In Canada; the spouse who provides money for an investment is taxable on the earnings.  If one spouse is in a lower tax bracket, or you expect one spouse will be mostly staying home with the responsibility of managing the household, or one spouse is expected to earn more because of their expected career advancements or business ventures; then you must make plans to ensure investment earnings are taxable to the lower income spouse only. 

In order to transfer investment income to the lower income spouse who pays less tax, you must follow acceptable procedures and methods called income splitting.  You can not transfer property or hand the lower income spouse the cash to pay for an investment because it will still be considered the higher income persons investment (known as the attribution rules).  Nor can you register an investment in the lower income spouse’s name and SIN unless they used their own funds gained by inheritance, investing, earnings or by borrowing.  Therefore; income splitting is finding ways of putting income towards the lower income spouse instead of the higher income spouse by avoiding the attribution rules and by using life style choices.

The first life style choice is to have the lower income spouse have their own separate bank account which is used exclusively for investment purchases.  Money put into this account comes directly from their pay cheques, investments, inheritances, windfalls, loans, etc.  Do not use money from joint accounts because Revenue Canada is very clear on original intent and back tracing of funding.  They could easily declare it joint income and disqualify your planning.  In this life style choice the higher income spouse instead of buying the investments only pays for the non investment expenses, otherwise the family will lose part of their investment returns to the tax collector and diminish future available investment profits.

The chief and foremost best method for avoiding the attribution rules is to top-up the lower income spouse Tax-free Savings Account (see related blog topic for more information) before any other similar investment.  Legislation has made this a legal entity for giving money to your spouse to buy qualifying investments in their name without invoking the attribution rules.

If you borrow money from a third party for investment purposes, have the loan in the lower income spouse’s name.  The investment will then be in their name.  All interest paid for an investment loan is a tax deduction.  If there is a lack of funds the higher income spouse can pay the interest (but not the principle) and still avoid any attribution rules.  The interest deduction remains with lower income spouse.

The higher income spouse can lend investment money to the lower income spouse at the rate known as the prescribe rate to avoid the attribution rules or if lower, a reasonable commercial rate (such as a secured collateral loan rate).  The prescribe rate is set quarterly by the department for the Federal Minister of Finance.  Presently it is 1% which can be locked in.  The interest received is taxable to the lender but a tax deduction for the borrower, who must reinvest the loan and ideally receive a higher rate of return.   The interest payments must be paid each year or by the following January the 30th.  The agreement is voided and all investment income received for that year and future years is attributed back to the lender spouse if the interest payment is not made.

If the lower income spouse has to pay income tax on their investments, consider having the higher income spouse pay the taxes payable because the attribution rules will not kick in.

If your spouse has none or little income you can create a secondary income stream for them.  The process is easy to set-up.  You simply give your spouse investment funds which is invested in their name.  The income earned is attributed back to you but arrange for the money earned to be immediately transferred to the lower income spouse’s separate bank account.  This secondary income is now considered the lower income spouse’s money which can be reinvested without any further attribution rules applying. 

If you’re both over 60 years of age you can arrange to have the Canada Pension Plan payments split up to 50% each, effectively transferring taxable income to a lower income spouse.

Many couples started spousal RRSP’s to effectively spilt future retirement income.  The assumption was if one spouse had a generous private pension plan and/or a large amount of RRSP investments a spousal RRSP would allowed for the lower income spouse to have retirement income that would be taxed at a lower rate.  In 2007 the tax rules have changed so that pension income can now be spilt between both spouses up to a maximum of 50% each so the need for a spousal RRSP is not as great.   The rules state that if no spousal RRSP are purchased for 3 years, the existing RRSP’s can be cashed and not attributed back to the contributing spouse.  This may present opportunities for spousal RRSP to be cashed at a lower taxable rate and reinvested back into the higher income spouse’s RRSP to receive a tax refund which will be higher than the lower income spouse’s tax bill.  Of course this works best if you don’t expect to be able to top up your life time RRSP limit and you are not concerned about any future old age security or employment benefit payments clawback implications.

When a spousal RRSP can be cashed and the income is not attributed to the higher income spouse and it becomes the lower spouse’s own money.  The funds can be used by the lower income spouse to invest in a business, a rental property, or investments that can be used for collateral.   Alternatively a Tax-free Savings Account can be set up which would generate tax free investment income instead of taxable RRSP income, or maybe the funds can be used to pay off a mortgage to free up mortgage payments for investment opportunities.  Whatever the opportunity do not cash a RRSP unless you have a serious plan to develop a better retirement or investment plan with the funds – otherwise that would be foolish.