Tax-Smart Parenting

Strategies to Support Your Children Financially in a Tax-Efficient Manner

Mahika Nasa

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Supporting your children financially can be rewarding, but it’s crucial to navigate Canada’s tax system carefully as there are strict tax rules that prevent income splitting strategies with children. Without proper tax planning, these efforts can backfire, ultimately resulting in unexpected tax consequences. Below are a few tips to help parents support their children financially in a tax-efficient manner.

Understanding Income Attribution Rules

In Canada, every individual reports any income that they earn personally. Canada has a progressive income tax system; meaning the more income that is earned, the higher your income tax rate will be (based on the individual’s applicable marginal tax bracket). There are many income attribution rules that exist within Canada’s tax system. These regulations are designed to prevent income splitting and ensure that the individual who earned the income is paying the corresponding tax.

For example, if a parent transfers an asset generating interest or dividend income to their minor child (with the intention that the income generated would be taxed at the child’s lower marginal tax bracket), there is an attribution rule that would cause that income earned to be taxable to the parent and not the child. This attribution rule would apply regardless of what the income is used for (i.e. even when the goal is to fund a child’s education or other expenses).

Special Considerations for Owner-Managers

Parents who are business owner-managers should be especially cautious. One common strategy that parents may pursue involves paying dividends from their corporation to children. However, these dividend payments may fall under Canada’s Tax on Split Income (TOSI) rules. The TOSI rules are an anti-avoidance regime that is designed to prevent private corporations from splitting income with family members. When TOSI applies, the dividends are taxed at the highest marginal rate to the individual recipient (such as the child), which eliminates any desired tax benefit of the income splitting.

Alternative Tax Strategies for Parents

While direct tax asset transfers may not be tax-efficient, there are legitimate ways to support your children financially in a tax-efficient manner:

1. Prescribed Rate Loans

A prescribed rate loan can be a tax-efficient way to fund a child’s financial needs without triggering any attribution rules. This arrangement involves transferring funds, under a formal loan agreement, to a lower-income family member (or possibly a trust for their benefit) to invest. To prevent the attribution rules from applying, the rate of interest charged on the loan must generally be at least equal to the federal prescribed rate of interest. The loan interest must also be paid on or before January 30 of the following year (for every year the loan is outstanding). Any investment income earned that exceeds the prescribed interest rate charged on the loan would be taxed in the lower income family member’s name.

2. Registered Education Savings Plan

Utilizing a Registered Education Savings Plan (RESP) is another tax-efficient way to save for your child’s education. The RESP is ideal for parents saving for a child’s education. Investment income grows tax-free within the plan, and contributions may also qualify for government grants. While there is no annual contribution limit, the lifetime contribution limit for any beneficiary is $50,000. If used for education, withdrawals from the RESP are taxable to the student beneficiary. The portion of the withdrawal that represents prior contributions is not taxable. Students usually have little or no income, so they will likely pay a lower tax rate on withdrawals. However, be mindful not to overcontribute, as any excess contributions would be subject to a penalty.

3. Establishing a Trust

Depending on your financial situation, establishing a trust may be a beneficial option. A trust may provide income-splitting opportunities while also offering asset protection.

How Can We Help?

We understand the complexities of managing family finances in a tax-efficient manner while navigating CRA regulations. Our team of experts is here to assist with a range of tailored solutions. With the right strategies and expert guidance, you can support your child’s future in a tax-efficient manner. Contact Crowe Soberman today to explore customized tax planning solutions for your family’s financial goals.

This article has been prepared for the general information of our clients. Please note that this publication should not be considered a substitute for personalized advice related to your situation.

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