When a marriage or common-law relationship fails, there are a number of issues that need to be dealt with. While tax issues may not be at the top of the list for the former couple, there are numerous tax rules to consider; some are beneficial and can make a difficult situation easier to deal with. This article will examine some of the key Canadian tax considerations for Canadian resident couples during a marital breakdown.
Who is considered to be married for tax purposes?
Although the answer will usually be obvious, we still need to review who is and who isn’t considered to be married for income tax purposes. In addition to individuals who have married each other legally, our income tax rules recognize “common-law” unions, including same-sex couples. Two individuals (who aren’t otherwise married) are generally treated in the same manner as spouses for tax purposes if they have been living together in a conjugal relationship and have been living in such a relationship for at least 12 consecutive months or have a child. In the remainder of the article, a reference to a spouse also refers to a common-law partner.
How does a marriage end for tax purposes?
The timing is somewhat different for legal marriages and common-law relationships. In a legal marriage, the couple typically separates for a time, and then the relationship ends when the couple obtains a divorce.
In a common-law relationship, the couple will no longer be common-law partners when they live separate and apart for at least 90 days due to a breakdown in their relationship (the relationship is deemed to end on the first day they separate).
For purposes of determining when a couple is separated for tax purposes, the 90 day rule is also applied to legal marriages. So once a legally married couple has been separated for 90 days, the effective day they separated is the day they started living separate and apart.
The CRA should be notified of the change in marital status by filing Form RC65, Marital Status Change. This will allow them to take into consideration the new marital status and new adjusted family net income to recalculate any child and family benefits.
What are the key tax rules to consider?
An end to a marriage can trigger two important events — a division of family assets, and the payment of support to a partner as spousal support (alimony) and/or child support.
Tax rules for a division of assets
A breakdown of a marriage may result in a requirement to divide assets under provincial family law. For income tax purposes, rollovers are available for these asset transfers, which allow an accrued gain or income inclusion to be deferred until the asset is disposed of or liquidated, as follows:
Capital property — Property can generally be transferred between spouses at its adjusted cost base. This means that no tax will arise on the transfer, and tax will not arise until the asset is sold. Income attribution may or may not apply, depending on the circumstances. The couple can also jointly elect to divide property as a fair market value disposition in order to use capital loss carryforwards or the capital gains exemption in the case of qualifying property. Also, the taxpayer may be required to make this election pursuant to the terms of a separation agreement, which would ensure that the transferee spouse acquired a property with a cost base equal to fair market value.
Registered Retirement Savings Plans (RRSPs) — Funds can be transferred on a tax-deferred basis from the RRSP of one spouse to an RRSP for the other spouse where the transfer is made in settlement of property rights and the money transferred remains in the RRSP of the recipient spouse. In addition, the transfer must be made pursuant to a court order or written separation agreement using CRA Form T2220. The funds will then be taxed in the hands of the recipient spouse when the money is later withdrawn from the RRSP. Similar rules apply for Registered Retirement Income Funds (RRIFs) and Pooled Registered Pension Plans (PRPPs).
Tax-Free Savings Accounts (TFSAs) — TFSA property can be transferred from one spouse’s TFSA to the other spouse’s TFSA. When the transfer is made in settlement of property rights and is made pursuant to a court order or written separation agreement, then the contribution to the receiving spouse’s account will not affect their contribution room, but the transferor spouse would not have any reinstatement of TFSA room for the amount transferred.
Canada Pension Plan credits — Although exceptions apply, CPP credits of both spouses earned during the marriage can be combined and split on the end of their marriage.
Other pension income — It is important to review both provincial family law and provincial pension law before dividing pension income (other than CPP credits already discussed above) between spouses. Otherwise, there may be unintended tax consequences resulting from the division of this income.
Tax treatment of support payments
Again under family law, one spouse may be obligated to pay spousal and/or child support to the other spouse on the breakdown of the marriage and we’ll address how these payments will be taxed when an obligation does arise.
Spousal support payments (payments made solely for the support of the spouse) are generally deductible to the payer and taxable to the recipient. However, there are conditions to be met — the payments must be periodic (as opposed to a lump sum) and must be made pursuant to a court order or agreement. However, a lump sum which is a payment of periodic amounts in arrears will generally be treated as a periodic payment. Where such a lump sum payment is received and parts of it were for previous years, normally the whole payment is included in income in the year the lump sum payment is received. However, if the amount that applies to previous years is $3,000 or more (not including interest), the recipient can request the CRA to tax the amount as if the payments were received in those previous years. The CRA will apply a special calculation to determine if it is advantageous for tax purposes.
In the case of child support, the payment will generally not be deductible to the payer and won’t be taxable to the recipient. An exception applies for orders or agreements made before May 1997 (where the tax treatment will generally be the same as for spousal support, unless the former spouses elect jointly to be subject to the current child support rules). Where an agreement or court order calls for both spousal and child support payments, the payments will be allocated first to the child support obligation.
Are legal fees deductible?
For child or spousal support recipients, legal fees are deductible if paid to collect late support payments, to establish a support payment entitlement, to increase a support payment entitlement or to make child support payments non-taxable. From the payer’s perspective, legal fees paid are generally not deductible. Also, fees related to custody of a child or visitation issues are not deductible.
Legal fees are generally deductible in the year that they are incurred and cannot be carried forward to be deducted in another year. It is possible, however, that where the legal costs incurred in a year are higher than the recipient’s income in that same year, a non-capital loss is created which can then be carried back or forward.
What other tax rules need to be considered?
Personal tax credits — Where a couple has dependants, they will have to determine which spouse can claim personal credits. In particular, if neither spouse enters into a new marriage, each spouse has the ability to claim a dependant as an “eligible dependant”, meaning that the credit amount will be the same as the basic personal credit (subject to a reduction based on the dependant’s income).
To claim an eligible dependant amount, the following conditions must first be met:
- the taxpayer does not have a spouse or common-law partner, or if there was one, the taxpayer was not living with, supporting or being supported by that person,
- the taxpayer supported a dependant in the year who lived with the taxpayer in a home maintained by the taxpayer (this would include dependants living away from home while attending school as long as the dependant ordinarily lives with the taxpayer when not in school), and
- the dependant supported is the taxpayer’s child who is either under 18 years of age or has an impairment in physical or mental functions (note that other individuals are eligible but in the context of this article, we are only referencing a child of the taxpayer).
Once all of the above conditions have been met, a taxpayer can claim an eligible dependant only if the taxpayer is not claiming a spouse or common-law partner amount, the taxpayer is not making support payments for the dependant, the taxpayer is not claiming the amount for infirm dependants age 18 or older in respect of the dependant and no one else in the household is making an eligible dependant claim. This claim can be made in the year of separation (a special rule also applies for support payments in the year of separation).
As only one spouse can claim this amount for a particular dependant, the former spouses will have to determine who will make the claim. This will be the case if both are eligible, or if neither are eligible because both are making support payments but the CRA will allow one to still claim the amount. A common planning idea where there is more than one dependant is to allow each spouse to claim one dependant as an eligible dependant (if possible).
Child care expenses — Separation impacts the claim for child care expenses. Separated or divorced parents may claim the child care expenses incurred for the period during the year that the eligible child resided with them and only to the extent that the expenses were paid by them. The CRA will generally consider each parent to reside with a child while the child is in their custody.
Tuition and education credit — Where the parents of a student are separated or divorced, the student can transfer the unused portion of their tuition, textbook and education credits to either parent subject to the usual rules (but not a portion to both). As the transfer of the credit is not based on whether a parent actually supports the child or even pays the amounts for the child, the former spouses and the student will have to come to some agreement if there are credits to be transferred.
Universal Child Care Benefit (UCCB) — Where one parent has custody of the child(ren), the UCCB will be paid to that parent. Where the parents have shared custody, the parents can apply to have the UCCB payment split between them so that they each receive one half of the UCCB. The UCCB is taxable. For couples, the spouse with the lower income would report the amount as income for the year. Taxpayers who are single parents at the end of a year have the option of reporting the UCCB on their own return or electing to include all UCCB amounts in the income of the dependant for whom the amount for an eligible dependant (discussed earlier) is being claimed. If there is no claim for an eligible dependant, the single parent can choose to include all the UCCB amounts in the income of a child for whom the UCCB was received.
Principal residence rules — As a couple can only designate one residence as a principal residence, they will need to decide how the exemption will be used when more than one residence is held.
Joint and several liability — The rules are complicated, and the key point to keep in mind is that a transfer of property could result in a joint and several liability for the associated tax on that transfer in some situations.
Note that several of the issues we have addressed require the couple to agree on how tax-related amounts will be reported. For the larger items, documenting the agreement reached in the separation agreement or court order may be prudent.
This article has described, in general terms, just some of the important tax points that need to be considered on the breakdown of a marriage. It is crucial to get specific tax advice when agreements are prepared and tax returns are filed.
Credit: This article was published by BDO in its August 19, 2014 Tax Factor. For more information, check out BDO’s website www.bdo.ca