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Divorce: an income splitting tool?

Sham marriages exist.  People enter into them for a variety of reasons, including citizenship, financial security, colouring public opinion (for example, politicians) and religious reasons.

But are there also reasons to undertake a “sham divorce”?

There may soon be for private business owners, based on the Canadian government’s newly proposed tax legislation, released July 18, 2017, relating to “income sprinkling”.

For clarity, I am not suggesting divorce is a path I recommend to any of my clients, friends or colleagues. 

 

Background

On July 18, 2017, the Canadian Government finance minister, the honourable Bill Morneau, released a 63 page “white-paper” outlining certain Private Company Tax Planning that he alleges is being used to unjustly enrich a select group of Canadian citizens, namely owners of small and medium size Canadian Controlled Private Corporations (“CCPCs”).

Included in the proposed changes to the Income Tax Act (Canada) are measures to eliminate the “unreasonable” income sprinkling tools currently available to entrepreneurs through CCPCs.  The tax proposals also include measures to eliminate the multiplication of the Lifetime Capital Gains Exemption on the sale of Qualified Small Business Corporation (“QSBC”) shares.

Basically, the government has proposed to eliminate a Canadian Private Business owner’s ability to distribute after-tax corporate income, or value created in their private company, to their spouse or family members without being subjected to extremely punitive tax measures.  For the remainder of this paper I have based my discussion on a Canadian Private Business owner and his or her spouse living in British Columbia (“BC”).

 

Who Cares About Income Splitting?

Countless narratives and illustrative mathematical examples have been published that tout the merits of income splitting.  I will not go through the mechanics to prove the financial benefits of income splitting here.  Suffice it to say, the non-refundable tax credits, incremental income tax brackets and income tested social benefits are some of the reasons income splitting between spouses is beneficial.

For example, let’s assume that a single earner family where a private business owner operating a CCPC withdraws $150,000 per annum from the business as dividends or salary for personal use can save approximately $15,000 per annum by income splitting with his or her spouse.

Let’s further assume that the tax savings on using a spouse’s lifetime capital gains exemption on the sale of QSBC shares is approximately $160,000.  This assumes the business has accrued over $825,000 in value which is available for allocation to the spouse after the primary shareholder has fully utilized their own lifetime capital gains exemption.

Most Canadian entrepreneurs care, or should care, about their ability to income split.

 

Human Behaviour – negative externalities

Would someone get divorced, or pretend to get divorced, to save $15,000 in tax (each year) or $160,000 in income taxes on the sale of their business?

I once had a friend volunteer providing medical aide (Doctors Without Borders) in Kenya.  The primary purpose was to battle the AIDS epidemic. The program was specifically targeting women who had contracted AIDS.  The program provided a financial stipend, medication and a high level of medical care to those women who tested positive for the disease.  A very commendable venture to embark upon.

After a few months working in Kenya my friend was puzzled by the rate of women who continued to contract the disease. Some of the women she had personally met, tested negative, and educated upon arrival.  She eventually realized that the Kenyans were perceiving the women who had tested positive to have a higher quality of life than those women who hadn’t contracted the disease, because of the financial aid, medication and a high level of medical care Doctors Without Borders was providing to them.

Those without the disease were getting purposely infected so they could reap the actual or perceived benefits of the Doctors Without Borders program.

Perhaps this is too dark an anecdote for this paper, but it serves to provide an extreme example of unintended consequences and human behaviour.

 

An Incongruence of Law

Please note:  I am not a lawyer.  I don’t pretend to be one.  I cannot be relied on for any form of legal advice.    

The BC Family Law Act came into effect on March 18, 2013.  One of the cornerstones of this legislation is the equalization of family assets (non-excluded property) between spouses upon the dissolution of their relationship.  Excluded from family assets is any property a spouse owned prior to entering the relationship.  Family assets are divided equally upon the dissolution of the relationship and is any property that was acquired, or grew in value, during the common-law or marital relationship.  Family assets include the increase in value of the shares of a private company.

In short, the BC Family Law Act allocates half of the growth in value of an interest in a private business to the entrepreneur’s spouse. This allotment attempts to quantify the immeasurable contributions a spouse has made as the entrepreneur’s life partner.

Is accruing 50% of the growth in value of the private business to the spouse always fair?  Perhaps not.  Is it a perfectly imperfect measure?  Yes, it is the best we’ve got and it is the law by which we currently live.

The newly proposed tax legislation specifically excludes any growth in the value of a Private Canadian Business from being allocated to the entrepreneur/business owner’s spouse.  The “white-paper” goes on to suggest how we might quantify the reasonable contributions a spouse has made to the business, based on factors such as capital contributions and services rendered (i.e. hours worked at fair market value rates).

The diverging theories underlying the BC Family Law Act and the July 18, 2017 proposed tax rules represent an enormous discrepancy in how we measure and attribute the value a spouse has contributed to an entrepreneur’s business. 

Quite simply, the current family law in BC states that a spouse’s contributions are equal to half of the growth of the value of the business, but the proposed tax legislation states that the spouse’s contributions to the business cannot be valued at an amount greater than their measurable (provable) services rendered and capital contributions to the business.

To some, this divergence in law may be viewed as an opportunity.

 

Divorce – Tax Law and regulation in Canada    

Divorce is prevalent in society today.  When a private business owner gets divorced, what is the fairest way for the corporate assets to be divided?  Should the Canada Revenue Agency (“CRA”) receive a 1/3rd portion of the value of a private business every time an entrepreneur gets divorced?

CRA is the big winner from divorce where the private company needs to be liquidated (i.e. sale of assets or shares or distribution of all corporate value as a taxable dividend) in order to finance the equalization payment upon marital breakdown.

Fortunately, the Income Tax Act (Canada) (the “Act”) has various provisions[1] which contemplate marital breakdown.  The Act recognizes that an arbitrary and painful life event (i.e. divorce) should not result in an enormous tax bill.

Provisions of the Act allow for an equitable division of corporate assets to occur on a tax deferred basis.  Commonly, the end result is an ex-spouse owning 100% of a “Holding Company” where approximately half of the value of the existing Canadian Private Company now resides.  This value can then be paid out of the Holding Company (as a taxable dividend or salary) to the ex-spouse at their discretion (i.e. they control the Holding Company as a director).

Explaining the exact step by step mechanisms which allow for a tax deferred transfer of corporate assets upon divorce is beyond the scope of this paper.  I highly recommend obtaining advisory services from a tax professional with experience in this field if you or your private business owner client is undergoing a divorce.

Tax laws related to divorce allow for an agreed upon portion (usually no more than half) of the value of a private business to be transferred to the entrepreneur’s ex-spouse’s without being subjected to personal income tax.  Thereafter, the ex-spouse can plan to withdraw money out of his or her Holding Company to optimize use of his or her non-refundable tax credits and lower income tax brackets each year.

A divorce will also “allow” an entrepreneur to enter into an arrangement with his or her ex-spouse whereby the entrepreneur will pay tax-deductible spousal support; the ex-spouse receiving the support must report it as taxable income (effectively income splitting).

 

Conclusion

To achieve annual tax savings from income splitting and an enormous tax saving (i.e. utilizing the lifetime capital gains exemption of their former spouse) an entrepreneur will be incentivized, from a tax perspective, to follow through with a divorce they are considering, under the new proposed tax laws and rules.

I would not put it past some private business owners to get “divorced” to crystallize these tax benefits and “reconcile” their relationship a few years later (i.e. once the CRA has processed their assessments).

Under the new tax rules, the after-tax sum of the two individual parts, once divorced, will be greater than the after-tax sum of the family unit’s wealth if the traditional relationship is maintained.

While I am reasonably certain the proposed tax measures are not meant to create a financial benefit rewarding divisiveness and relationship breakdown, it would appear they do.

Different treatment of the valuation of an interest in private company shares under family law and tax law will cause confusion, even for the most sophisticated participants.  Tax and law are complicated matters which require an enormous amount of care when implementing even the smallest change.  It will be interesting to see how tax planning and human behaviour react to sudden tectonic shifts in the foundation of private company taxation in Canada.

I hope the government will critically reconsider the new tax changes proposed as the topic in this paper represents just one of many potential unsavoury outcomes.

 

        

Jared Behr, CPA, CA, CBV, CFF (AICPA)

Principle/Partner at Lighthouse Valuations Inc. and Horizon Chartered Professional Accountants Ltd.

 

For inquiries about tax and advisory services please contact the author at jb@horizoncpa.ca

 

[1] Alimony, maintenance or support payments under subsections 56(12), 60(b), 60(c) of the ITA; attribution rules do not apply (ITA 74.4 and 74.5(3)); RRSP withdrawals and transfer under subsection 146(8.3) or 146(16)(b); registered education savings plan, rights transferred under subsection 204.91(3) of the ITA et al.