Income splitting is a valuable tax-planning strategy for many Canadian families. The goal of income splitting is to transfer income from a higher-income family member to a lower-income one, taking advantage of Canada’s progressive tax rates and thereby reducing the overall tax burden.

While the Canada Revenue Agency (CRA) has stringent rules to limit income splitting, there are still several legal methods that families can use effectively.

Why Income Splitting?

Canada’s tax system uses a progressive rate, meaning that the more you earn, the higher the percentage of tax you’ll pay. For example, in 2023, the highest federal tax rate is 33% for incomes over $235,675, while the lowest federal rate is 15% on income up to $53,359. By transferring some of a higher-earning spouse’s income to a lower-earning spouse or a child in a lower tax bracket, families can reduce their total tax bill.

Common Income-Splitting Strategies

1. Pension Splitting

• ‍Eligibility: Canadian taxpayers over the age of 65 who receive eligible pension income (e.g., Registered Pension Plan, RRIF, and annuity payments) are allowed to allocate up to 50% of that income to a lower-income spouse or common-law partner.
  
  Pension income-splitting is also available to taxpayers younger than 65 if they receive pension income due to the death of a spouse or through certain annuities.‍
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• Tax Savings: When one spouse is in a higher tax bracket than the other, splitting pension income can reduce the couple’s combined tax bill. It can also help the higher-income spouse avoid the Old Age Security (OAS) claw back, a 15% reduction applied when individual income exceeds certain thresholds (e.g., $86,912 in 2023).

2. Spousal RRSP Contributions

• Eligibility: If one spouse has a higher income than the other, the higher-income spouse can contribute to a spousal RRSP in the lower-income spouse’s name. Contributions are deducted from the contributing spouse’s income, while the receiving spouse will eventually withdraw these funds at retirement, ideally at a lower tax rate.
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• Tax Savings: This strategy allows couples to shift income from a high-earning partner to a low-earning one, achieving a lower tax burden when the funds are withdrawn. However, note that there is a “three-year attribution rule”: if funds are withdrawn within three years of the contribution, they will be attributed back to the higher-income spouse.

3. Family Business Income Splitting

• Eligibility: Family-owned businesses can pay salaries or dividends to family members, such as a spouse or child, for services they genuinely provide to the business. This must be done carefully due to the Tax on Split Income (TOSI) rules, which impose higher tax rates on certain split income earned by individuals under 18 and others who don’t meet specific criteria for involvement in the business.
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• Tax Savings: When family members are actively involved in the business, paying them a salary can reduce the family’s overall tax rate. To comply with CRA rules, compensation must be reasonable for the services provided, and family members must be meaningfully engaged in the business’s daily operations.

4. Joint Ownership of Investments

• Eligibility: When a high-income spouse transfers investments to a low-income spouse or family member, they must adhere to CRA attribution rules. These rules generally prevent direct transfers by attributing any investment income back to the original holder. However, couples can navigate this by lending funds at the CRA’s prescribed rate to a lower-income spouse or family member, allowing them to invest in their name.
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• Tax Savings: The prescribed rate loan strategy allows income earned on the investment to be taxed at the recipient’s lower rate. This rate is set by the CRA quarterly and has often been quite low, making it an appealing option. The loan interest must be paid annually by January 30 to avoid CRA penalties.

5. Canada Child Benefit (CCB) Planning

• ‍Eligibility: CCB is calculated based on family income, so lowering a family’s taxable income can increase the benefit amount.
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• Tax Savings: By transferring investments to the lower-income spouse or using tax-efficient investments like TFSAs, families may reduce taxable income and potentially qualify for a higher CCB. Note, however, that the CCB is targeted at lower- and middle-income families, so the effect may vary depending on total family income.

6. RESP Contributions by Grandparents

• Eligibility: Registered Education Savings Plans (RESPs) allow contributions for a child’s post-secondary education. Grandparents with funds to spare can contribute to their grandchildren’s RESP accounts, where the income generated grows tax-free until withdrawal.
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• Tax Savings: While this does not directly lower the grandparents’ tax, it reduces the family’s overall tax burden by allowing education savings to grow tax-free. Withdrawals are taxed in the hands of the student, who will often have little to no taxable income while attending school.

Key CRA Rules and Considerations

The CRA enforces strict rules to prevent what it considers "income splitting" abuse.

Here are some crucial considerations:

• ‍Attribution Rules: These rules prevent taxpayers from transferring investments or income to lower-income family members by attributing back any income or gains earned on those investments to the original owner. The prescribed rate loan is an exception.
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• Tax on Split Income (TOSI): TOSI applies to income earned by a spouse or minor child in a private business, usually if they aren’t actively involved. TOSI imposes the highest marginal tax rate on income that doesn’t meet the CRA’s definition of “active involvement” in the business.
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• Genuine Business Involvement: For family business salaries to be deductible, they must be "reasonable" and "commensurate with the work performed." The CRA will scrutinize family payrolls to ensure compliance.

Conclusion

Income splitting can be a powerful tool to reduce taxes in Canada, but it must be used carefully to stay within the law. The CRA has numerous safeguards in place to prevent abuse, and improper use of income-splitting techniques can lead to tax penalties.

Consulting a qualified tax planner or financial advisor is essential for implementing these strategies effectively and compliantly.

By carefully planning and adhering to the CRA’s rules, Canadian families can achieve substantial tax savings and ensure a tax-efficient financial future.