Planning to gift non-registered assets to your spouse or family member? Find out income tax attribution rules and how to do it in a tax-efficient way.
“What’s the best way of gifting assets to my family?” is one of the topics the Invesco Tax & Estate InfoService most frequently discusses with advisors. There is no doubt that everyone wants to take care of their loved ones, ideally in a tax-efficient way with minimal uncertainties. Sometimes a “simple” strategy on its face could give rise to unintended consequences.
This series of blog posts discusses the tax and non-tax considerations on two common ways of benefiting family members with non-registered assets – creating a joint ownership and providing an outright gift during lifetime.
Income tax considerations – Gifts to spouse or common-law partner
Automatic spousal rollover
The default rule under Canadian tax law is that spouses are allowed to transfer capital property between them on a tax-deferred basis (commonly referred to as the “spousal rollover” rule), including during the lifetime of the spouses or upon the death of one spouse. Common-law partners enjoy the same treatment for income tax purposes. Our discussion below will use the term “spouse” to include both legally married spouses and common-law partners.
When an individual acquires ownership rights from his or her spouse, either as a joint owner or through a complete transfer of ownership, the transfer automatically happens at the transferring spouse’s adjusted cost basis (ACB) without a taxable disposition.
For depreciable capital properties, the transfer happens at the undepreciated capital cost. However, the spouses have an option to elect out of the spousal rollover rule and transfer the property at fair market value (FMV), deliberately creating a taxable disposition.
The resulting capital gain or loss from the transfer is generally taxed to the transferring spouse. To make the election, spouses should attach a letter with their tax returns to the Canada Revenue Agency (CRA), indicating the property is being transferred between spouses at its FMV and that they do not want subsection 73(1) of the Income Tax Act (ITA) to apply – this is the section of the ITA that permits the automatic rollover of the property between spouses at the property’s ACB.
The option of triggering an immediate capital gain may be appealing when the transferring spouse has unused capital losses to offset the resulting taxable capital gains, with an effect of “bumping up” the ACB in the receiving spouse’s hands and thereby reducing future capital gains for that property. Note that a transfer at the FMV to trigger a capital loss will likely be caught under the superficial loss rules. (Please refer to our Tax & Estate InfoPage, Capital Loss Planning for more details on the superficial loss rules.) Another reason to elect out of the automatic spousal rollover could be to avoid the spousal income attribution rules, discussed below.
Income attribution rules
Income attribution rules apply to the direct and indirect transfer of assets between spouses where there is no consideration given for the transferred property.
The rules aim to prevent income splitting between spouses by transferring assets from a higher-income spouse to a lower-income spouse with an intention to tax the income and capital gains generated from the asset at a lower tax rate.
Generally, the rules operate to put the transferring spouse in the same tax position as if the transfer had not happened. Therefore, when spouses transfer assets between themselves, the income and capital gain generated from such transferred assets are attributed back to the transferring spouse for income tax purposes.
Certain exceptions apply, such as if the transferring spouse is a non-resident of Canada, deceased, or separated or divorced from the receiving spouse. (Caveat: capital gains are still subject to attribution during separation unless a joint election is filed by both spouses.)
Spousal attribution also applies when the spouses own the account equally (i.e., each spouse has an equal right to enjoy the property) but contributed unequal amounts to the account. In that case, despite the equal beneficial ownership, spouses generally pay tax based on the proportion of their respective contributions.
For example, if a husband contributes 70% of capital and the wife contributes 30% of capital to a joint account owned by both of them, any income or capital gains generated on the assets in the account would be taxed 70% to the husband and 30% to the wife. It is the responsibility of the individuals to keep track of their contributions to support their income filing.
How to avoid the income attribution rules
To avoid the income attribution rules, the following must occur:
- the transferring spouse must elect out of the spousal rollover (i.e., choose to transfer the asset at the FMV); and
- the receiving spouse provides FMV consideration back to the transferring spouse.
The consideration for the transferred property can be cash or non-cash assets, such as jewelry or some other tangible property, which should be of equal value to the gift received.
Alternatively, consideration can be in the form of an interest-bearing loan between the spouses. The minimum required interest rate of the loan is the CRA’s prescribed interest rate at the time the loan is entered into and can remain the same for the rest of the loan duration. As of May 2021, the prescribed rate is 1%.
To avoid income attribution, the interest must be paid within 30 days after the end of the calendar in which the loan takes place, and every subsequent year. The transferring spouse must report such interest payments as interest income on his or her income tax return. Violation of these terms will trigger the income attribution rules for all future years.
For more information on income attribution rules and income splitting strategies, please refer to our Tax & Estate InfoPage, Income-splitting opportunities and the income attribution rules that may prevent them.
Bob and Nancy are married. Nancy is a high-income earner and accumulated some non-registered assets under her own name. She wishes to gift half to Bob, so Bob can share the tax burden on income generated on these assets since Bob is in a lower tax bracket. She adds Bob on her Invesco non-registered account worth $600,000. Her ACB is $200,000.
Nancy is gifting Bob 50 percent of her account. Under the spousal rollover rule, the transfer to the joint account would occur at ACB by default, without triggering any immediate capital gains to Nancy. However, the income attribution rules attribute the income earned on Bob’s 50 percent share of the account back to Nancy. This means Nancy will continue to pay taxes on income generated on the entire account. The income attribution would only cease if Nancy dies, becomes a non-resident, or if they have a relationship breakdown.
To avoid the income attribution rules, Nancy can elect to transfer her property into a joint account with Bob at FMV. Nancy is deemed to have disposed of 50 percent of the account and is responsible for paying taxes on the resulting capital gain in the year of transfer.
In return for the gift, Bob can give $300,000 worth of assets back to Nancy as consideration. If he does not have sufficient cash or non-cash assets, they can arrange to treat the $300,000 Bob receives as an interest-bearing loan from Nancy to Bob, at the CRA prescribed interest rate (currently 1%). Every year after the year of the loan creation, Bob has to pay Nancy the calculated interest no later than 30 days after the previous calendar year end. Nancy has to include the interest received from Bob as income on her tax return. This way, Bob can pay tax on 50 percent of the income generated on the Invesco account without attribution to Nancy.
Bob and Nancy bear the responsibilities to accurately record their transactions and gifting arrangement (e.g., promissory notes if treated as a prescribed rate loan), to properly back up their income tax claims. In the loan scenario, since Bob is borrowing money to make an eligible investment, he may deduct the annual interest paid on his income tax return.
Assuming Nancy instead gifts the entire account to Bob, income attribution applies on the entire account on all future investment income generated after the gift. Without special arrangements, the transfer of ownership happens at ACB, and Nancy continues to pay tax on all the income and gains earned in the account, even if Bob is the sole registered owner. Nancy and Bob can avoid the attribution rules by following an arrangement similar to the one discussed above for joint ownership.
Our next blog post will cover income tax considerations when gifting to adult children.