Among the various tools that high-net-worth individuals (HNWIs) use to reduce their tax liabilities, income splitting is one of the most effective. However, it can be quite a complex concept to apply without the help of an experienced financial planning professional. This blog aims to summarize and demystify income splitting and reveal its benefits for you and your family.

What is Income Splitting and How Does it Work in Canada?

Income splitting is commonly applied by tax planning professionals in Canada on behalf of their HNWI clients – but what exactly is it and how does it work? Simply put, income splitting is a tax reduction strategy that involves reducing a family’s overall tax liability. It works by adjusting income levels among family members so that some of them take on a higher individual tax burden while that of other members, as well as the family as a whole, is significantly reduced.

In practice, this might look as follows: one family member transfers a portion of his or her income to another member who is in a lower tax bracket. The family still earns the same amount of money overall, but the total tax it must pay is reduced. However, it is not always so simple to implement this strategy here in Canada because of the Tax on Split Income (TOSI) rules, which were implemented to prevent the abuse or unreasonable use of income splitting and ensure that the tax system is as equitable as possible. Families and family-owned businesses can still take advantage of income splitting, but they need to do so carefully, using TOSI guidelines.

Key Income Splitting Strategies for High-Income Families

Keeping TOSI rules in mind, high-net-worth families can apply a range of strategies that will enable them to make effective use of income splitting to reduce their overall tax burden. Five of the most effective strategies include:

  1. Pension income splitting: Couples can share up to 50% of their eligible pension income and thus reduce their total tax liability, as well as claim credits and benefits on their net income.
  2. Loans to spouses or common-law partners: One partner in a marriage or common-law relationship can make quarterly loans to their partner, at the CRA-determined interest rates. These loans are tax deductible for the borrower, while forming part of the lender’s taxable income. The overall tax reduction effected by the loans more than compensates for the lender’s increased individual tax liability.
  3. Loans to a family trust: Parents can make loans to their family trusts, and the dividends or income earned on these funds will be attributed back to the parent and taxed accordingly. Although they take on the increased tax burden, the net liability for the family is reduced.
  4. Salaries paid to family members: Business owners can hire family members as employees, and deduct the expense from personal or corporate tax returns, depending on the business structure. However, this must be done with care to ensure that you are making a valid tax deduction.
  5. Loan to an adult child: Parents can provide loans to adult children for major expenses such as the purchase of homes. Since there is no income generated on the part of the parents, there is no corresponding increase in taxable income for the lender.

Understanding the Attribution Rules in Canadian Tax Law

Central to income splitting in Canada, and the TOSI rules that govern it, are the various federal attribution guidelines. This is a fairly complex set of laws used to direct and restrict income splitting. They exist to ensure that the income earned and gains made are taxed to the right individual – usually the transferor, not the transferee. Say, for example, that a parent decided to save on taxes by transferring a certain amount of assets to his or her children. Once the transfer is done, even though the assets themselves would not be in the possession of the children, the tax burden would still rest on the parent who made the transfer in the first place.

Leveraging Family Trusts for Effective Income Splitting

Family trusts are commonly used by high-net-worth families and their financial planners to split income and effect tax savings. With a family trust, the settlor (usually a parent, but not always) transfers ownership of assets to a trustee on behalf of the beneficiaries (usually children and grandchildren). There is, thus, an effective separation between legal ownership and beneficial enjoyment. This is a particularly effective strategy for high-income earners who want to redistribute their income among family members in lower tax brackets.

Momentum Financial is a boutique wealth management and financial planning firm based in Georgetown, ON. We are here to help our clients with their financial planning. We provide excellent financial management strategies for individuals and families, and we can help you apply a wide range of planning tools, including income splitting, among others. Contact us for more information.