 and the legal owner must report the income generated by the asset.
16 Section 74.1
17 Section 74.2
18 Paragraph 74.5(3)(a)
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Attribution of capital gains, however, continues until the divorce itself. It is possible to elect that capital gains will not attribute after separation.19 This joint election, which has no prescribed form, must be filed in the tax return of the transferor for the year the asset is disposed of. It is prudent to ensure such an election is, or will be, filed where one party may or will dispose of assets during the period of separation, so as to prevent undesired income tax consequences. As always, the settlement agreement should detail who is intended to bear these costs.
Tax on Split Income (TOSI)
The TOSI rules20 can subject the recipient of income in various forms, including many forms of income from private corporations, to the highest personal tax rate. A full review of these provisions is beyond the scope of this paper. However, there are two provisions specific to relationship breakdowns which merit noting, as follows:
• Income from property transferred to the individual under a written agreement or order addressing division of matrimonial property is excluded from TOSI.21
19 Paragraph 74.5(3)(b)
20 Section 120.4
21 Paragraph (b) of the definition of “excluded amount” in Subsection 120.4(1)
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• Where, at the end of the year, spouses live separate and apart by virtue of the breakdown of their marriage, they are deemed to be unrelated for the entire year for purposes of TOSI.22
1.2 Pensions, Registered Retirement Savings Plans (RRSPs) and other Registered Plans Registered Pension Plans:
The valuation of pension plans (not RRSPs) can be tricky at best, and subject to many assumptions which affect the value of the plan. This is well beyond the scope of this paper, other than to note that “commuted value” is almost always wrong, and that defined contribution (money purchase) plans are normally worth the accumulated funds in the plan and a formal valuation is rarely necessary.
Depending on the terms of the pension plan, it may be possible to split the pension at source. This ensures that the recipient spouse receives his or her funds without any risk of the payer defaulting. As well, it may eliminate having to deal with some assumptions (age of retirement, inflation, plan improvements), however it does not eliminate the need to determine which portion of the plan will go to which party, nor the impact of future years of employment. Additionally, it tends to maintain a relationship between the parties as there is no money available until the pensioner decides to start collecting. As well, what happens if the pensioner dies before retiring and the pension never pays out? What if the pensioner chooses options (e.g. guaranty period, co-ordination with Canada pension plan (CPP) and/or OAS) that the former spouse disagrees with? Such situations may result
22 Paragraph 120.4(1.1)(e)
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in the issues being reopened decades in the future, especially if one party fails to honour the original agreement.
Where the plan does not allow for a split at source, an agreement that the payer will remit X% of the pension, as and when received, to the recipient as his or her share of the pension, will often be accepted by CRA, thus allowing both parties to report their share of the payments as pension income on their respective personal tax returns, and each to claim the pension income credit.
Since CRA generally matches information slips, such as T4As reporting pension income, to the income tax returns filed, this can result in CRA querying the pension recipient, since his or her return will not report the full amount of the income reported on the T4A slip. Unfortunately, CRA often reassesses without contacting the taxpayer, resulting in effort, time and costs to correct the matter. Providing a copy of the agreement indicating the pension split will normally suffice to have the return reassessed to delete the erroneous income inclusion, but this creates additional administration.
Where the parties wish to avoid the irritation of CRA automatically reassessing the pensioner’s return, another option is to report the full amount of the T4A as income, but then deducting the other spouse’s share. The other spouse would still report his or her share of the pension – CRA doesn’t often question taxpayers who report more income than they have information slips for. This procedure eliminates the risk of an automatic reassessment, but may require the payer to provide evidence of the deduction. Again, a copy of the settlement agreement should suffice.
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If this method is chosen, the classification of the deduction must be considered. Reflecting the amount as a support payment will reduce the “earned income” of the pension recipient claiming the deduction, reducing their RRSP contribution room. Additionally, there is the risk that CRA, having seen it deducted as support on one return, will consider it to be support income on the other, and therefore not eligible for the pension income credit.23 If that spouse already has over $1,000 of other qualifying pension income, this “disallowance” would not have any negative impact.
As this is a division of the pension, and not a support payment, we suggest it is more appropriate for the pensioner to report the full amount as pension income, but deducting the other spouse’s share as an “Other Deduction” from net income. CRA often requests support for such deductions, so any approach carries a high likelihood of being queried. Here again, a copy of the settlement agreement should be sufficient documentation for CRA’s purposes.
If the pensioner has remarried, care should be taken in addressing any use of the spousal pension income splitting rules24 where the full pension is reported and an offsetting deduction claimed. Only the net pension would be relevant for these purposes.
Another issue with not splitting the pension at the source, arises with respect to source deductions withheld from the payments. The pensioner must pay out a percentage of the gross pension receipts, but must absorb all taxes withheld, potentially resulting in a much smaller monthly
23 Subsection 118(3)
24 Section 60.03
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payment. Meanwhile, the other spouse has a large tax bill at the end of the year. The solution for the pensioner is to apply for a reduction of withholdings at source.25 The other spouse will likely have a quarterly instalment requirement.
While not common, if the pension plan so allows, it is possible to transfer some or all of the value of a pension plan on a tax deferred basis to one’s spouse26 (or former spouse). In order to qualify, it must be:
“under a decree, order or judgment of a competent tribunal, or under a written agreement, relating to a division of property between the member and the individual in settlement of rights arising out of, or on a breakdown of, their marriage or common-law partnership”
RRSPs and Registered Retirement Income Funds (RRIFs)
RRSPs and RRIFs can be transferred between spouses without any current tax cost,27 under similar terms as a pension plan. Such a transfer can occur during marriage or subsequent to the divorce (even long after), and can relate to a property settlement, or even spousal support.
25 Subsection 153(1.1); CRA Form T1213 is used to apply
26 Subsection 147.3(5)
27 Subsection 166(16; CRA Form T2220
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Normally, if one spouse has made a contribution to the other spouse’s Registered Retirement Savings Plan (a spousal RRSP), any withdrawals from any spousal RRSP may attribute back to the contributor spouse, to the extent of contributions made in the year of withdrawal or the prior two calendar years.28 This attribution rule ceases if the parties are living separate and apart due to breakdown of marriage relationship. However, if the spouse has withdrawn the funds while still living together, even if immediately prior to their separation, some or all of the income may attribute back to contributor. It is therefore advisable to deal with such matters as part of the settlement agreement, as otherwise it could be a few years before the contributor became aware of his or her tax liability.
Tax-Free Savings Accounts (TFSAs)
The legislation governing these accounts also permits a transfer to an account for a spouse or former spouse in settlement of matrimonial obligations, similar to the provisions applicable to RRSP’s.29
28 Subsection 146(8.3)
29 Subsection 207.01(1) “qualifying transfer”
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The draft legislation to implement this new plan, first announced in the 2022 Federal budget, is also proposed to allow transfers of this nature.30
Home Buyers Plan
While not unique to relationship breakdowns, the ability to borrow funds from an RRSP, to be repaid over 15 years under this provision31 has been extended to permit access for the purposes of acquiring a residence, or acquiring a spouse or former spouse’s interest in their prior residence.32 The details of the home buyers plan are beyond the scope of this paper.
CPP
Either member of a divorced or separated couple may unilaterally apply for a split in their CPP credits.33 If this occurs, the credits built up by the two parties during each year of marriage are combined, and then split equally.
30 Proposed Subsections 146.6(6) and (7)
31 Section 146.01
32 Paragraph 146.01(2.1)(a)
33 CPP Act Section 55.1
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This will generally reduce the eventual CPP retirement (and disability if qualifying) pension of the higher income spouse, and increase those of the lower income spouse. In many cases, the combined pensions will be less than the undivided credits would have generated. This is due to the fact that child rearing years can be dropped out for one spouse (generally the mother), if this results in a higher overall pension. Notwithstanding the fact that those years are not being used in the mother’s eventual pension, the father’s earnings for those years may well be reduced, effectively for little to no overall benefit.
It is not possible to contract out of a CPP credit split except in Quebec, Saskatchewan, Alberta and British Columbia.
1.3 Principal Residence Exemption
Multiple Residences
In general, gains on ownership of a person’s principal residence are exempt from tax, through the use of the “Principal Residence Exemption.” The rules and case law surrounding the exemption are surprisingly complex, and full details are beyond the scope of this paper. Income Tax Folio S1-F3-C2, Principal Residence is a good starting point for further research.
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Technically, the principal residence exemption (the portion of the gain on a principal residence which is exempted from tax) is computed by the following formula:
Gain realized x 1 + # of years designated as “Principal Residence”
Total years of ownership
Under current tax law, a family is restricted to the designation of only one property as a principal residence per calendar year.34 Where a couple owns two properties, each of which could be a “principal residence” (for example, a house and a summer cottage), the designation of the principal residence for the years of marriage will need to be determined. Assuming one spouse takes the house, and the other receives the cottage, they will not be able to fully exempt the gains on each property from taxation. There are some exceptions if the properties were acquired before 1982, however this is beyond the scope of this paper. Consequently, as part of the matrimonial settlement, the parties should elect on one or the other residence for their period of marriage. This may avoid potential disputes in the future as one or the other property is sold, and the tax implications arise.35 However, no provision provides for a designation prior to a property sale.
New Residence Acquired by one Spouse
34 Definition of principal residence Section 54
35 See The Estate Of The Late Helen Bouldin Balanko vs. HMQ for a case where a claim was reduced due to designations made by the former spouse.
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A more common concern arises where one party retains the family residence, and the other acquires a new home during the period of separation. Both spouses or common law partners must designate the same property for all years during which the relationship exists, except for years throughout which they live apart and are separated under a judicial separation or a written separation agreement. In is not uncommon for parties to live apart for several years during which there is no written separation agreement. Where a second residence is acquired by one party during that period, the issue of which property will be designated the parties’ principal residence can become significant.
As an example, consider Mr. and Mrs. X, who married in 2014, and acquired a residence in that year. In 2019, they separated, and Mrs. X moved out of the matrimonial home. In 2020, she acquired a residence for her own occupation. The parties never had a written separation agreement, and they are divorced in 2024.
From 2014 to 2019, there is only one residence, so there is no issue of which property will be designated their principal residence. As they will not be married throughout, or after, 2024, they will each be entitled to independently designate a property as their principal residence for 2024 and later years. However, only one property can be designated for the years 2020 through 2023. For simplicity, assume they both sell their residences in 2029. Mr. X will have owned the former matrimonial home for 16 years, while Mrs. X will have owned her residence for 10 years.
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Assuming Mrs. X’s property is designated her principal residence for 2021 through 2029 (only 9 years are required due to the +1 factor), she can exempt the full gain on her property from tax, as follows:36
Gain realized x 1 + # of years designated as “Principal Residence”
Total years of ownership
= Gain realized x 1 + 9
10
= Gain realized x 100%
However, Mr. X is then not permitted to designate the former matrimonial home as his principal residence for 2021, 2022 and 2023. He will be able to exempt only a portion of the gain on that property from tax, as follows (designating the property his principal residence for 2014 through 2019, and 2024 through 2019):
Gain realized x 1 + # of years designated as “Principal Residence”
Total years of ownership
= Gain realized x 1 + 13
16
36 Applying the mechanics in Paragraph 40(2)(b) and 40(4)
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He will be required to pay tax on 12 ½% of the gains on the matrimonial property. In order to permit 100% of his gains to be tax-exempt, three of the four years from 2020 to 2023 must be designated to his property, and not to Mrs. X’s residence. In that case, however, she will only be able to designate her property for 7 years, resulting in 80% of her gains escaping taxation, but 20% being subject to tax. In other words, one party will be required to pay tax on a portion of their gains.
In finalizing property matters with spouses who each have a residence, it is prudent to address the issue of how the principal residence exemption will be allocated. Better yet, where each party owns a residence, entering into a written separation agreement as early as possible, to minimize the years in which one property cannot be designated, is clearly advisable. This agreement need not deal with all separation matters, providing that it meets the requirements of a “written separation agreement.” At its simplest and barest minimum, this could be a one paragraph agreement that specifies that they agree to live separate and apart from this date forward.
Another planning possibility would be to transfer one property electing out of the spousal rollover, to permit the reporting of the disposition and the designation of the property as the principal residence for the agreed-upon years. The property on which all gains will be exempt would be the property transferred.
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This problem is much less acute in a common-law partnership. Since, for income tax purposes, the dissolution of the relationship occurs 90 days after the parties cease to cohabit in a conjugal relationship, it is uncommon for the principal residence exemption rules to cause any significant problems. Any separation on or before October 2nd of the year will allow both parties to claim the principal residence exemption for the year of separation and all subsequent years. Even with a post October 2nd separation, the “+ 1” factor in the numerator of the formula should generally eliminate any taxation concerns.
Larger Parcels
The principal residence exemption applies to no more than ½ hectare of land, unless it is shown that the excess land was necessary to the use and enjoyment of the housing unit as a residence.
CRA has stated that they will now take into consideration the fact that, where the lot could not be subdivided any further, the excess land “may” be necessary, and therefore qualify for the principal residence exemption. In addition to the fact that CRA has only said that they will take this into consideration (and not that it is a determinative factor), concerns still exist if the lot could have been subdivided in the past, but this was not done and now subdivision is not possible. As well, if subdivision of the property has been possible for some time, does the excess land still qualify for the principal residence exemption?37
37 Cassidy vs. HMQ, 2011 FCA 271, indicates the exemption on the excess land would be prorated based on the years when subdivision was, and was not, possible.
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Where the land is also used to earn income from a business or property (such as market gardening, equipment storage, workshops used in or rented to a business, commercial RV storage, etc.), CRA generally takes the position that this land (whether or not greater than ½ hectare), is not necessary for the use and enjoyment as a residence and is therefore not eligible for the principal residence exemption.
Because of these concerns, where the parties are relying on the non-taxability of the principal residence, and any of the above situations exist, the settlement agreement should specify who bears the tax if a portion of the proceeds on the residence is determined to be taxable.
1.4 Corporate Interests
Where the parties own a corporate entity, it is common that it is transferred to one or the other spouse as part of the settlement. Where that entity owns various assets, for example some operations and some investments, it is sometimes desired that one party to receive certain assets and the other receives the balance. Where the parties own two or more corporations, inter-corporate transfers can often be structured to occur on a tax-deferred basis, however this can be quite complex. All of this can normally be accomplished, albeit at a cost, with proper planning. The issues will vary depending on the corporate structure, involvement of the spouses, other family members and third-party shareholders; the assets and liabilities of the corporations themselves; and the desired division amongst the parties. As such, this area often requires considerable analysis and planning.
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It is commonly much more difficult, and sometimes not possible, if this planning and reorganization takes place after the issuance of the decree nisi. As well, these are often complex transactions which take some time to effect. Consequently, these matters must be dealt with well prior to the actual divorce decree.
To frame this overview of possible approaches, opportunities and challenges, consider the following fact pattern:
Clark and Lois are married shareholders in CL Inc. a CCPC (corporation) agreed to be worth $5 million. Their other assets have been valued at $2 million, for a total value of $7 million. Unfortunately, due to various irreconcilable differences, Clark and Lois have decided to part ways and have chosen their own lawyers to represent them in obtaining equitable share of personal and business assets. For now, we will set aside the personal component of the family wealth and concentrate on how Clark and Lois will be separating the business assets. The parties have engaged independent valuation, and both have concluded to the $7 million valuation for the corporation. The settlement agreement that has been concluded is for Clark to receive $500k of other assets and keep corporation; Lois is to receive $1.5 million of other assets and an equalization payment of $2 million. No tax considerations yet; that’s why the family law lawyer is coming to us.
As tax advisors, what are our options?
Buyout – no/minimal tax planning
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Does Lois need the cash right away or can the payment be settled over a period of time? If the cash is to be paid immediately, in the absence of any tax planning, Clark can borrow money from the bank or any willing lender and in order to do so, he has to demonstrate an ability to service the loan. The cost of borrowing will not be deductible as there is no income generating purpose to the money borrowed.
Alternatively, if there is enough capital in the corporation, Clark can borrow money from the business. However, when Clark withdraws $2 million from corporation to pay Lois, he will incur a shareholder debt for $2 million which if not paid by the end of the fiscal year of the corporation following the advance, will mean an income inclusion on the date the loan was advanced38 and a deduction when the loan is repaid.39 If the loan is repaid within that timeframe, Clark will be required to report deemed interest benefits40 for the period in which he is overdrawn. With recent increases to prescribed interest rates, this benefit is rising.41
It is likely Clark will have to cover the withdrawal with some form of corporate distribution. The tax cost may be mitigated depending on corporate tax attributes, as follows:
38 Section 15(2)
39 Paragraph 20(1)(j)
40 Section 80.4
41 Note that any benefit is deemed interest paid under Section 80.5, so an offsetting carrying charge may be available, on the same basis as deductibility of third-party interest
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i. If there is sufficient Capital Dividend Account in the corporation, Clark can use this to elect a tax-free capital dividend;42
ii. If the corporation has eligible or non-eligible Refundable Dividend Tax on Hand (RDTOH) pools then it could receive refunds up to these balances to mitigate the overall cashflow.
Dividends can be paid to Clark on his shares after the transfer. Alternatively, Lois could receive dividends on her shares, or deemed dividends if some or all of her shares are repurchased.43 If the tax cost of extracting the equalization payment has not been considered, this may be a significant impediment to finalizing the agreement between the parties.
Some further planning possibilities are discussed below.
a. Tax savings – Clark to Pipeline cash
A “pipeline transaction” could be considered to enable Clark (or Lois) to extract corporate cash as a capital gain, without access to the CGE. The mechanics of such a transaction are beyond the scope of this paper. The tax savings or accessing capital gains, rather than dividend, rates may be
42 Subsection 83(2)
43 Subsection 84(3)
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significant, however factors including the risk of CRA audits, professional costs etc. should also be considered. These issues are beyond the scope of the paper.44
b. Finance the buyout Lois’ shares personally – access deductions under subsection 20(1)(c)
An option to look in to is for Clark to borrow funds to purchase Lois shares – the cost of borrowing under these circumstances can avail of interest deductions under subsection 20(1)(c) since the shares that are purchased from Lois will be expected generate income. In order for a share purchase option to be implemented, both parties need to agree as part of the settlement agreement on the purchase plan and terms.
Subsection 20(1)(c) allows for cost of borrowing when the acquired property is used for income earning purposes. Therefore, when permissible, divorcing couples can avail of an ability to borrow monies to purchase shares or any other business property. This provision can be abused when mutually cooperating couples can sell and repurchase business property and benefit from interest deduction – this is something that the tax practitioner must convey to the divorce lawyers and the divorcing spouses. Continuing along the lines of borrowing funds to purchase certain capital property as part of the asset separation.
c. Lois disposes of her shares – rollover at cost or sale
44 For a more extensive discussion by the authors, see Shareholder Renumeration: Bonus, Dividend or Pipeline? – Balaji Katlai and Hugh Neilson, Tax for Owner Manager, Vol 22, Number 3, July 2022.
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Let us assume there could be a disruption from extraction of immediate cash from the corporation and since Lois wants to move on and end her participation in the business she is open to transferring her shares to Clark for consideration. Financing Lois’ $2 million cash settlement will likely be challenging without disruption to the corporation and in fact may not even be possible without business being hamstrung. Clearly, it does not appear that Clark can meet his end of the settlement without incurring significant costs. Is there an alternative which meets a tax deferral, savings or a combination of both – these factors are motivating transferring her shares?
In the following we discuss some of the concepts attached to share rollover, tax deferred or taxable transfer and repurchases from one of the spouses. As we see below, there are tax consequences – especially, taxes payable and the settlement agreement must address this in advance and the value of the taxes owing established.45
i. Section 73(1) – share transfer and alternatives:
In contrast to an application of subsection 69(1) (discussed later) which requires FMV, often it is common for spouses to consider an automatic rollover under subsection 73(1) and hence receive the asset at cost. However, if the transferor spouse elects out of this provision, then there is a disposition at FMV – and in certain cases, subsection 69(1)(c) needs to be revisited. The rollover
45 Often the tax liability cannot be ascertained in exactness, and it is important to stress this.
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provision applies only for capital property, and for depreciable property, the rollover will be at the UCC value. One caveat about transferring depreciable assets is to ensure that all assets in the given capital cost allowance (CCA) class is transferred else, this will result in a deemed disposition of the asset transferred and the recipient of the asset will report the amount as the cost basis. While subsection 73(1.1) applies for transfer of capital property following a legal transfer to a spouse its application ceases if the transferor spouse is dies prior to the transfer of the capital property – see CRA Views Doc 2016-0651721C6. This subsection also does not apply if the transferor spouse is not a resident of Canada at the time of transfer. If the property transferred is a stock option that was conferred to the transferee spouse, then in such a case, the option is deemed to be exercised and the gain is added to the ACB of the stock and the tax deferral is not available – see Views Doc No 2015-0572901I7.
At certain times a rollover of corporate shares and depending on the transferor’s tax situation it might be tax effective to elect out of subsection 73(1) and minimize the tax consequences at the time of transfer – usually the case when there is capital loss that can be used to offset the resulting capital gain. However, at the same time the transferee may choose to receive the shares at cost –
this will become a matter of settlement and it becomes an item that often tax accountants have to be mindful of. These often occur when both spouses want to access any potential capital losses46 or if the shares are expected to realize sufficient gains over future period and both the spouses are
46 If there is superficial loss existing subsection 40(2)(g) will deem it nil, since married couples are affiliated due to subsection 251.1.(1)(a) but this is no longer the case once the couples are legally divorced.
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competing to access their life-time capital gain exemption pursuant to subsection 110.6(1) or if there is a tax benefit due to lower marginal tax cost at the individual level (transferee). These factors also bring up other issues – will future tax on disposition be factored in as part of equalization process; or, what about potential long-term association of corporations within corporate groups that divorcing couples can be caught in unintentionally and also be subject to sharing small business deduction amounts.
When divorce is amicable, tax panning can structure any capital gain to access capital gain reserve pursuant to subsection 40(1)(a)(iii) and spread the income inclusion of the gain over a five-year period. Administratively, the seller of the shares or capital property has to be reminded of the tax and cash impact on each of those five years when there is a capital gain to be realized. A gain reserve is available only if the parties are Canadian resident taxpayer – so one must consider if at any future date before the five-year period, there is a possibility for emigrating from Canada. Further, the transaction must be at arms-length which can be at times challenging (see commentary under subsection 84(3) – share repurchase).
There is a time period before actual divorce and when negotiations are being considered – and planning must take in to affect any impact from income attribution due to subsection 74.1(1) if there a spousal rollover of shares has occurred prior to divorce. This provision will deem income or loss on property to be attributed back to the transferor while the benefits will be enjoyed by the transferee. The income here is capital, and ordinary income. However, subsection 74.5(3) provides for an exception when the couples are separated and living apart and jointly file an election under subsection 74.2. Often under these circumstances, divorce lawyers will ask for the transferor to be
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not responsible for any tax consequence should it be found that the conditions under subsection 74.5(3) is not met at a future date. Readers are also encouraged to refer to IT325R2 – Property transfers after divorce and annulment.
Finally, joint and several tax liability can apply when property is subject to section 74.1 or 74.2 the transferee is held liable for any taxes along with the transferor – pursuant to subsection 160(1)(e) and applies if the nature of the interaction, is not at arm’s length. A relief on this is subsection 160(4) is when parties are divorced or separated and, in such cases, the transferee will no longer be held liable. However, this does not exclude tax liability due to any transaction prior to the separation or divorce. Likewise, when ex-spouses continue to manage business operations post-divorce.
ii. Clark – share repurchase
it is also not uncommon when one of the couples (as shareholder) is allowed to draw funds from the corporation and use the funds to purchase business property of the same or a related corporation. In all such cases, this will result in the application of deemed dividend rules under subsection 84.1 and may throw a nasty surprise for the borrower. A similar consequence will be the case if funds are moved as part of tax-free intercorporate dividends between corporations that are jointly held by both married spouses and one of the purposes is to effect purchase of capital property by one of the connected corporations prior to a divorce. Note, that until married couples are divorced, subsection 184(2) and/or (4) will deem corporations held between the spouses to be connected. Overall, application of subsection 84.1 can be a “question of fact” and we also
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recommend – Steve Carreiro and Ryan Hoag, Marriage Breakdown and the Division of Corporate Wealth, 2012 British Columbia Canadian Tax Foundation Conference.
Even if there was buy-sell agreement between divorcing couples, factors of acting under duress, emotional stress, or influence from family members can taint the transaction from being a genuine arms-length transfer. This can be challenge when it comes to asset separation especially, when one of the transacting parties end up lot higher value which is otherwise not legally ratified – such as say, due to an equalization payment. These additional factors can throw a wrench on how the any buy-sell transactions between divorcing couples are handled.
Whenever, there is a deemed dividend or a dividend, it is a good practice for the tax accountant to ensure who is responsible for filing the year-end T5 slips and also discuss the costs associated to this. Finally, what if Clark and Lois could not work out an amicable settlement and the couple had concluded on the option for share redemption as part of an eventual winding up of the corporation jointly held by the spouses – if so, subsection 84(3) will not apply since subsection 84(2) will apply to the transaction – similarly, if there is an application of subsection 84.1 subsection 84(3) will not apply.
Canadian Tax Foundation, YP Focus Virtual Conference, September 7, 2022 6:37 d. Clark paying Lois dividends as part of settlement – does subsection 56(2) and 56(4) apply?
Continuing along the above lines, if a business split will mean putting the operations at risk, then, the courts can order alternative methods to equalize – one possibility is profit sharing for a fixed period of time; but the courts may not contemplate corporate attribution rules under subsection 56(2) and (4). Since any payments or transfer of property is made at the direction of one shareholder, benefit to be conferred to a specific person (here the divorced spouse) and any income paid would otherwise have been part of the individual’s income – clearly, conditions that can meet requirements under subsection 56(2). All of this is occurring when the recipient spouse is not even controlling the business property! Such factors must be included as part of equalization payments. However, subsection 56(4) will cease to exist to apply when the interaction is not at non-arm’s length – in all likelihood this does not apply when subsection 251(1)(a) is no more relevant, i.e., couples are divorced or separated and living apart. Regardless, one must still examine if the parties (after divorce) are still acting under separate mind and interests to ensure an arm’s length interaction.
e. Lois not an active participant in the business – TOSI
A remark on TOSI. Subsection 120.4 will apply to shares owned in private corporation and is intended to restrict distribution of corporate surplus to non-active family members and use any lower tax rates to affect ab overall income-splitting between related family members. But subsection 120.4(1.1)(e) TOSI will not apply for income that is attributed to spouses if throughout the calendar year were not married or common-law partners. Hence, there is no notion of a “source-
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individual” for the purposes of TOSI. Therefore, distributions from corporations to former spouse or common-law partner is not subject to TOSI. However, for a period when the couples are not divorced, in such a case, TOIS could apply leading to taxes at the top marginal rate. In practice, in almost all cases, couples who have been shareholders have had substantial participation in the business and TOSI may not be an issue since the shares held will likely be part of excluded shares under subsection 120.4. For further reading, please refer to Kyle Lamothe, TOSI on a Marriage Breakdown, Canadian Tax Highlights, July 2018.
f. Lois decides to leave Canada
A comment on withholding taxes – there are scenarios where one of the spouses after divorce or separation may choose to reside outside of Canada and in such cases, the arrangements prior to final signature of settlement documents must contemplate potential withholding taxes as well and the cash-flow constraints to the payor person and some cases may also require clearance certificates if there is a disposition of property.
In fact, any continued payments such as dividends from the corporation will be subject to the withholding taxes; but, on the other hand, TOSI will not apply for non-resident beneficiary – which could be a trade-off in terms of taxes to be paid.
Canadian Tax Foundation, YP Focus Virtual Conference, September 7, 2022 6:39 A. Clark and Lois – separation of business assets
What happens when both couples are participant in the business? It is not often the case where a division of a business can be straightforward and can also lead to squabbles over what is considered fair division. In several instances, it might be that a business cannot be separated without damaging the operation of the business – that means one of the spouses could get compensatory payments which if not planned properly can impact the overall financial stability of the underlying businesses. Let us discuss the various sections of the Act which needs to be discussed in the context of any divorce transaction.
Section 69 – Inadequate considerations
When two individuals who are married and in the process of a divorce, pursuant to subsection 251(1), the parties are still acting at non-arm’s length, even though they may be acting “separate” in minds and interest.47
Rules in subsection 69 deal with disposition of property if not at FMV. This can occur when there is a division of property and valuation is at question, especially, if an external professional valuator is not been used for whatever reason. Often in many circumstances where there is a transfer of properties at non-arm’s length transaction, a price adjustment should also be considered.48 Para a
47 See also Folio S1-F5-C1.
48 See Folio S4-F3-C1.
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of this subsection deals with value above FMV and para b deals with values below FMV – often these can occur when there is share transfer as part of a divisive transfer of assets/property. However, there is also a possibility where separating couples have assets which can be part of a gift or inheritance;49 in which case, it is essential that the disposition to the individual acquiring the property, the cost is at FMV – para c of this subsection. Also, one has to note that an application of subsection 69(1) can lead to double taxation which in a divorce context is likely the last thing one would like to encounter.
Note FMV is not defined in the Act. The guiding definition is as stated in in Henderson v MNR, [1973] CTC 636 at 644 (FCTD) (see para 21):
…” The statute does not define the expression “FMV,” but the expression has been defined in many different ways depending generally on the subject matter which the person seeking to define it had in mind. I do not think it necessary to attempt an exact definition of the expression as used in the statute other than to say that the words must be construed in accordance with the common understanding of them. That common understanding I take to mean the highest price an asset might reasonably be expected to bring if sold by the owner in the normal method applicable to the asset in question in the ordinary course of business in a market not exposed to any undue stresses and composed of willing buyers and sellers dealing at arm’s length and under no compulsion to buy or sell. I would add that the foregoing understanding as I have expressed it in a general way includes what I conceive to be the essential element which is an open and unrestricted market in
49 See IT-209R.
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which the price is hammered out between willing and informed buyers and sellers on the anvil of supply and demand. These definitions are equally applicable to “FMV” and “market value” and it is doubtful if the use of the word “fair” adds anything to the words “market value” …
Administratively, the CRA will consider property transfer between non-arm’s length parties (here divorcing spouses) in exchange for a nominal amount50 to recognize a gift for the purposes of subsection 69(1)(c). In Views Doc No 2018-0773301E5, the CRA states:
…” Paragraph 69(1)(c) … will apply where a taxpayer (the recipient) has acquired property by way of “gift, bequest or inheritance.” If paragraph 69(1)(c) applies, the recipient is deemed to acquire the property at FMV. The term “gift” is not defined in the Act and therefore assumes its common law meaning. In our view, a gift at common law is a voluntary transfer of property from a donor, where the donor freely disposes of the property to a donee, and the donee confers no right, privilege, material benefit, or advantage on the donor or on a person designated by the donor. [The common law meaning of a “gift” is discussed in the commentary to subsecs 248(30)– (41) under “Meaning of a “Gift” (subsec 248(30))”…
Note, in situations where subsection 69(1) is to be considered, one must also analyze for any shareholder benefits under subsection 15(1) which requires a shareholder (could be either of the spouse) to income inclusion that will be an amount or value of the benefit conferred on the shareholder on account of disposition of a property.
50 A nominal amount can be a $1 to represent that the agreement is legally binding.
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B. Related party Butterfly – Subsection 55(3)(a) – related party asset division
One of the advantages of this type of reorganization is the ability to defer taxes and further the separating couples can also have the option to keep controlling the business in the manner they choose to. A typical transaction will involve getting FMV of the assets to be transferred – often to a newly incorporated corporation, and subsequent cross-redemption of shares that is intended to set off the value of the assets being transferred. Since the transactions occur on a tax-deferred basis (usually via sequence of section 85 rollovers) there is no immediate taxes.
Although cross-redemptions will involve an application of subsection 55(2), subsection 55(3)(a) provides for an exception following a related party transaction – this applies as long as the assets are divided before the couples are not divorced.51 It is therefore important that all part of the transactions meet the related party criteria until the end of transaction – i.e., completion of the entire asset division –for an extensive discussion of divisive transaction and transfer of assets, we highly recommend the book, Understanding Section 55(2) and Butterfly Reorganization, 3rd Edition (2010) CCH – authored by Rick Mclean.
51 In the case of common-law couples, this timeline ends by 90 days of separate and living apart.
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One should not forget, even though certain provinces do not consider business assets for division, under certain circumstances, the provincial courts can exercise discretion to do so. An example could be where one of the spouses (even if not participating in the business) but has contributed capital either initially or at a later date can become eligible to a compensation due from a business. Such measures are exercised to achieve equitable transfer of matrimonial property. The rationale for this is establishing a so-called “resulting trust” in the business necessary to achieve an equity in property division. Consider a situation where the matrimonial home was used as a collateral to initial funding the family business – now at the time of matrimonial division, the value of division, that one of the spouses (say the non-participating) is 50 percent of an equitable share of the house and therefore 25 percent interest in the business. While a preservation of the business is required, the spouse entitlement is secured by a charge on the assets of the corporation until the interest is extinguished. This example demonstrates that in a matrimonial division of assets, business property can be attached as part of asset division – principally driving the concept of constructive trust doctrine – see also, the SCC decision on Rawluk vs. Rawluk, (1990), 65 DLR (4th) 161 (SCC).
C. Part IV circularity
Given a butterfly transaction involves cross redemption of shares without any transfer of cash – the deemed dividends pursuant to subsection 84(3)2 will not result in any part IV tax unless one of the connected corporations has a E or (NE)-RDTOH balance in which case, this will give rise to a part IV tax and a circularity of dividends paid to each of the connected corporations.
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Theoretically, part IV tax will occur without a breaker and the value saturates at 38.33% of the E or (NE)-RDTOH balance.52
There are a few approaches to avoid this circularity issue:
1. Ensure that all E or (NE)-RDTOH balances are cleared out prior to cross-redemption of shares in a 55(3)(a) transaction – this could be part of equalization payment; 2. Structure transaction such that payor is not connected to recipient but the recipient is connected to the payor – this can be achieved by falling off-side of subsection 184(2) and/or 184(4) for payor corporation. A simple approach is for the recipient to have 10% of votes but not value or vice-verse and in either case, the corporations are not connected. However, the recipient will be subject to any part IV tax and this needs to be clarified on this tax cost to the relevant spouse even if recoverable at a future date; 3. In situations where possible, the transaction can occur in different fiscal year end period, this will imply, the E or (NE)-RDTOH balances were not available at the end of the fiscal period – hence, there is no part IV taxes that arise from cross redemptions. This approach may not be suitable where the couples are separating as common-law due to the stringent time of 90 days, after which they are not considered as related party for the purposes of subsection 55(3)(a) type asset separation;
52 Of course, if both payer and recipient corporations have equal balances there is no part IV circularity.
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4. Incorporate a so-called “blocker” corporation and the appropriate amounts of corporate assets are transferred from the operating corporation. The logic in this approach is that the blocker corporation is new and there is no opening E or (NE)-RDTOH balances and has the flexibility to close its year-end without much consequences. In this situation, the blocker will redeem the shares that it issued received in consideration of the property from corporation and then immediately end its taxation year. The blocker will be deemed to have paid, in its first taxation year, a dividend to corporation but not be eligible for a dividend refund as there was no E or (NE)-RDTOH balances – hence, the corporation will not be subject to any subject to part IV tax on the receipt of dividend.
It is important to recognize that in many settlement agreements embed a transfer of RDTOH and General Rate Income Pool (GRIP) (where available) and if so, the circularity is a merely a compliance item to be addressed as part of filing the tax return.
D. Family Trusts and Association
Even after the assets are divided in a manner as agreed upon, the divorced individuals can be tied into a corporate relationship – especially, if there has been family trust set up and the couple are beneficiaries of the trust. Couples when married are not contemplating a divorce and as years progress and with a successful business in the works, it is not uncommon for an estate and trust planning. However, tragic divorce hits and life takes a new meaning – but, rules under subsection 256(1.2)(f)(ii) will not let the parting as simple. Tax practitioners are aware that all beneficiaries
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of a discretionary family trust have deemed ownership of any shares of a corporation owned by the discretionary trust. This provision can lead to association issues53—for example, when the beneficiaries establish their own individual corporation such as following a subsection 55(3)(a) transaction as discussed above. This deeming provision under subsection 256(1.2)(f)(ii) reads:
…”where a beneficiary’s share of the accumulating income or capital therefrom depends on the exercise by any person of, or the failure by any person to exercise, any discretionary power, those shares shall be deemed to be owned at that time by the beneficiary, except where subparagraph (i) applies and that time is before the distribution date..”
Even if either or both of the couple are not named beneficiary, but can become a beneficiary following certain contingent conditions, the CRA has taken a broader view on the notion of a beneficiary for the purposes of association rules.54 This follows the case ruling in Canada vs. Propep Inc. (2009 FCA 274), which states in obiter, a person should be regarded as a “beneficiary” throughout the Act even f that person was “beneficially interested” in the trust. As a consequence of this, one is forced to consider beneficially interested persons to be on the same footing as a
53 See for example Discretionary Trusts and Associated Corporations – Eric Hamelin, Tax for Owner Manager, July, 2018.
54 The Propep interpretation has been adopted by the CRA – see CRA document no. 2014- 0538021C6, October 10, 2014.
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named beneficiary — while this is a questionable approach to some tax practitioners, it is the administrative position.55
The complexity of including a trust is only exacerbated by Propep ruling which incidentally the only case that has addressed the association rules in the context of a beneficial interest. This is in contrast to association rules in section 256 that only deals with named and not beneficially interested persons.
E. Ancillary Corporate Issues
Who pays the costs?
Often, owner-managers undertake aggressive tax planning strategies. In a divorce context, it is important to consider who reaps the benefits, and who bears the tax risks. For example, if planning is undertaken to utilize Lois’ CGE on a post-divorce sale of shares from Lois to a holding corporation owned by Clark, reducing his tax cost to access $2 million of corporate equity, who bears the costs if CRA subsequently reassesses Lois? She might be assessed on the basis that Section 84.1 applies, and she was deemed to have received a dividend. Even on a transfer to Clark directly, the eligibility of the shares for the CGE could be challenged, or there may be an impediment to Lois claiming the full CGE.
55 See also, New Trust Disclosure Rules: Unfolding of the Propep Nightmare, Balaji (Bal) Katlai and Kate Harris, Tax for Owner Manager, October, 2020.
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Both tax risk and the costs of professional assistance to deal with CRA reviews should be considered. Further, if Clark bears all the risks, should the agreement permit him to decide the extent to which costs are incurred to support the tax strategy? If Clark bears all the risk, perhaps Lois simply accepts a reassessment with no objection. If Clark must pay the costs of any objection or appeal, or any tax assessment, it seems reasonable that he would decide whether to incur costs of further challenge (e.g. a Tax Court appeal) or to pay the tax assessed, and that Lois would cooperate with the process he decides to undertake.
Case law56 highlights this risk. The taxpayer, M, was required to pay support to his former spouse, G, and also to reimburse her for any taxes arising as a consequence of those support payments. In 2003, G was reassessed for 1996, 1997 and 2000 to include support payments previously not reported in her income, and M reimbursed her for these taxes. However, the 1996 and 1997 reassessments were issued well past the usual three year limit, and the 2000 support payments should not have been taxable under the post-April, 1997 child support rules. M therefore filed Notices of Appeal to the Tax Court.
Unfortunately, because the taxes were assessed to G, the Court found that M was without status to appeal, and he did not have G’s authorization to represent her. As a result, the Appeal was dismissed. Given the pace with which appeals before the courts progress, we would expect that it was far too late for G to launch an appeal by the time the Tax Court ruled.
56 Bourque vs. HMQ, 2004 TCC 404
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Where the payer agrees to reimburse the recipient for any taxes paid, the authors suggest that it would be prudent that the Agreement include a clause requiring the individual whose taxes are to be reimbursed to:
▪ Disclose all assessments or reassessments of tax to the payer on a timely basis (perhaps within 30 days of the date of assessment)
▪ File appropriate Notices of Objection and/or Appeals to any tax assessment or reassessment, as requested by the payer
▪ Pursue such appeals with due diligence, or authorize the payer to represent the recipient in such matters
It would also be wise for the agreement to address who will be responsible for the costs of any such appeals, as professional advice and representation before the Courts can be quite costly. As it is the payer who benefits if the recipient’s taxes are reduced, it is our experience that most such agreements require the payer to pay all costs incurred in challenging the taxes assessed against the support recipient. This is not invariable, however. Where the amount of support paid has been negotiated to share the tax savings to the payer, both parties are benefiting, and it may therefore be appropriate for the costs to be shared as well.
Ongoing filings
If Lois receives her equalization payment corporately, and now has a holding corporation, it is important to ensure she understands her ongoing recordkeeping and tax filing obligations.
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Depending on her involvement with the business and corporation historically, she may fully grasp these issues, however assuming this can be dangerous.
Salaries or Support?
Where corporations exist, there is often a temptation on the part of the payer of spousal support to simply pay salaries from the corporation, especially if both spouses were involved in the business, and took salaries in the past. However, Lois may have little to no involvement in the corporation, post separation. This is almost never a benefit, since such salaries attract CPP and possibly employment insurance (EI) premiums.
As well, CRA often questions such salaries and requests documentation of the work done for the corporation, its value, etc. In a worst case scenario, CRA could disallow the expense to the corporation, tax the amount as a shareholder benefit to the “payer” spouse, and leave it as taxable salary to the “recipient”: triple taxation! There is precedent for such reassessments (adding in penalty and interest costs)57
In addition, the payment of such salaries may provide an enhanced ability for Lois to claim against the company for benefits, notice, etc. Clearly a settlement agreement binding Clark to keep Lois on the payroll for some period post-divorce would indicate this was not a business decision.
57 See Hilderman vs. HMQ, 2020 TCC 58
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For all of these reasons, it is generally better for the corporation to pay a larger salary to the active shareholder, and then use this to fund the payment of spousal support. By their own administrative policies, CRA rarely questions the magnitude of bonuses to an active shareholder, and since the impact in all tax areas, including RRSP contribution room, is virtually identical, this is much the safer approach. Of course, the support payments must meet the normal definitions, discussed elsewhere in this paper.
Clearing Old Drawings
Another problem that occasionally arises in the corporate situation is the “surprise” T4 or T5. These are often received well after the fact, possibly after the settlement agreement has been finalized. Often the first the “recipient” knows about it is when CRA reassesses to include the amount in income! Interest is charged, and sometimes penalties. Needless to say, these result in accounting and legal costs disputing with CRA and the other party. Consequently, the settlement agreement should address whether any T4 or T5 slips will be prepared, their magnitude (including any taxes withheld), and the responsibility for the resulting taxes.
Another relatively common corporate issue relates to overdrawn shareholder loan accounts. It is not uncommon that in the normal course of events, the parties draw funds from their corporation and that these would have been “repaid” via the reporting of additional salaries or dividends. Post separation, this may no longer be feasible. As well, there may now be a dispute as to the validity of any charges to the loan account. The settlement agreement should therefore address these
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personal liabilities, including who will pay them back, who bears the tax if they are “repaid” by declaring taxable income items, and who pays any tax on the deemed interest benefit.58
As part of the settlement, the parties should likely release any claims they many have against any corporate entities, and vice versa.
Director Liability
Often, both spouses are directors in a corporation. As directors can be liable for unremitted source deductions59 and GST/HST60 (ignoring any non-tax implications under corporate law), ensuring a timely resignation which complies with the relevant corporate law is important to minimize this risk, and start the two-year period for the end of liability.61
Existing Tax Strategies
58 See Trower vs. HMQ, 2019 TCC 77, for an example of these issues,
59 Section 227.1
60 Excise Tax Act Section 325
61 See Zvilna vs. HMQ 2022 TCC 50 for an example of such an assessment subsequent to a relationship breakdown
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A detailed assessment of existing strategies is impractical, as every family adopts its own unique strategies due to their circumstances. As such, this paper can only provide a few brief words of advice.
Existing family strategies should be reviewed. Will they still be suitable after the divorce? Can they be used to fund matrimonial liabilities in a more tax-effective manner? Does the divorce place them at risk?
One of CRA’s most common sources of “tips” is disgruntled ex-spouses. Hopefully, both spouses understand that a CRA assessment of either party serves only to deplete the resources available to the family as a whole, regardless of whether the audit actually discovers any additional taxes payable. The wise professional may wish to remind them of this fact. If there are potentially contentious tax issues in the family history, an agreement that any reassessments, and costs of addressing CRA enquiries, will be shared may be prudent for the protection of the party who would otherwise bear the brunt of these costs.
SECTION 2: SPOUSAL AND CHILD SUPPORT
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Also commonly referred to as alimony and maintenance, such amounts may be taxable to the recipient62 and deductible to the payer.63 The provisions in this regard are virtually identical, such that if a payment is deductible to the payer, it is taxable to the recipient, and vice versa.
There has been a tremendous amount of litigation with respect to the tax treatment of various amounts paid and received as part of marriage settlements. Nearly all the judges making the decisions have taken a very restrictive view with regard to the meaning of the words in the various provisions, and it is clear that, unless marriage settlements are structured very carefully, there may well be some unfair, very punitive, and unexpected tax results. Adding to the confusion, in some cases the court decisions are not consistent.
Agreements or court orders can be submitted to CRA with Form T1158 to provide support for future support deductions claims in advance of the filing of the relevant tax returns. CRA commonly questions these claims.
Support Amount
The tax status of support payments is dependent on it being a “support amount.” This is a defined term,64 requiring payments to meet all of the following criteria:
62 Paragraph 56(1)(b)
63 Paragraph 60(b)
64 Subsections 56.1(4) and 60.1(4)
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• Payable or receivable on a periodic basis – lump sum payments do not qualify
• For maintenance of the recipient and/or children of the recipient (continuation of payments beyond the death of the recipient/children may indicate payments are disguised property settlements, and not for maintenance)
• Recipient has discretion as to the use of the funds
• Either:
o The recipient is the spouse or former spouse (including common law partner) of payer
o Parties live separate and apart
o By virtue of breakdown of their marriage, and
o Amount is receivable under a written agreement or court order
Or
o The payer is the natural payment of the recipient’s child, and
o Amount is receivable under a court order (note that a written agreement is not adequate)
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Payments made for the benefit of the recipient and/or the recipient’s children are deemed to be payable to, and receivable by, the recipient. Thus, if payments were required to be made to the recipient’s legal counsel or a provincial maintenance enforcement agency, rather than to the former spouse directly, the payments would still be taxable and deductible if the relevant criteria were met.65
These terms raise several issues which can cause unexpected results.
Periodic Payments/Allowance
While this requirement clearly precludes a single payment in lieu of ongoing support payments being taxable or deductible, the question of whether payments are “periodic” can be more complex. In a 1990 case.66 the Federal Court of Appeal (FCA) considered whether a series of five annual payments totaling $115,000 constituted a series of periodic payments made as an allowance, or were instalments of a lump sum. The Court set out several considerations that should be taken into account in this regard:
65 Subsections 56.1(1) and 60.1(1)
66 McKimmon vs. MNR, 1 FC 600, 44 DTC 6088, 1989 CanLII 8563; cited in the more recent case of Ross vs HMQ, 2018 TCC 215 which also reviewed a series of sporadic payments of support
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• The length of the periods at which the payments are made. Amounts which are paid weekly or monthly are fairly easily characterized as allowances for maintenance. Where the payments are at longer intervals, the matter becomes less clear. While it is not impossible, it would appear to be difficult to envisage payments made at intervals of greater than one year as being allowances for maintenance.
• The amount of the payments in relation to the income and living standards of both payor and recipient. Where a payment represents a very substantial portion of a taxpayer’s income or even exceeds it, it is difficult to view it as being an allowance for maintenance. On the other hand, where the payment is no greater than might be expected to be required to maintain the recipient’s standard of living, it is more likely to qualify as such an allowance.
• Whether the payments are to bear interest prior to their due date. It is more common to associate an obligation to pay interest with a lump-sum payable by instalments than it is with a true allowance for maintenance.
• Whether the amounts envisaged can be paid by anticipation at the option of the payor or can be accelerated as a penalty at the option of the recipient in the event of default. Prepayment and acceleration provisions are commonly associated with obligations to pay capital sums and would not normally be associated with an allowance for maintenance.
• Whether the payments allow a significant degree of capital accumulation by the recipient. Clearly not every capital payment is excluded from an allowance for maintenance:
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common experience indicates that such things as life insurance premiums and blended monthly mortgage payments, while they allow an accumulation of capital over time, are a normal expense of living which are paid from income and can properly form part of an allowance for maintenance. On the other hand, an allowance for maintenance should not allow the accumulation, over a short period, of a significant pool of capital.
• Whether the payments are stipulated to continue for an indefinite period or whether they are for a fixed term. An allowance for maintenance will more commonly provide for its continuance either for an indefinite period or to some event (such as, the coming of age of a child) which will cause a material change in the needs of the recipient. Sums payable over a fixed term, on the other hand, may be more readily seen as being of a capital nature.
• Whether the agreed payments can be assigned and whether the obligation to pay survives the lifetime of either the payor or the recipient. An allowance for maintenance is normally personal to the recipient and is therefore unassignable and terminates at death. A lump or capital sum, on the other hand, will normally form part of the estate of the recipient, is assignable and will survive him.
• Whether the payments purport to release the payor from any future obligations to pay maintenance. Where there is such a release, it is easier to view the payments as being the commutation or purchase of the capital price of an allowance for maintenance.
Discretion of Recipient
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The recipient of the funds must have discretion as to the use of the funds. For example, if the parties agreed that one spouse would pay the other’s grocery bills, the recipient would not have discretion as to the use of the funds – they are required to be used to purchase groceries – and the payments are therefore not taxable or deductible. However, it is possible to make such payments fall within the tax regime. Payments will be deemed payable and receivable on a periodic basis, and the recipient will be deemed to have discretion as to their use, where they meet all of the following criteria:67
• Paid in respect of an expense for the maintenance of the recipient and/or the recipient’s children
o Not for acquisition of tangible property other than property related to education or medical expenses
o Not payments in respect of acquisition or improvement of the recipient’s residence, including mortgage or loan payments, in excess of 1/5 annually of the original principal amount
• Incurred in the year or the preceding year
• The order or agreement provides that Subsections 56.1(2) and 60.1(2) of the Act will apply to the payments
67 Subsections 56.1(2) and 60.1(2)
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Such payments can therefore be taxable or deductible provided they meet all of the other relevant criteria. In some cases,68 the Courts have permitted these provisions to apply despite the fact that the relevant sections were not explicitly referred to in the agreement or order. It was clear from the context that the parties expected that these amounts would be taxable to the recipient and deductible to the payer. In another case,69 the agreement was silent, and the taxpayer was not allowed to deduct these payments.
In a third case,70 the agreement was silent with respect to the taxability of house payments. The Court held that 56.1(2) therefore did not apply, but went on to conclude that the amounts were nonetheless within the terms of 56(1)(b) as Ms. Carmichael:
“had a discretion with respect to the house expenses referred to in paragraph 6 of the Order; and she exercised that discretion by constituting her husband her agent to pay on her behalf all house expenses.”
Consequently, in this fact scenario, Ms. Carmichael was taxable on the amounts paid directly for house expenses, despite the absence of any reference to the specific provisions.
68 For example, Veilleaux vs. HMQ, 2002 FCA 201
69 Grainger vs. HMQ, 2003 TCC 130
70 Carmichael vs. HMQ, 2003 TCC 379
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In an abundance of caution, we suggest that any agreement not only indicate that subsections 56.1(2) and 60.1(2) of the Act are to apply to the payments, but also explicitly state the parties’ understanding that this will result in these payments being taxable to the recipient and deductible to the payer. This then clearly meets the legislative requirements, and it is clear that taxability/deductibility was the result desired by the parties.
Written Agreement or Court Order
It is not uncommon for support to be paid from separation until a written agreement is prepared. As such payments are not made under a written agreement, they would generally not be taxable or deductible. However, where a later agreement or order provides that an amount received and paid previously is to be considered paid and received under the agreement or order, the amounts will be deemed paid and received thereunder, such that they can be taxable and deductible.71 The payments must have been made in the calendar year of the later order or agreement, or the immediately preceding taxation year.
For example, assume Susan has paid $500 per month in support to Ron since they separated in July, 2022. To make the 2022 payments deductible to Susan, and taxable to Ron, they must enter an appropriate agreement (or a Court must order) no later than December 31, 2023.
Spouse or Former Spouse
71 Subsections 56.1(3) and 60.1(3)
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The requirement that payments be received by a spouse or former spouse can create issues. If the spousal support obligation continues beyond the payer’s death (e.g. payments continue throughout the recipient’s life, and must be made by the Estate), the payer is no longer a former spouse of the recipient, and the payments are neither taxable to the recipient nor deductible to the Estate. The payer is now using after tax dollars to discharge an obligation that was calculated on a pre-tax basis, and the recipient is no longer required to pay the taxes that had originally been anticipated. If this is of concern, the settlement agreement could contemplate a reduction to the support amount if it becomes non-deductible/non-taxable.
Some historical issues related to parties whose common-law relationship ended prior to such relationships being recognized as “spouses” for income tax purposes, raising the question of whether they were “former spouses.” As the most recent amendment in this regard was in 2000, when provisions in existence since 1993 were expanded to include same-sex partners, this is a historical issue now. Similarly, since child support is neither taxable nor deductible under agreements subsequent to April, 1997, changes in custody arrangements no longer impact deductibility.
Amount Taxable/Deductible
The amount of support included in (or deducted from) income is computed as the total of all “support amounts” (as discussed above) received after 1996 and prior to the end of the year, less the total of all “child support amounts” (another defined term, discussed below, but primarily
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relevant to post April 30, 1997 agreements or orders) receivable during that period under an agreement or order after its “commencement day” (yet another defined term, also discussed below), and less all amounts included in (deductible from) income in a previous year.72 Where support payments are repaid, the income inclusion (or deduction) previously reported is reversed.73
This generally results in spousal support being taxable and deductible, but child support falling outside the tax system. Note, however, that the phrasing of the rules results in child support payments being deemed to be paid prior to spousal support payments where the actual payments fall short of the combined amounts due. The parties cannot agree or designate that spousal support is paid first, as the law effectively deems this not to be the case.
The formulaic nature of the provisions can have unexpected results. For example, if Clark were required to pay monthly support of $5,000 to Lois, of which $3,000 is spousal and $2,000 is child support, this would result in a $36,000 annual deduction (and income of $36,000 to Lois). However, if Clark encountered financial difficulty, and failed to make the September – December payments, he might expect a $24,000 deduction would be available.
He would be incorrect. The legislation would allow the total paid in the year (8 x $5,000 = $40,000) less the child support payable in the year ($2,000 x 12 = $24,000) for a deduction of only $16,000.
72 Paragraphs 56(1)(b) and 60(b)
73 Paragraphs 56(1)(c.2) and 60(c.2)
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It will not surprise the reader that the tax rules are not optional. However, in some cases, family courts believe they can be overridden. One example dealing with support issues74 serves as a reminder of the significance of income tax in ensuring a support recipient is provided with sufficient funds to maintain an appropriate lifestyle. The taxpayer was awarded support of $5,000 per month by the provincial Court. In its reasons, there was no indication that the taxes which would be payable on this support were considered, and the budgeted expenses on which support was based did not include any amount for income taxes.
Before the Tax Court, the taxpayer argued both charter issues, and that the taxation of her support would result in an economic result not intended by the provincial Court, such that her support was consequently not received “pursuant” to that Court’s Order. Although accepting that the Court “may not have considered the tax liability in question,” this did not change the fact that her support was properly taxable under tax law.
The Courts have historically held that the tax provisions cannot be varied by agreement between taxpayers, nor by orders of other courts. As such, it is critical for support agreements and orders to consider the income tax ramifications to the parties. Where such consideration was not undertaken, the parties cannot look to the Tax Court for relief. Their only viable options are to re
open the support issue, either between themselves or before the family law courts, or to seek 74 Bailey vs. HMQ, 2004 TCC 98
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compensation from legal counsel who failed to advise them, or the trial judge, of the income tax consequences of their support receipts.
Child Support Amount
As noted above, child support amounts are neither taxable nor deductible. A child support amount is any support amount which is not identified in the agreement or order as being solely for the support of the recipient. Note that, where payments are not so specified, they will be neither taxable nor deductible.75
The tax rules related to child support were amended effective in 1997. Prior to that time, child support was taxable on a similar basis to spousal support. Fortunately, with the passage of time, pre-May, 1997 child support agreements and orders have become uncommon, rendering the transitional rules beyond the scope of this paper.
Payments in Arrears
Settlement of payments in arrears remains taxable and deductible as the payments were still payable on a periodic basis. However, where an agreement is reached to pay a lump sum in settlement of all arrears and/or future obligations (rather than simply paying the accrued arrears), this payment is made in lieu of the periodic payments under the agreement or order. Historically,
75 Subsections 56.1(4) and 60.1(4)
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this was accepted as being non-taxable/non-deductible. In practice, this was often an unclear differentiation.
To be deductible to the payer, and taxable to the recipient, support payments must be payable or receivable both “on a periodic basis” and “under an order of a competent tribunal or under a written agreement.” The Tax Courts have historically held that, even when payments fall into arrears and are later paid as a lump sum, they were still payable on a periodic basis under an order or agreement, and as such have held that such amounts are still taxable when received.
However, they have also held, in a long line of cases76 that payments made in lieu of obligations under support agreements or orders, such as lump sums which are significantly different from the aggregate payments in arrears, are not paid under the order or agreement, and are consequently neither taxable nor deductible. Similarly, the Tax Courts have consistently held that payments to release a support payer from any future support obligation are neither taxable nor deductible.
While largely consistent with later jurisprudence, in February, 2005, the Supreme Court of Canada (SCC) issued a ruling77 on disability insurance, which is also taxable only where payments are periodic. The SCC held that the portion of the payment allocated to future obligations was clearly not taxable, as it was not payable pursuant to the insurance plan, nor was it payable on a periodic basis. This is consistent with the jurisprudence regarding lump sum payments to eliminate future
76 See MNR vs. Armstrong. 1956 CanLII 71, a SCC decision
77 Tsiapailis vs. Canada, 2005 SCC 8
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support obligations. However, the Court also held (in a 4-3 split decision) that the portion of the settlement intended to compensate for arrears payments was taxable, despite the fact that it was significantly less than the accumulated arrears under the policy.
In its response to a question posed at a Round Table with the Alberta Institute of Chartered Accountants,78 CRA indicated that the Tsiaprailis decision did not change their position in respect of a lump sum support payment. The writers are not aware of any challenge to this position being addressed by the Tax Courts to date.
Retroactive Lump Sum Payments
In general, individuals are taxable on income in the year they receive it. In some cases, this can be disadvantageous, especially when large amounts related to previous years are received all in one year. Commonly, a portion of such income is taxable at rates much higher than would have been the case had the funds been received in the years to which they relate. In respect of certain receipts of this nature, it is possible to elect that the income be taxed as if it had been received in the year(s) to which it relates, including an interest factor based on when the taxes would have been payable. When such an election is filed, CRA computes the taxes payable normally. They then compare this amount to the total taxes that would have been payable if the income had been reported in the
78 CRA document 2005-0139731C6; this referenced Interpretation Bulletin IT-530R, since transitioned into Income Tax Folio S1-F3-C3
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years the payments related to (plus the interest factor). The lesser amount is assessed as the final taxes payable.
Taxable support payments are eligible for such treatment provided they meet the following criteria:79
• Not deducted under certain other provisions in computing taxable income • Related to years after 1977 during which the recipient was resident in Canada (years in which the taxpayer was non-resident, which include or predate bankruptcy, or which were part of a block averaging period for a farmer prior to 1988 cannot be included) • Amounts related to years prior to the year of receipt and after 1977 exceed $3,000
Since CRA will assess the lower of the two tax amounts, if the relevant conditions are met it is always prudent to file this election. The prescribed form under which such an election is requested, Form T1198, includes a signature line for certification by the payer of the income. However, nothing in the legislation requires such certification. In our experience, even though the election has no impact on the payer, obtaining certification is often difficult, and a copy of the agreement or order under which payment was made is generally more practical. However, if the election can be obtained at the time of finalizing the settlement agreement, this could avoid a CRA query with respect to a missing signature.
79 Sections 110.2 and 120.31
Canadian Tax Foundation, YP Focus Virtual Conference, September 7, 2022 6:69 No similar option exists for the payer – the deduction may be claimed only in the year of payment. Payment of Former Spouse’s Taxes
In some cases, agreements or orders require the payer of support to reimburse the recipient for any income taxes paid on that support. This is, in many cases, a reasonable mechanism for ensuring that desired after-tax amounts are, in fact, received by the support recipient, while potentially reducing the overall tax burden on the parties. However, case law80 highlights a risk in such agreements, and in other situations where one party assumes responsibility for the other’s tax risks, as discussed earlier in the paper.
CRA Verifications and Enforcement
CRA appears to actively review deductions for support payments. They generally require copies of agreements or orders to confirm support was, in fact, payable, as well as copies of cancelled cheques to prove payment has been made. Where payments were not made by cheque (such as cash or electronic transfers), proving payments were made can be difficult. CRA will normally accept a signed confirmation from the recipient, but the ease of obtaining such a document depends on the parties’ relationship at that time. Assuming they allow the deduction, they then normally trace the payments to the recipient to ensure they were reported. This sometimes results in a renewed conflict between the parties where the payer has deducted amounts the recipient believes
80 Bourque vs. HMQ, 2004 TCC 404
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are not taxable. Where all matters were clarified in the settlement agreement, such conflicts should be, if not eliminated, at least significantly reduced.
SECTION 3: TAX ISSUES RELATED TO CHILDREN OF THE MARRIAGE Eligible Dependant Amount
This credit is identical in amount to the married credit and can provide a considerable income tax benefit, especially when the child claimed has little or no income.81 It is available to a taxpayer who, at some time in the year, meets each of the following conditions:
• Is either unmarried or lives separate and apart from his or her spouse due to breakdown of their marriage.
• Maintains a self-contained domestic establishment (i.e. a residence)
• Supports, in that residence, a person who is:
o Resident in Canada or a child of the taxpayer
o Wholly dependent on the taxpayer (alone or with other persons) for support o Related to the taxpayer
o Is either dependent by reason of infirmity, is under 18 or is a parent or grandparent of the taxpayer
81 Paragraph 118(1)(b)
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Where a marriage breaks down, this credit is potentially available in respect of a child in the year of separation. There is no requirement that all of the above criteria be met simultaneously. For example, an individual could maintain a residence and support a child therein from January 1 to June 30, then leave the household and live separate and apart. The first test is met from July 1 onward, and the others until June 30, so a claim could be made by this individual.
However, only one person may claim any one dependent, and only one claim is possible per “self contained domestic establishment.”82 As such, in the above example, only one parent could receive a claim assuming that the departing spouse did not establish a second residence, and support at least one of the children there during the year. Theoretically, this limitation also applies if two unrelated single parents share a home. If it is considered to be one “self-contained domestic establishment,” even though both parents would otherwise meet the tests, only one ESA can be claimed.
As well, this tax credit is denied to a parent required to make support payments for a child where either the spouse or common-law partners/parents are separated for the entire year, or where these support payments are deducted.83
While this may make sense where only one spouse has custody, this final requirement had the potential to cause significant difficulty in the case of shared custody, especially if the settlement
82 Subsection 118(4)
83 Subsection 118(5)
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agreement is not properly drafted. However, the legislation was amended in 2007 to provide that this restriction could not result in the claim being unavailable to any person.84
This provision has caused further challenges, as it applies where each parent is required to pay support for the child to the other parent. The Courts have held85 that the determination of child support based on the support each party would pay if they had sole custody (under the Federal Child Support Guidelines) does not mean each parent is required to pay support. Other cases have examined various orders and agreements. CRA addresses the issue in their Folio on support payments86 and has assessed the issue from the perspective of several cases in a 2019 Technical Interpretation.87
One of the writers had the recent experience of bringing this document to the attention of an Appeals Officer who, on review, concluded that the taxpayer’s claim was appropriate based on an agreement which clearly spelled out the support payments required by each spouse, and their setting off into a single monthly payment. Other practitioners have related similar anecdotes, and cases where such claims were denied.
Where both parents could potentially advance a claim, this matter should be addressed so that the parties know what is, or is not, going to be available with respect to the eligible dependent amount.
84 Subsection 118(5.1)
85 See Verones vs. HMQ, 2013 FCA 69
86 Folio S1-F3-C3
87 2019-0818101I7
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This significant payment for children88 is payable to the primary caregiver. Where the parents are “shared-custody parents”89 (generally requiring the child spend at least 40% of their time in the custody of each parent), the benefit is split between them. This status can vary month to month. In a recent case,90 school closures due to COVID-19 changed the percentages, and the status of the parents.
Other credits for children are shared on similar terms.
Child Care Costs
Child care costs can be deducted,91 within certain limitations (which are not discussed in this paper), if these costs are incurred in order to earn income (whether wages or self-employment), or attend school.
In the case of shared custody cases, each party can claim costs incurred that otherwise meet the requirements, irrespective of the amount claimed by the other spouse.
88 Sections 122.6 through 122.64
89 Defined in Section 122.61
90 Friesen vs. HMQ, 2022 TCC 53
91 Section 63
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Where only one parent has custody, child care costs paid by the non-custodial parent may not be claimed by anyone. While it is possible to include such payments in the income of the custodial parent through the third party payment procedures noted earlier, this does not allow the recipient to deduct the costs. Consequently, any settlement agreement should take this into consideration.
SECTION 4: LEGAL FEES RELATED TO SUPPORT
Recipient
There are no specific provisions allowing deduction of legal fees related to support. However, over the years, considerable common law has evolved in this regard, permitting an individual to deduct legal costs incurred to enforce or defend an existing right to support. As current Federal child support legislation provides a right to child support, CRA has indicated that the costs of obtaining such child support (including obtaining an agreement or court order) is deductible, despite the fact that child support is not taxable. Further, the courts have determined that Federal divorce legislation provides a pre-existing right to spousal support. Based on this decision, CRA has reached a similar conclusion in respect of legal costs related to spousal support.
CRA has indicated that they believe the deduction for legal fee is properly claimed on the accrual basis; although they commonly allow it on the paid basis as well. As there is no requirement that the support reported exceed the legal fees incurred, they would appropriately be claimed in the year incurred, even if no support has yet been received.
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CRA considers the costs of obtaining an increase in support, or converting taxable child support to non-taxable support, to be non-deductible. These interpretations have not been tested before the courts. However, CRA’s conclusion that legal fees related to non-taxable child support are deductible also has never been tested. Legal fees related to a lump sum (which would not be a support amount) are not deductible.
CRA sets out their views in their Folio92 on support payments (paragraphs 3.81 to 3.84). CRA Verifications and Enforcement
While CRA accepts that these costs are deductible, it is our experience that they require considerable documentation to support the deductions claimed. Individuals claiming such a deduction may therefore rest assured that the CRA will require supporting documentation. Although it would be prudent to obtain copies of the legal invoices, this is usually not sufficient to determine the allowable deduction. Fees related to support, for example, tend to be blended with other divorce-related costs such as property division and child custody, as well as obtaining the divorce itself. Appropriate correspondence from the taxpayer’s legal counsel is therefore extremely helpful in supporting such claims. Many lawyers provide their clients with a summary of legal costs incurred in the year and/or a breakdown of these costs, in dollar or percentage terms, between the various issues. For example, a letter specifying that the taxpayer paid $20,000 of fees in 2005, of which 5% related to obtaining the divorce, 20% to custody matters, 25% to property
92 Income Tax Folio S1-F3-C3
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settlement, 30% to spousal support and 20% to child support would indicate the individual is entitled to a $10,000 deduction (the portion of payments related to support). This is useful both in the tax filing process, and the subsequent questioning by CRA.
In addition to this, CRA often requests additional documentation, including copies of related court orders and/or support agreements. In our experience, they are reviewing these carefully to determine whether or not the allocation is reasonable (Were the support issues complex enough to support the lawyer’s cost allocation? Is the overall allocation reasonable given the issues ultimately before the courts, or resolved by agreement?) They also look for reimbursements of legal fees by the other party, which would reverse a commensurate portion of the deduction available to the original payer of the fees. Where there is to be a reimbursement of fees, it may be worthwhile negotiating (and then specifying) that it relates to those areas that do not provide a tax deduction. There is no financial advantage or disadvantage to the payer in this regard, since the payer’s legal costs are never deductible.
We have, however, encountered one issue where CRA’s interpretations cause a concern. Some lawyers indicate a portion of costs related to “spousal/child support.” In this case, because spousal support was awarded but child support seemed not to be at issue, they assumed that only half of the amount described by legal counsel as being in respect of “spousal/child support” was deductible. The reader may rest assured that this was corrected by a CRA Appeals officer.
Payer
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While legal fees incurred in establishing a right to child or spousal support are generally deductible for income tax purposes, this applies only to support recipients. As the support payer will never have a source of income related to any legal fees, the costs incurred by a payer of support have never been accepted as a valid deduction before the Tax Courts.
This position was affirmed in a 2003 FCA decision,93 denying costs of $4,284 in defending against an application for increased spousal and child support, which the taxpayer won. The FCA refused to allow a deduction, consistent with the historical case law. In obiter the Court also discussed the deductibility of costs incurred by support recipients. The Court felt that, as this regime has been accepted by the CRA, in one form or another, for over 40 years (in the words of the Court), it would be reasonable to expect legislation to have changed if this were not the intention of Parliament. Consequently, the Court was of the opinion that the deduction of legal fees incurred by recipients of spousal and child support is correct case law, and is consistent with the intentions of Parliament.
SECTION 5: NON-RESIDENTS OF CANADA
Many provisions of the Act require parties be Canadian residents, and the discussion above assumes both spouses are residents of Canada for income tax purposes. If one or both spouses are non-residents of Canada, it is important to review whether the income tax provisions we often take for granted are modified, or even rendered inapplicable. Some issues which can arise in a matrimonial breakdown include the following:
93 Nadeau vs. MNR, 2003 FCA 400
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(a) No Canadian tax is imposed on support payments made by a resident of Canada to a non-resident recipient of such payments. The Canadian payor is still permitted to claim a deduction, provided the criteria set out earlier in this paper are met.
(b) Where the recipient of support is a resident of Canada, the residence of the payor is irrelevant to the income tax results. This can be problematic where support from a foreign jurisdiction was set on the belief it would not be taxable to the recipient.
(c) Where either party is not resident in Canada, or this is likely in the future, the spousal support rules for the other country should be considered. If the payer will be a resident of a country which does not allow any deduction for spousal support, it may be desirable to structure the spousal support such that it is not taxable to the recipient. A more common, case exists where one party lives in Canada and the other is in the US. Although the US and Canadian rules are very similar with respect to spousal support, US law allows the parties to elect out of the taxable/deductible structure, by making the appropriate election. Where spousal support paid by a Canadian resident to a US resident can be structured to meet the Canadian criteria for deductibility, and elected top fall outside the tax regime in the US, a considerable windfall for the couple is available.
(d) Where either party is a non-resident of Canada, the usual default rule that capital property is deemed to pass between spouses or former spouses at income tax cost does
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not apply.94 As such, it is not possible to transfer capital assets between the parties on a tax-deferred basis. This can result in property equalizations triggering substantial income tax consequences, even where the underlying property is not disposed of.
(e) The acquisition of “taxable Canadian property” from a non-resident of Canada typically requires the purchaser either receive a certificate from the CRA that all applicable taxes have been remitted, or withhold a portion of the transfer price and remit this on account of the transferor’s income taxes.95 Disclosure of the transfer to the CRA is also required, The fact that the transfer is not undertaken for cash does not alleviate this requirement.
(f) The provisions allowing for transfer of RRSP’s, TSFAs and similar assets do not require either party be a Canadian resident, so these rules are unchanged.
(g) Non-residents are typically not entitled to many of the tax credits available to residents, or to benefits such as the Canada Child Tax Benefit.
In any situation where non-residents are involved, the provisions of any Tax Treaty between Canada and the country of residence should be considered. As well, tax advice should be obtained regarding the tax rules in that foreign country. It is impossible to address the possibilities in this
94 Subsection 73(1)
95 Section 116
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paper, however it is important to be alert for situations where double taxation could result (for example, an asset transfer attracts Canadian tax, but does not increase its tax cost in the foreign country, or support is taxable to the recipient, but not deductible to the payer, based on the two countries’ laws). In some cases, it may be possible to achieve the a positive result – for example, if support can be structured to be deductible to the payer in their country of residence, but non
taxable to the recipient in their country of residence.
International taxation is complex at the best of times. Adding in the rules for marriage breakdowns only adds to the risks and complexities.
Conclusion
The number of issues affecting both family law practitioners and their advisors are legion, and income tax matters do not make it any easier.
Whenever tax matters arise in the context of Family Law matters, it is ideal if the expected tax results are explicitly noted, so that there are minimal surprises. Either in the main agreement, or in a separate document, it is advisable to specify matters such as:
♦ Spousal support will (or will not) be taxable to the recipient and deductible to the payer ♦ Third party payments will (or will not) be taxable/deductible
♦ The recipient of assets (including RRSPs) will bear all future income tax and related costs. ♦ The owner of the corporation will bear all taxes and none will attribute to the spouse