There are several tax considerations to examine when transferring property from one spouse to another after a separation or divorce. Partners may not spend much time dealing with the tax considerations since it is assumed a property will qualify as a principal residence and there will be no tax consequences arising from the transfer. It may come as a surprise this is not always the case.

Consider the following example.

John and Jane Doe owned their Toronto home together since 2010. The purchase price was $600,000.

In January 2023, the couple separated. John stayed in the home while Jane moved to Calgary to be closer to her family. The property was worth $1,500,000 at the time of separation.

The couple plans to transfer the home to John’s sole name while settling the couple’s property rights, and John plans to transfer assets or cash of $750,000 to Jane. The tax implications of a transfer of property other than real property have been discussed in a separate article, where it is assumed a taxable capital gain may result. However, where the property is personal‑use real estate, the couple’s expectation may be a tax‑free transfer. Any unanticipated tax consequences will affect the amount John should pay Jane in the division of property.

In advising the couple concerning the division of property, it is important to know the couple’s history of ownership of any real estate that may have been used as a home.

• Did John or Jane own a second home at any time between 2010 and 2023 (14 full or part years)? This may include a cottage or other home used seasonally.
• Was the property sold or is it still owned?
• If sold, was the disposition reported on the tax return in the year of sale?
• If the property was sold after 2016, was a Form T2091 filed to designate any part of the ownership of the second property as a principal residence?
• Has Jane purchased a new home in Calgary?

The answer to these questions may affect whether the transfer of the property to John will be eligible for the principal residence exemption. We will assume Jane and John only owned one property. To qualify for the principal residence exemption on the transfer of Jane’s 50% interest of the home to John, the following steps need to be taken:

• Jane and John must jointly elect to transfer Jane’s 50% of the property at its fair market value of $750,000 (50%). Without the election, the property will be transferred at $300,000 (50% of the cost), and no gain will result (see previous article for a more in‑depth analysis). Although a transfer without the election (i.e., at cost) does not trigger any immediate tax, it also does not increase John’s cost for the purpose of any future capital gain and may affect the amount of eligible principal residence claim.
• In addition to the election to transfer the property at fair market value, Jane must designate the property as her principal residence for each year of eligible ownership by filing Form T2091 and reporting the capital gain on her return of the year of transfer. Jane may designate only 13 years, as the formula provides a “plus one” year to take into consideration that more than one property may be owned in the year of purchase or sale. Jane will be disqualified from the principal residence exemption claim if she fails to report the sale on her return.
• Jane must not have designated any other property as her principal residence for the same years. This should be included as a condition of the transfer of property.
• John must not designate any other property as his principal residence for the same years. This should be included as a condition of the transfer of property.

What if John and Jane owned a cottage from 2015 and the property is still owned by both of them (nine full or part years of ownership)? The cottage’s cost was $300,000, and its value is $1,000,000. John and Jane plan to put the cottage on the market and sell it as soon as possible.

The potential gain per year of ownership of the Toronto home ($900,000 total gain/14 years of ownership = $64K per year) is lower than the potential gain per year of ownership of the cottage ($700,000/9 years of ownership = $78K per year). It is more advantageous for John and Jane to designate the cottage as their principal residence for 2016‑23, (i.e., 8 plus one equals 9 years) and the Toronto home for 2010‑15 (6 plus one equals 7 years). The steps outlined previously should be amended to take this into consideration.

Professional assistance is required to appropriately sort out the tax implications of the principal residence designation. Talk to a Segal GCSE advisor for more information.

Solutions on your side

We previously sent out articles about the new expanded trust reporting rules and the new form Schedule 15 (as part of the T3 trust reporting) that will require certain trusts to file tax returns and provide information about “reportable entities,” which include beneficiaries, trustees, settlors and persons with the ability to exert influence over trustee decisions (“protectors”) of a trust. The first reporting under these rules will be March 30, 2024 (not March 31, 2024, due to 2024 being a leap year).

Trust accounts for lawyers

Lawyers are in a unique situation in that they often have trust accounts for their clients. The legislation exempts a lawyer’s general trust account. These would be funds that are required under the professional conduct rules ⁠–⁠ as well as federal or provincial rules ⁠–⁠ for a purpose that is regulated under these rules. However, all trust accounts are not created equal.

Trust funds that are not exempt

Trust accounts that would not be exempt could be the following:

• Retainer funds
• Trust settlement amounts
• Proceeds from the sale of real estate
• Withholding taxes being kept in trust until the Canada Revenue Agency (CRA) provides a compliance certificate
• Investment funds being administered by the lawyer on behalf of the client(s)

Possible exemptions

For those trust accounts not automatically exempt, they could be exempt if they meet one of the following conditions:

1. The trust account has been in existence for less than three months as of December 31 of the year in question
2. The trust owns property with a fair market value of less than $50,000 throughout the taxation year. The assets can only be:
   1. Cash
   2. Certain debt obligations, and
   3. Listed securities, such as public companies, mutual funds and segregated funds

Information to be reported

• Trustees: The lawyer or law firm
• Beneficiaries: Those for whom the funds are being held
• Settlors: Entities/individuals who transferred in the funds
• Any individual with the ability to influence a trustee’s decision ⁠–⁠ this could be an advisor who is not a trustee, beneficiary or settlor

The information that will have to be provided for each of the above is:

• Name
• Type of entity
• Address
• Date of birth (if applicable)
• Jurisdiction of residence
• Taxpayer identification number (e.g., Social Insurance Number, business number, trust account number or taxpayer identification number used in a foreign jurisdiction)

Filing notes

If an entity ceased to be a reportable entity in the tax year, the information is still required but won’t be carried forward to the next tax year. That is, if there was a trust account in existence for six months during the year, it would have to be reported even if it didn’t exist as of December 31 of the year in question. It is the CRA’s position the trustees must make best efforts to obtain required information from beneficiaries.

There is a section of the form to provide information about beneficiaries the trustee cannot list by name. This could be relevant where trust funds are being held as part of a lawsuit where the beneficiaries of the funds have not yet been determined.

Penalties for non‑compliance

Failure to file penalties

Failure to file the required information discussed above will result in a penalty of $25 per day, with a minimum penalty of $100 to a maximum of $2,500.

Additional penalties

If it is deemed the failure to file was made knowingly or because of gross negligence, there were false statements or a failure to respond to a CRA demand to file, there will be an additional penalty equal to the greater of $2,500 or 5% of the fair market value of all the property held by the trust. As an example, if there are funds with a fair market value of $20 million held by the trust, this gross negligence penalty could be $1 million per year!

The cost of non-compliance is significant. If you think you or your firm would be affected by these rules, please contact us.

Put your trust in us

Prescribed rate loans provide an opportunity to split income with a spouse, a common‑law partner, children or other family members. Although the prescribed rate is at the highest level since 2007, the timing might be right to make such a loan. We will discuss how to use the prescribed rate to your advantage by making a loan directly to family members ⁠–⁠ or using a family trust where minors are involved.

Income splitting is the transferring of income (or capital gain) from a high‑income family member to a lower‑income family member. There is no attribution of capital gains earned by minor children. Since our tax system has graduated tax brackets, by having the income taxed in the lower‑income earner’s hands, the overall tax paid by the family may be reduced. Prescribed rate loans can be used to help fund minor children’s expenses, such as paying for private school or extracurricular activities.

The “attribution rules” in the Income Tax Act (ITA) prevent certain types of income splitting by generally attributing income or gains earned on money transferred or gifted to a family member back to the original transferor. The ITA does provide an exception to this rule if funds are loaned, rather than gifted, at the prescribed rate in effect at the time the loan was originated and the interest is paid annually within 30 days (i.e., Jan. 30) after the end of the year. The loan must have bona fide repayment terms, and if the interest on the loan is not paid within 30 days after the end of any year, the loan will be offside and caught by the income attribution rules.

Prescribed rates are set by the Canada Revenue Agency (CRA). Even though the prescribed rate has crept up gradually from 1% ⁠–⁠ in effect from July 1, 2020 to June 30, 2022 ⁠–⁠ to 5% beginning April 1, 2023, it is expected to continue to increase in the fourth quarter (October through December) of 2023.

For loans put into place before Oct. 1, 2023, the 5% rate would be locked in for the duration of the loan without being affected by any future increases.

If a loan is made when the prescribed rate is 5%, the net effect will generally be to have any investment return generated above the 5% prescribed rate taxed in the hands of the lower income family member. Even if the prescribed rate increases to 6%, you will only need to use the prescribed rate in effect at the time the loan was extended.

Refinancing a loan when the prescribed interest rate decreases

What happens if you made a loan to your family member when the prescribed rate was 5% (or higher) and the rate drops? To be eligible to use the lower prescribed rate (for determining if there will be attribution of income from the investments), the family member should sell any investments made with funds from the original 5% loan and repay the loan to you. You can then enter into a completely new loan agreement using the new, lower prescribed rate.

What if this results in unwanted tax consequences such as triggering tax on capital gains or brokerage fees? Furthermore, given market volatility, what if the fair market value of the investments is insufficient to pay off the original loan? In these cases, while you may be tempted to either adjust the rate on the loan or refinance it at the lower rate, both measures may put you offside.

You must enter a new loan for the lower prescribed rate to apply. In fact, the CRA has stated simply repaying a higher prescribed rate loan with a lower rate loan could trigger the attribution rules.

Be sure to obtain tax and legal advice before implementing a prescribed rate loan, to determine the best way to structure and operate this type of arrangement, as well the implications for your unique circumstances.

As a shareholder, the benefits you receive could have significant tax implications. In many cases, shareholders are unaware that a corporation ⁠–⁠ even if wholly owned ⁠–⁠ is a separate taxpayer. Money earned by a corporation is meant to be used for business purposes, paying for expenses or costs associated with the operations of the corporation. If a corporation pays for a shareholder’s personal expenses or permits its assets to be used by the shareholder for personal purposes, a taxable benefit may result. 

The corporate bank account should not be considered the shareholder’s personal piggy bank. When money or property is extracted from the corporation other than through salaries, dividends, repayment of capital or loan or reimbursement of expense, a benefit may have been conferred by the corporation on the shareholder. 

Any benefit conferred on a shareholder by a company must be reported on the shareholder’s personal tax return, unless the shareholder has reimbursed the company in a timely fashion or has credit in his or her shareholder loan before the benefit was received. There may also be GST/HST consequences that need to be addressed. If the Canada Revenue Agency (CRA) audits the corporation, the shareholder could be assessed a benefit in addition to the CRA denying such expenses as deductible to the corporation, and double taxation may result. 

It may be difficult to determine whether an expense is incurred for business purposes if a personal element is involved. This could be the case with meals, entertainment, parties, gifts, travel with family members, etc. It is important to document the reason for the expense to demonstrate it was incurred for business purposes. Expenses that are not deductible to the business (such as golf club dues) may still be a benefit to the shareholder. 

If corporate‑owned property (such as an aircraft, a luxury yacht or a cottage) is used by the shareholder for personal reasons, the benefit may be calculated as what the shareholder would have had to pay for the same benefit in the same circumstances if he or she had not been a shareholder of the company. In order to address this issue, the shareholder is charged with fair market value rent. On occasion, fair market value rent may not be adequate to provide the business with a reasonable return on the cost or the value of its investment, and the benefit will be computed based on a normal rate of return on the greater of the cost or the fair market value. An offset of the benefit may be possible if the shareholder provided the funds to purchase the property, and the offset will be equal to the foregone interest on the loan. 

A shareholder can avoid the shareholder benefit rules by characterizing the extraction of corporate funds as a loan. In order to avoid the shareholder benefit rules, it is necessary to document a debtor‑creditor relationship. This may include a loan agreement and terms of repayment. In addition, one of the following conditions must also be met:

a) The company is in the money lending business. Under recent changes, more than 90% of the total outstanding loans at any time during which the shareholder loan is outstanding must be owed by arm’s‑length parties;

b) The loan is repaid no later than one taxation year after the year the loan is made, and the loan is not part of a series of loans and repayments. For example, a loan made on July 1, 2023 must be repaid by December 31, 2024 (assuming the corporation has a calendar year‑end). Annual dividends declared to clear out the loans are acceptable to the CRA; or

c) The loan has been provided to a shareholder who is also an employee by virtue of his/her employment. The loan must be provided to enable the employee to purchase a home, a car used for work or shares of the employer, and bona fide arrangements are made for the repayment of the loan. A loan can be considered to be given to the employee qua employment if it can be considered part of a reasonable employee remuneration package. Where the shareholder is also an employee, it is difficult to argue the loan is received as an employee unless other employees are given the ability to borrow funds for the same reasons.

Even if the loan is exempted from income under one of the exceptions, interest at prescribed rate (currently 5%) less the amount paid on the loan no later than 30 days after the end of the year must still be calculated and included in income. If the loan is included in income, no interest benefit will need to be included. In addition, a repayment of the loan may be deductible. 

The rules governing shareholder benefits are complex. It is important to identify whether such a situation exists on a timely basis and discuss the best path forward with your tax advisor.