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“We’re getting a divorce” – How to ease some of the (tax) burden

25/10/2011


The Income Tax Act provides for capital property received by Canadian resident spouses “in settlement of rights arising out of their marriage” to be received at their tax cost or adjusted cost base or other income tax cost amount. In general, this means that assets can transfer without causing any immediate income tax liability for either party.

Where things are fairly straightforward

Dealing with assets such as RRSPs or RRIFs can be fairly straightforward, provided the related documents contemplate this division of property. The principal residence can also be transferred to one spouse or the other without tax consequences, but care must be taken if there is an extended period of separation (in the absence of a judicial separation or written separation agreement) during which one of the spouses acquires an additional principal residence. The spouses must share the principal residence exemption, which ensures gains on the sale of a principal residence are tax-free, for all years up to the year there is a written separation agreement in place.

Where things get complicated

Where things can get complicated is where there are corporate shareholdings held by the spouses. There are many rules in the Income Tax Act that allow for transfers of equity on a tax-deferred basis between related parties (such as married persons) and many rules which preclude this sort of tax-deferred transfer between unrelated parties (for example, individuals who are no longer married). So while married couples will be related during their marriage and will be able to transfer shareholdings without incidence of tax, they will no longer be related once their divorce is final. There is additional planning, which can be undertaken prior to the divorce, but it is imperative that this planning is contemplated before any separation or other agreements are executed. Note that the attribution rules in the Income Tax Act, which attribute income and capital gains back to a transferor spouse for asset transfers taking place during the marriage, cease to apply once the divorce is final.

The taxability of support amounts

There is often some confusion as to the taxability of support amounts, since the term can be used to describe amounts paid as spousal support or amounts paid as child support, and the two are treated differently for tax purposes. In general, for agreements entered into after May, 1997, amounts paid for periodic spousal support are deductible to the payor and taxable to the recipient. The rules are fairly specific and the courts have been very restrictive in interpreting the legislation, so it is very important that the separation or other documents be explicitly clear on the nature of the payments. Amounts paid for child support, on the other hand, are neither deductible to the payor nor taxable to the recipient. By default, any support amount, which is not explicitly described as being solely for the benefit of the spouse recipient, is assumed to be child support. So, again, clarity in the separation or other agreements is essential.

A couple of things to note

  • the rules differ slightly with respect to timing of division of assets if you are in a common-law relationship, so care must be taken to ensure you achieve the appropriate income tax result. Parties to a common-law relationship are no longer considered to be related to one another 90 days after separation;
  • the taxability of support amounts may be altered if the parties amend an agreement that was in place pre-May, 1997;
  • clarity in the agreements with respect to the parties’ intent can be important in the event of a challenge by the Canada Revenue Agency.

To learn more about how MNP can assist you and your legal counsel if you’re going through a divorce, contact your local MNP Tax advisor.

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