Tax/Valuation Marriage Breakdown and Income Taxes N E W S L E T T E R Autumn 2010 By J. Thomas McCallum, CBV, FCGA A substantial number of marriages end in what can broadly be described as a breakdown. Divorce rates (38% of marriages) in and of themselves don t tell the whole story, given the additional potential for judicial separation, desertion, and the breakdown in common-law relationships. After marriage breakdown, provincial family law generally provides for an equal settlement of property, which necessitates the transfer of both capital and non-capital properties (including cash) between the spouses or former spouses. The Income Tax Act (the Act ) serves the dual role of being an instrument of social policy as well as economic policy, hence it is appropriate that it contains a number of rules directed toward the matter of marriage breakdown. It s believed appropriate to describe these rules as an attempt at ensuring fair and equitable treatment, and in this newsletter we ll mainly examine the rules addressing the division of property. Key definitions The word spouse is not defined in the Act but it is interpreted as meaning persons legally married to each other. A former spouse is someone from whom you are divorced (not just separated). Pursuant to subsection 252(3), both spouse and former spouse also includes parties to a void or voidable marriage. A common-law partner is defined at subsection 248(1) as a person with whom there s co-habitation (12-month minimum) in a conjugal relationship or a person who is a parent of the other co-habiting/conjugal relationship person s child. A former commonlaw partner is one where the partners live separate and apart, for at least 90-days, because of a breakdown in their conjugal relationship. Equalization payments While equalization payments are a division of property, the disposition of cash is a non-event for income tax purposes. For example, Ron and Betty are divorcing, and Ron has $350,000 in family property, whereas Betty has only $150,000. Ron s payment to Betty of $100,000 in cash as an equalization payment would not trigger any tax consequences. If Betty invests that $100,000, the income she ll earn is taxable to her; the attribution rules of section 74.1 and 74.2 don t apply as Betty and Ron are not spouses (as of the divorce). However, if this division of property was made pursuant to a separation agreement rather than a divorce, then Ron and Betty are still each other s spouse and the attribution rules are applicable, albeit on an adjusted basis. Attribution rules Where property is transferred to a spouse, section 74.1 of the Act attributes any income earned from that property back to the transferor spouse. Similarly, section 74.2 attributes any capital gains/losses from that property back to the transferor spouse. For income tax purposes, property includes cash and all the items we generally conceive of as property, like real estate and securities, as well as other things, such as certain rights, which we don t often envisage as being property. Page 1 of 6
As already noted, separation is not divorce and so separated parties are still spouses, whether or not there is a separation agreement. Consequently, income and capital gains/losses arising from property transferred prior to divorce is subject to the attribution rules until the divorce is final. Fortunately, the attribution rules contain a provision, subsection 74.5(3), that mitigates their application. Paragraph (a) provides that the attribution rules do not apply to any income or loss from the transferred property (or substituted property) that relates to a period throughout which the taxpayer is living separate and apart from their spouse or common-law partner due to a breakdown in their marriage or common-law partnership. Paragraph (b), which applies to capital gains/losses from dispositions of property in the same period, is conceptually the same as paragraph (a), but unlike the automatic application of paragraph (a), it requires a joint-election to be made or to have been made. A copy of that election needs to be filed with the transferor s income tax return in either the year the subject property was disposed of or a preceding year. Once the property is in the hands of the other spouse or common-law partner, the transferor will have no control over the timing of the property s disposal, nor might the transferee even inform them of the disposal, and in a worst case scenario they may be unwilling to execute the joint-election. To be practical then, it s usual that the election is filed in the year the separation occurs and common family law practice is to include the election in the written separation agreement. Divisions of property Capital property Subsection 73(1) is the governing provision. It allows that capital property transferred to a spouse or common-law partner, or a former spouse/common-law partner in settlement of rights arising out of their marriage or common-law partnership, is deemed disposed of, as applicable, at UCC (undepreciated capital cost) or ACB (adjusted cost base). It further deems the acquirer to have acquired the property at those same deemed proceeds. In effect then, subsection 73(1) is an inter-vivos tax-free rollover. For this provision to apply, it s necessary that both parties be resident in Canada at the time of the transfer. Also, and very importantly, it s possible for the transferor to elect to not have the provision apply. This option will be reviewed later in this newsletter. While depreciable property transfers at UCC, that s only 100% true if the property is the only property in the depreciable Class. If it s one of several properties in the Class then it s a pro rata share of UCC as given by the formula: fair market value of particular asset fair market value of all asset in the Class UCC Subsection 73(2) also charges the receiving person with potentially having to recapture any CCA (capital cost allowance) already taken on the property. This is the same treatment as is given to the rollover of depreciable property to a spouse on death or a section 85 rollover to a corporation. This (latent CCA recapture) is accomplished by deeming, where proceeds as determined by 73(1) are less than the transferor s capital cost, the receiving person to have a capital cost the same as the transferor s capital cost. The application of the foregoing is illustrated in Example 1. As you can see, the realisation of accrued income (capital gains, CCA recapture) is deferred until the actual disposition, or some deemed disposition, of the property by the transferee. Page 2 of 6
Example 1 Pierre and Louise are finalizing their divorce and as part of the property settlement Louise will receive one of two industrial units Pierre owns. Both properties are included in Class 3 in Pierre s personal tax return. Original cost: Property 1 (to be transferred) Property 2 (Pierre retains) Fair market value: Building Land $40,000 $20,000 $35,000 $15,000 Property 1 $75,000 $35,000 Property 2 $60,000 $25,000 UCC of Class 3 $55,000 N/A Pierre s proceeds of disposition: $30,556* $20,000** * Per the formula ($75,000 over $135,000) $55,000. ** At his ACB. Pierre realises no income of any kind on the transfer of the property. Also note, his remaining UCC is $24,444 ($55,000 $30,556). If Louise were to sell Property 1 (without having taken any CCA) at the same price as the fair market value at the time of transfer and ignoring any disposition costs, she d realise the following income: CCA Schedule Building Capital Gains Land Proceeds of $40,000 $75,000 $35,000 disposition UCC $30,556 N/A N/A ACB N/A $40,000 $20,000 Recapture $9,444 of CCA Capital gain $35,000 $15,000 The intent of subsection 73(1) is to provide a taxdeferred transfer. However, the UCC allocation formula can, in some circumstances, cause a gain to be recognized. For example, if we alter the fair market values in Example 1 to $80,000 and $20,000, the proceeds for Property 1 will be $44,000. As ACB is $40,000, a capital gain results (taxable to Pierre). If the tax payable represents a hardship, a taxpayer who finds themselves in this position can apply to the CRA for administrative relief. Two last things need to be noted about depreciable property. Louise does not apply the CCA half-year rule to the acquisition of the property (see REG 1100(2.2)), and she continues to use Class 3 for the property (see REG 11002(14)) and does not move it to Class 1 (buildings acquired after 1987). Electing out of 73(1) Instead of using the tax-deferred rollover, subsection 73(1) allows the transferor to opt out of that rollover. Pursuant to the non-arm s length provisions of section 69, that alternative will require the recognition of fair market value as proceeds. No form is provided for this election, and simply reporting the disposition at fair market value and including the related amounts as income will be sufficient as an election. This election can be made on one property or two or more properties, to the exclusion of other properties. This is not a joint-election, as it is made only by the transferor. Why would the transferor make this election? Here are some possibilities: There may be otherwise unused capital losses available as a carry forward. The related capital gain may be eligible for the capital gains deduction. The negotiated settlement between the parties may dictate the opting out. The advantage to the transferee is that the accrued or latent tax liability is not inherited. Page 3 of 6
Example 2 Return to Example 1 and assume Pierre has opted out of the 73(1) rollover. Pierre goes from a $zero tax position to: CCA Schedule Building Capital Gains Land Proceeds of $40,000 $ 75,000 $35,000 disposition UCC $55,000 N/A N/A ACB N/A $40,000 $20,000 Recapture NIL of CCA Capital gain $35,000 $15,000 UCC $15,000 All of the capital gain has shifted from Louise to Pierre, as has the CCA recapture, although Pierre s recapture is deferred by still having a positive UCC. If, using the examples, Louise and Pierre are just separating rather the divorcing, Pierre s opting-out will have one other impact on Louise. As they d be non-arm s length, paragraph 13(7)(e) will apply to reduce her capital cost of the building to $57,500. This is for CCA purposes only; the ACB of the building for capital gains purposes remains at $75,000. The $57,500 is determined as: capital cost otherwise ($75,000) minus ½ of Pierre s capital gain ($35,000). The logic of this provision is that it stops the acquirer from having a tax write-off (CCA) on an amount the non-arm s length transferor didn t have taxed as income. Matrimonial home and recreational properties Both the matrimonial home and recreational properties (cottages, cabins, camps) are capital properties and subject to the application of 73(1). In most instances the matrimonial home will qualify as a principal residence and any capital gain offset by the principal residence exemption. Usually, then, it will be transferred at fair market value (opt-out of the rollover), as no tax consequences arise. The transferee will get a bump in the ACB of the residence, potentially improving their tax position in case of some future change in the status of the property. Recreational properties may qualify wholly or partially as a principal residence. Partially refers to those owned since before 1982 (a time when each spouse could have a principal residence). Allowable business investment losses If the property transferred is one (debt or shares) on which any underlying loss would qualify as an ABIL (allowable business investment loss), any loss realised on the transfer might or might not be allowed. Paragraph 39(1)(c) requires the property be disposed of to an arm s length person. Such a loss resulting from the transfer of property as part of a divorce settlement should qualify, as the divorced parties are arm s length, although the Minister has the authority to assert that they are not at arm s length. Eligible capital property If the transferred property is an eligible capital property to the transferor a licence is a good example subsection 73(1) does not apply. This is because eligible capital property is not capital property. So how is the disposition of such a property treated? The answer is it depends. If the transfer is between spouses (separation, not divorce) or common-law partners (not a former common-law partner), then a rollover is possible pursuant to subsection 24(2). However, to access this rollover it s necessary that the transferor has ceased to carry on the business the eligible capital property is connected with and the transferred property represents all the eligible capital property of that business and the transferee continues to carry on that business. As is the usual case with these types of rollovers, the recipient taxpayer inherits the tax position of the transferor. That is, she or he inherits the potential amortization recapture as they are Page 4 of 6
required to account for the property as if the original cost was their cost. If the transfer is to a former spouse (divorce) or former common-law partner, or if the requirements in the above paragraph aren t met, there is no rollover entitlement, as subsection 24(2) wouldn t apply. In this case there would be a disposition of the property at its fair market value and the usual incidences of that apply, those being possible amortization recapture and gains. If the receiving taxpayer does not carry on the related business, the property would be a capital property rather than eligible capital property, in their hands. Life insurance policies The Act has a rollover provision at subsection 148(8.1) for life insurance policies that is identical to that for capital property at subsection 73(1). Any transfer to a spouse or common-law partner, or a former spouse/common-law partner in settlement of rights arising out of their marriage or commonlaw relationship occurs at the adjusted cost basis of the policy. The transferor has the ability to elect out of this automatic rollover if desired. RRSPs and similar deferred income plans Under 146(16), an RRSP may be revised or amended at any time to provide for the payment or transfer before maturity of any of its property to an RRSP or RRIF of the annuitant s spouse, former spouse, common-law partner or former common-law partner, provided: They are living separate and apart; and The payment or transfer is made under a decree, order or judgment of a competent tribunal or under a written separation agreement, relating to a division of property in settlement of rights arising out of, or on the breakdown of their marriage or common-law partnership. The transfer between the plans is not income to either the transferor or transferee, and the transferee s otherwise existing RRSP contribution room is unaffected. Under 146(8.3), amounts withdrawn from a spousal or common-law partner RRSP are included in the contributor s income to the extent that contributions were paid in the year of the withdrawal and the two immediately preceding years. This rule is not applicable where the taxpayers are living separate and apart because of a breakdown in their marriage or partnership at the time of the withdrawal. Any such withdrawals are included in the annuitant spouse s income. Subparagraph 146.3(2)(f)(iv) provides for a taxdeferred transfer of a RRIF from one spouse to another (or former spouse, or common-law partner or former common-law partner) on the same conditions as specified above for an RRSP. Under 146.3(5.1), amounts from a spousal or common-law partner RRIF in excess of the minimum required withdrawal are income to the RRSP contributor spouse/partner to the extent of the RRSP contributions made in the year of withdrawal and the two immediately preceding years. Again, as discussed above for these types of RRSPs, this rule is waived where the spouses/partners are living separate and apart because of a marriage or partnership breakdown. 147.3(5) provides for a tax-deferred transfer of a Registered Pension Plan from one spouse to the other s (or former spouse, common-law partner or former common-law partner) RPP, RRSP or RRIF on the same conditions as specified above for an RRSP. There is no provision in 147 (Deferred Profit Sharing Plans) for a tax-deferred transfer of a spouse s DPSP interest to the other. Usually, any property settlement that included the DPSP interest would be settled by either: A transfer from the DPSP to an RRSP and then from the RRSP to an RRSP or RRIF of the spouse on whom the property is settled; or A cash equalization payment. In summary, it is generally possible to split retirement savings and other deferred income plans without immediate tax consequences. Page 5 of 6
Joint/several liability Section 160 of the Act creates a joint and several liability for taxes where property is transferred to a spouse or common-law partner. This ensures that taxes cannot go unpaid merely because assets have been transferred into the name of the other spouse. Viewed another way, the transferor s tax liability attaches to the asset. Under subsection 160(4) this joint and several liability is rendered inapplicable where the transfer has been made pursuant to a decree, order or judgment of a competent tribunal or under a written separation agreement and the parties are living separate and apart due to a breakdown in their marriage or common-law partnership. The need for such a rule is obvious. It would be inequitable if the CRA had the right to attach the transferor s taxes to a property transferred to a spouse/partner on marriage breakdown. Partitioning The common law definition of partition is the physical division of land previously held in a shared ownership such as joint tenancy or tenants-in-common. In the Act, partition applies to all property, not just land. An example is where two owners of a property divide it into two separate and distinct properties, each of equal value. Neither party is considered to have a disposition, and each merely assumes an ACB equal to their previous ACB of their half-interest. If the partition is not equal (in terms of value), the party receiving a compensatory payment reduces the ACB of their new interest and the compensation payer increases their own ACB. The CGA s Role While the services provided in a marital breakdown will include working hand-in-hand with the client s legal counsel and compiling schedules of assets and liabilities along with valuation, perhaps the most important contribution will be in providing tax analysis and advice. There can easily be more than one tax alternative in any given situation, and those possibilities need to be quantified and the client s lawyer apprised. Disclaimer: Readers should not rely on or use the information provided as a basis for a course of action without first obtaining the appropriate professional advice. Page 6 of 6