Separation or Divorce: A New Relationship with the CRA

By Evelyn Jacks, President and Founder, Knowledge Bureau

Going through a separation or divorce is stressful. Being ill-prepared for the associated tax consequences can add a layer of unanticipated financial stress and expense, and could result in headaches during tax season. Before agreeing to a final settlement, it’s wise for all involved parties to seek guidance to understand the rules.  Some tips follow. First, it’s important to understand that a couple need not be legally or formally separated for their tax status to change. In general, a couple is considered to be separated if co-habitation has ceased for a period of at least 90 days. 

Upon separation, you will be taxed as an individual. As a result, you will no longer combine family net income for the purposes of claiming certain social benefits, like the Canada Child Benefit (CCB), the Working Income Tax Benefit (which will be known as the Canada Workers Benefit after 2018) or the GST/HST credit.

In addition, custody arrangements will determine who makes the claims and receives these funds. Where both parents share custody of a child, the Canada Revenue Agency (CRA) allows the parents to share the CCB and GST/HST Credit, beginning with the first payment for the current benefit year, which spans from July to June.

When meeting with your tax and legal advisors, it’s prudent to add three other important considerations to the tax checklist for your discussion:

• Division of assets
• Attribution Rules
• Support payments for children and ex-spouses              

When discussing asset accumulations, it’s helpful to review registered and non-registered investment accounts separately:  

Registered Accounts

• Where the terms of a written separation or divorce agreement, or court order, require that the funds from one spouse’s TFSA, DPSP, RESP, RPP, RRSP, or RRIF be transferred to the other spouse’s account, the funds may be “rolled over” on a tax-free basis.   
• The transfer must be made directly between the registered plans of the two spouses and one spouse cannot be disqualified because of age.  This means, in the case of the RRSP, the spouses can be over age 71. Form T2220 Transfer from an RRSP, RRIF, PRPP or SPP to Another RRSP, RRIF, PRPP or SPP on Breakdown of Marriage or Common-law Partnership is used to authorize the transfers between the plans. 
• After separation, spousal RRSP contributions will no longer be allowed. Further, the minimum holding period of three years from the last contribution to a spousal RRSP will be waived.
• Another common concern is what happens to the TFSA.  The funds from one party’s TFSA may be transferred tax-free to the other party’s TFSA and this will have no effect on the contribution room of either party.

Non-registered Accounts

• Property can be transferred at its adjusted cost base (ACB), so that there are no tax consequences at the time of transfer on separation or divorce. This applies to property transferred in settlement of marital property rights, as well as any other voluntary transfers. The accrued gains on the property will eventually be taxed in the hands of the transferee.

Use of losses

• In certain cases, spouses may elect to transfer certain assets at fair market value (FMV). This could result in tax savings if, for example, the transferor had unused capital losses to apply to gains on the transferred property. In this case, the transferee also receives a significant tax benefit, as future capital gains will be calculated based on the FMV at the time of transfer.

Capital gains elections

• An often-forgotten tax benefit may be put to use when long-term unions dissolve, by taking into account any capital gains election the individuals may have made in February 1994. The purpose was to use up the $100,000 capital gains deduction which was eliminated that year. In such cases, use the elected adjusted cost base in calculating the tax consequences of property transfers.

Principal residence rules

• After separation, CRA recognizes two households, not one, and therefore it is possible for each ex-spouse to own one tax- exempt principal residence.
• It’s important to note that with the exception of the matrimonial home, property brought into the marriage by one of the spouses will be considered owned by that individual and assigned to that person during the negotiation of the separation agreement. Rules can differ by province.

Attribution rules

• When one spouse transfers assets to the other during their union, the Attribution Rules generally require any income earned on the transferred assets to be reported by the transferor. These rules will not apply to income earned during the period when the former spouses are living apart because of a breakdown in the relationship, as long as the separating couple jointly makes an election to this effect, and continues to live apart.   

Alimony or support payments made to a spouse or common-law partner are taxable to the recipient and deductible by the payor. In the year of separation or divorce, however, the payer may claim either the deduction for support or the spousal amount, but not both.

Essentially support payments will be deductible to the payor if:

1. An allowance is paid on a periodic basis for the maintenance of the recipient. (Notably lump sum payments in release of future liabilities are neither taxable or deductible).
2. The recipient has the discretion to use the amount as he or she wishes.
3. The recipient and the payer are living separate and apart.
4. The amount is receivable under an order of a competent tribunal.

Instalment Payments

• Individuals who receive taxable support payments often find themselves in tax trouble, because they fail to plan for the quarterly tax remittances to the CRA. This is required if the estimated taxes payable (including CPP contributions and EI premiums on self-employment income) in the current, and one of the two preceding tax years, exceed $3,000 ($1,800 on the federal return for Quebec residents).
  
• Three payment options are available:
       1.      No-calculation Option: CRA will provide the calculations and bill you. Taxpayers who pay using this method will not be subject to interest on deficient instalments.
       2.      Prior Year Option: Each instalment is one-quarter of the taxes payable in the prior year. There is an interest penalty for late or insufficient instalments, if the amount paid is less than the balance due when the tax return is filed.
        3.      Current Year Option: Each instalment is one-quarter of the estimated taxes for the current year.  Again, if payments are short, interest on deficient instalments will be payable.

Legal fees

• Legal fees paid to obtain a divorce or separation agreement or spousal support payments are not deductible. The same is true for fees paid to obtain custody or visitation rights. However, costs incurred to obtain child support are always deductible, as are costs to enforce pre-existing rights to interim or permanent support, or legal costs incurred to fight the reduction of support.  An important exception: costs incurred to obtain an increase in support, or to make child support non-taxable are not deductible. 

The tax consequences of separation or divorce are complicated, and take place in a stressful period; make sure all your professional advisors take the tax implications into account to ensure smooth sailing with CRA in the future.