Pursuant to a Decree, Order or Judgment of a competent Tribunal or Pursuant to a Written Agreement. As Alimony or Other Allowance

Transcription

1 TAXATION ISSUES IN FAMILY LAW I. Alimony & Maintenance Payments A. Alimony Paid in the Year Pursuant to a Decree, Order or Judgment of a competent Tribunal or Pursuant to a Written Agreement As Alimony or Other Allowance Payable on a Periodic Basis For the Maintenance of the Recipient and/or the Children of the Marriage Separated pursuant to a Divorce, Judicial Separation or Written Separation Agreement Actually Living Apart when the payment was made and throughout the Rest of Year B. C. Maintenance Payments section 60.1 re Expenses In Respect of Qualifying Expenses Incurred in the Year or the Immediately Preceding Year Specific Reference to the New Sections Ownership of the House re: Mortgage Payments Other Criteria D. Alimony & Maintenance Deduction v. Dependent Spouse & Child Deduction 20 E. Legal Fees 20 II. Distribution of Property 22 A. B. Rollover to Spouse Attribution of Income The Basic Rules 24

2 2. Exceptions: Separation & Divorce 25 3 Details of the New Attribution Rules 30 C. D. Matrimonial Property Awards after Death Spousal Joint and Several Liability for Tax On Amounts Attributed Under s Transfers when the Transferor was under a tax liability III. Addenda A. The following sections of the Income Tax Act (Canada): Section 60(b) I (c) I & (c.1) Sections 60.1 & 56.1(4) 3. Sections 70(6)(part) and (6.1) Sections 73(1) and (1.1) Sections 74.1 to B. C. D. The following interpretation bulletins 1. IT - 118R2 2. IT R IT - IT - 305R2 325R Tax calculations respecting deductible v. non-deductible maintenance payments Letter from Revenue Canada dated July 9,

3 TAXATION ISSUES IN FAMILY LAW I. ALIMONY & MAINTENANCE PAYMENTS Sections 60(b), (c) & (c.1) of the Income Tax Act provide for the deductibility of certain qualifying alimony and maintenance payments from the taxable income of the payor. These sections are set out in Addendum III A 1. Sections 56(1)(b), (c) and (c.1) contain identical reciprocal provisions for the inclusion of those qualifying payments in the income of the recipient. The result of these identical reciprocal sections is that, in theory, any payments in the nature of alimony and maintenance which are deductible for tax purposes to the payor should be taxable income to the recipient. Likewise, any payments which are not deductible to the payor should not be income to the recipient. Numerous court cases gave a very restrictive interpretation to some aspects of sections 60(b), (c) and (c.1), and the reciprocal subsections in section 56. Parliament then passed two separate sets of additional provisions, now both found in sections 60.1 and 56.1, to expand the interpretation of these subsections. Generally speaking, sections 60.1 and 56.1 contain deeming provisions, which have the effect of expanding the circumstances 1

4 in which payments made to third parties (rather than to the estranged spouse or former spouse) are deductible to the payor. Section 60.1 is set out in Addendum III A 2. Section 56.1 is its reciprocal section. A. ALIMONY - Section 60(b) and Section Section 56(l)(b) and Section 56.1 For a payment to a spouse or former spouse to fall within section 60(b) and thus be deductible from the income of the payor, and therefore income for tax purposes to the recipient, it must be: 1. Paid in the Year As individuals are cash basis taxpayers, only payments actually paid in cash in the taxation year are deductible. An obligation to pay is not sufficient. 2. Pursuant to a Decree, Order or Judgement of a Competent Tribunal or Pursuant to a Written Agreement Generally speaking, there must be a court order or written agreement in place in order for payments to be deductible. Under the Income Tax Act as it existed in 1983, if payments were made voluntarily before a separation agreement was entered into, or before a court order for maintenance was obtained, the payments were not deductible to the payor, and accordingly not taxable income to the recipient, because the payments, when made, would 2

5 not have been made pursuant to the written agreement or court order. Obviously, that document or order would not have been in existence at the date the payment was made. Further, payments made after the date of the order but in respect to the time period prior to the order were probably not deductible either. The problem of non-deductibility of the prior payments was in many cases avoided by having the written separation agreement state that the agreement was a verbal agreement made on an earlier date (the time the payments started) and subsequently reduced to writing. The agreement would also contain a covenant by the recipient to include those payments in income for tax purposes. As a matter of local assessing practice at Revenue Canada, if the recipient did include those payments in income the payor would be allowed a deduction for them, even though they would not technically qualify for deductibility under the Act. Sections 60.1(3) and 56.1(3) of the Income Tax Act (which came into effect in 1984) are intended to allow the deductibility of payments made before there is an order or written agreement, provided the order eventually made or the agreement eventually signed provides for such payments. Naturally, if the payments are covered by the agreement or order so as to be deductible to the payor, they will also be income to the recipient. Section 60.1(3) merely deems, in relation to such payments, that: a. payments made in the year the order is issued or the 3

6 written agreement is entered into, or in the immediately preceeding year, were paid pursuant to the court order or written separation agreement; and b. the person who made the payments was separated from the recipient pursuant to a divorce, judicial separation or a written separation agreement at the time the payment was made and throughout the remainder of the year. All of the other requirements of section 60(b) must be complied with for the payment to be deductible. Also, these payments are deductible to the payor only if the order or agreement provides that the prior payments are considered as having been paid and received pursuant to the order or agreement. This requirement will necessitate careful attention to the wording of orders and agreements if deductibility of prior payments is to be assured. 3. As Alimony or Other Allowance In order to meet the requirements of the Income Tax Act, a payment must either: a. Meet the definition of "alimony or other allowance" from the relevant cases; or b. Qualify under section 60.1(2). The second issue is discussed under I. C. infra. This part of 4

7 the paper will address the issue of deductibility of payments under section 60, without the assistance of section 60.1(2). There have been several recent cases surrounding the definition of "allowance". The results from older cases such as Brooke, infra, and Pascoe, infra, have been modified in some important respects. The Tax Review Board in Brooke v. M.N.R. 77 DTC 38 defined "alimony" as an allowance payable at regular intervals to provide a sum adequate to maintain the payee until the next payment. The Queen v. Pascoe [1975] CTC 656 (FCA) defined "allowance" as: "a limited predetermined sum of money paid to enable the recipient to provide for certain kinds of expense; if the amount is determined in advance and, once paid, it is at the complete disposition of the recipient who is not required to account for it. A payment in satisfaction of an obligation to indemnify or reimburse someone or to defray his or her actual expenses is not an allowance; it is not a sum allowed to the recipient to be applied in his or her discretion to certain kinds of expense." The result of the Pascoe decision was to deny the deductibility of mortgage payments made directly to the mortgage company (as they would not be at the complete disposal of the separated spouse) or payments made for house maintenance expenses or educational or medical expenses. These latter payments would be merely reimbursement of expenses already incurred, and accordingly could not be described as an allowance. (Some of 5

8 these payments, particularly ones made in reimbursement of expenses incurred, were also not deductible in that they did not meet the periodicity test described in 4. below.) Section 60.1 (an earlier version than that set out in Addendum III A) was introduced in an attempt to get around the restrictive interpretation which had been given by the courts and the Tax Review Board to "allowance", so as to make deductible payments made to third parties for the benefit of the separated spouse. However, this section too was given a very restrictive interpretation, particularly in leading case of The Queen v. Bryce [1982] CTC 133, 82 DTC 6126 (FCA) (this case is still under appeal to the Supreme Court of Canada). In that case, counsel for the Crown conceded that section 60.1 in effect made qualifying payments actually paid to third parties deemed to have been paid to the separated spouse. However, Revenue Canada's position, which was supported by the Federal Court of Appeal, was that these payments still did not constitute an "allowance" in that the recipient had no discretion as to the use of the money. As a result, the only time that payments made to third parties could have qualified as an allowance is if they were made to third parties with the consent of the deemed recipient spouse. Presumably, in order for those payments to qualify as an allowance, the deemed recipient spouse must have been able to revoke the consent and require the payments to be made directly to him or her. The recent decision of the Supreme Court of Canada in Jean-Paul 6

9 Gagnon v. The Queen, 86 D.T.C. 6179, has considerably softened the decision of the Federal Court of Appeal in The Queen v. Pascoe. In the Gagnon case, at issue was a payment to the wife of an amount equal to the monthly mortgage payment on the home. The amount was paid to the wife rather than to the mortgage company. The husband's obligation to pay the monthly amount was contingent on the wife using the money to meet the mortgage and tax payments. The Court states at 6184: "Seen in this context, the third condition imposed by Pascoe must be corrected: for an amount to be an allowance within the meaning of s. 60(b) of the Income Tax Act, the recipient must be able to dispose of it completely for his own benefit, regardless of the restrictions imposed on him as to the way in which he disposes of it and benefits from it." Accordingly, the fact that the agreement required the wife to use the monthly payments to meet the mortgage and tax payments on the property did not disqualify the amount from being an allowance. The Gagnon decision was applied by the Tax Court of Canada in Gavin Wood v. M.N.R. 86 D.T.C In that case, the taxpayer claimed a deduction for mortgage payments made on his ex-wife's residence. The payments were made pursuant to a court order under the British Columbia Family Relations Act, and were made directly to the mortgage company. The Tax Court allowed these payments to be deductible to the taxpayer on the basis of Gagnon, saying at 1392: "According to the said decision, for an amount to be at the complete disposition of the beneficiary, it is 7

10 sufficient that the said amount of money be completely at the beneficiary's profit. In my opinion, this is the case in the instant appeal. For these reasons the appeal is allowed... " There may be some question as to the scope of the decision of the Supreme Court in Gagnon. With respect, it appears that the Tax Court decision in Wood goes further than Gagnon. However, even in that event, the Gagnon decision may be of use in obtaining the deductibility of payments in the following circumstances: 1. If the agreement, like the one at issue in Gagnon, provides for payments to be made to the recipient but requires that the amounts be used to pay certain periodic obligations. 2. If the agreement provides for payment directly to the mortgage company, and you are accordingly relying on the old s. 60.1(1) (now 60.1(1)) to make the payment deductible. The problem in the ordinary case with payments made to the mortgage company is that s. 60.1(1) deems them to be made to the "recipient", but does not deem them to qualify as an allowance. The main difficulty with them qualifying as an allowance comes about as a result of the third branch of the Pascoe decision; this problem appears to be alleviated by the Gagnon case. (Please note, however, that if you have a more recent agreement that specifically refers to section 60.1(2), in most cases you will not need to have resort to section 60.1(1) to make the payments deductible. The discussion in this paragraph should apply only to agreements and court orders made before 1984.) 8

11 4. Payable on a Periodic Basis The order or written separation agreement must provide that the maintenance payments be payable periodically, presumably weekly, monthly, annually, or the like. Amounts paid for dental expenses, special camps and so forth have in the past not qualified for deductibility under section 60(b) due to the fact that they were not payable periodically but rather were occasional, sporadic and contingent payments. Again, the new section 60.1 will make many of these payments deductible, as discussed at I. C. infra. Another common reason for the disallowance of a deduction for payments due to the fact that they are not periodic payments arises out of attempts to disguise lump sum amounts (particularly lump sum distributions of property) as periodic allowances and therefore deductible. The wording of the separation agreement or court order will be crucial here. If the order is for the payment of a specified sum of money, to be satisfied by periodic installment payments, the installment payments are probably not deductible, as it is the lump sum payment which is the amount payable. (An example would be the sum of $12,000.00, payable by monthly installments of $1, ) On the other hand, regular monthly payments which add up to a specified sum payable may well be deductible. (For example, $1, per month for 12 months, for a total of $12, ) Further, if the payment is in consideration of a release of claims by the recipient, or in lieu 9

12 of alimony or maintenance, the installments would probably not be deductible on the ground that they are not alimony or other allowance but are payments in return for a release - a property exchange. Those wishing to have large annual payments be deductible as qualifying alimony payments can take heart from the decision of William K. Hanlin v. The Queen 85 OTC 5052 (F.C.T.O.) where annual payments of $18,000,00, $19, and $17,000.00, respectively, were held to be deductible. The court looked to the agreement, which contained an acknowledgment by the parties that the payments were for the periodic maintenance of the wife. At the hearing of the tax appeal, the payor husband stated that the reason for making the large annual payments was that, around that time of year, his law partnership made large distributions of cash to the partners, and accordingly, he would have the funds available to make the payments. He denied that the payments were made for any purposes other than periodic maintenance. The careful drafting of the agreement, and this testimony, greatly assisted in the argument for the deductibility of the payments. The Hanlin case may also be of assistance if you have a poorly worded agreement to contend with. In the recent Tax Court decision Henson v. M.N.R. 85 OTC 506, the court, in a judgment which does not contain any in-depth reasoning, uses the Hanlin case to include in the recipient's income a payment "by way of maintenance of $7, to be paid in four periodic instalments of equal value... ". 10

13 It should be noted that the periodicity requirement of the section only specifies that amounts be "payable" on a periodic basis, and not that they in fact be paid on a periodic basis. The Department's practice, as set out in IT-118R2, paragraph 10, is to allow the deduction of lump sum payments paid on account of periodic payments which otherwise meet the criteria in section 60(b) as long as the payments are in arrears. Thus the payor would get a deduction for late payments. This position was recently confirmed by the Federal Court of Appeal in the case of The Queen v. Sills, 85 DTC The agreement in that case provided for monthly payments, but the payor spouse paid lump sum amounts occasionally throughout the year, and indeed was in arrears at year-end. The recipient argued that the payments should not be included in her income because they did not meet the periodicity requirement. This argument was accepted in the Trial Division, but rejected by the Federal Court of Appeal. The Court said at page 5098: "On these facts, the $3,000 received by the Respondent from LaBrash was clearly paid by him and received by her to carry out the terms of the separation agreement. Some of the money was payable to the Respondent as alimony, the remainder was payable to her as maintenance for the dependant children. All of it was payable on a monthly basis as stipulated in the separation agreement. Where the Trial Judge erred, in my view, was in not having due regard to the use of the word "payable" in the subsection. So long as the agreement provides that the monies are payable on a periodic basis, the requirement of the subsection is met. The payments do not change in character merely because they are not made on time. The learned Tax Review Board member made the same error, in my view, when he said that the amounts to be included in income "must be received exactly according to the terms of the agreement". The subsection does not say that. If the learned Tax Review 11

14 Board member and the learned Trial Judge are right, then any monthly payment made to the Respondent on the second day of the month for which it is due, for example, would not be taxable in the hands of the Respondent. This is surely not a reasonable or a proper interpretation of the subsection." The respondent also argued that the payments were not in fact alimentary payments, as they were not paid in advance to allow the recipient to maintain herself until the date of the next payment. The court also rejected this submission, stating that: "One of the problems with this submission is that there is no evidence on this record of any re-imbursement for actual expenses. Furthermore, it seems clear that the kind of allowance contemplated by subsection 56(1)(b) would include any and all amounts paid under the agreement whenever they are paid and received since the amount is determined in advance and, once paid, it is at the complete disposition of the recipient who is not required to account for it." 5. For the Maintenance of the Recipient and/or The Children of the Marriage There are a number of court cases dealing with the question of whether or not payments of certain expenses are payments made for the maintenance of the recipient and/or the children of the marriage. Some examples of disputed amounts (where the Tax Review Board or Tax Court of Canada decisions have not been necessarily consistent) have been medical expenses, medical insurance premiums, and house payments. Many of these payments would of course be open to attack on the basis that they were not paid as an "allowance", or not paid on a periodic basis. The amendments to section 60.1, discussed at I.C., infra, clarify this area a great deal. 12

15 6. separated pursuant to a Divorce, Judicial Separation written Separation Agreement In the case of Smith v. M.N.R., 79 DTC 827 (TRB), the husband and wife (who were living separate and apart) entered into an agreement which essentially provided as follows: "I [the husband] agree to pay to you [the wife] $ on the first day of every month beginning April 1, 1974." The Court held that the husband could not deduct the payments made to the wife pursuant to this agreement, even though it had been signed by both parties, on the ground that it was not a separation agreement. The Court concluded that to qualify as a separation agreement the document had to contain an agreement to live separate and apart, which in this case was completely absent. 7. Actually Living Apart when the Payment was Made and Throughout the Rest of the Year If, part way through a year in which otherwise qualifying alimony payments are made, the spouses reconcile and once again cohabit, none of the payments made in that year will be deductible to the payor. However, it should be noted that, depending on the recipient's income, (which would not include any of the alimony payments) the payor may then be able to claim the married exemption and may be able to claim a deduction for dependent children. It is probable that the divorce cases dealing with the issue of whether spouses are living separate and apart even 13

16 though living in the same house would apply here as well to determine whether the parties are in fact cohabiting. B. MAINTENANCE PAYMENTS Section 60(c) and (c.1) are somewhat different in their requirements than section 60(b). For payments to be deductible under either of these sections, it is not sufficient that they be made under a written agreement; rather they must be paid pursuant to a court order. Section 60(c) covers payments made to spouses (not former spouses) for the maintenance of the spouse and/or the children. This would cover, for example, payments made pursuant to an order under The Deserted Spouse's and Children's Maintenance Act. Section 60(c.1) on the other hand does not require the payor and the recipient to be married. It is intended to cover payments made to common law spouses (which would not apply in Saskatchewan as there is no legislation in Saskatchewan requiring maintenance payments to be made to common-law spouses) and presumably to maintenance payments made under an order pursuant to The Children of Unmarried Parents Act. However, at this time there are no regulations "prescribing" a class of persons under section 60(c.1), and accordingly the section does not appear to be of much use. 14

17 C. SECTION 60.1 RE: EXPENSES Sections 56.1(2) and 60.1(2) greatly expand the circumstances in which a person can obtain a deduction for tax purposes for payments made for the benefit of a spouse or former spouse, where the payments are not made directly to that spouse. As is the case for alimony and maintenance payments under sections 56 and 60, supra, the amounts must be: Paid in the taxation year; Pursuant to a decree, order of judgment of a competent tribunal or pursuant to a written separation agreement; For the maintenance of a spouse or former spouse or a prescribed person (who will be called the "beneficiary") or children of the beneficiary; Where at the time the expense was incurred and throughout the remainder of the year, the taxpayer was living apart from the beneficiary. The payments must be: 1. In respect of qualifying expenses a. The expense must be for the maintenance of the beneficiary or the children of the beneficiary. b. It cannot be an expenditure for the acquisition of tangible 15

18 property, unless it is an expenditure on account of a medical or educational expense or in respect of an owner-occupied home. The intent of this provision appears to be to allow a deduction for all types of medical and educational expenditures, including those which result in the acquisition of tangible property. An exa~ple of this would be a medical expenditure for a wheelchair or an educational expenditure for text books. c. Qualifying payments of principal and interest on a mortgage on a owner-occupied home (see the definition of "owner-occupied home" in section 56.1(4)) and payments for improvements to the house, cannot exceed 1/5 of the original principal amount of the mortgage on the house or of the original principal amount of the indebtedness which financed the improvements to the house in any year. This subsection is a fine example of obfuscation in the drafting of the Income Tax Act. Translated, section 60.1(2) requires you to: i. s. 60.1(b)(ii) Take 20% of the original principal amount on the house mortgage and 20% of the original principal amount on any loan for improvements to the house. ii. S. 60.1(2)(b)(i) -- Add up all of the payments in relation to the house which you want to deduct using 16

19 section 60.1, which would include monthly mortgage payments, payments on a loan for improvements, and actual cash expenditures for improvements. It is unclear whether maintenance expenditures are to be included in this calculation, given that section 60.1(2) (a) refers to both "improvement" and "maintenance" and section 60.1(2)(b)(i) does not. iii. Section 60.1(2)(a).- Add up all of the amounts which you need the assistance of section 60.1 to be able to deduct. This will include all of the amounts in (ii), plus, probably, dental costs, camp fees, etc. iv. Subtrac t (i) from (ii) If you get a positive number, which will only occur if the house related payments which you want to deduct using section 60.1 exceed 20% of the original principal amount owing on the house, you must subtract that amount from the total amount in (iii), and the result is the amount deductible to the payor using section In essence, the deduction under this provision is reduced by the amount by which payments made in relation to the house exceed 20% of the original principal indebtedness outstanding on the house. 2. Incurred in the Year or the Immediately preceding Year payments are deductible to the extent they are actually paid in 17

20 the taxation year of the payor. However, if expenses are incurred in the preceeding year but are not paid until the taxation year in question, they are nonetheless deductible under this provision. Thus, if the payor did not pay the December 1st mortgage payment until the following January, that mortgage payment would be deductible for the payor in the year it was actually paid, due to the fact that the expense was incurred in the preceeding year. 3. Specific Reference to the New Sections The court order, or the written separation agreement, must actually make reference to sections 60.1(2) and 56.1(2) of the Income Tax Act. For this reason, payments made under old orders or agreements will probably not be worded to give the payor a deduction for otherwise qualifying expenses. It will be necessary, if those expenses are to be made deductible, to have the separation agreement amended, or to obtain a new court order. This is a reasonable restriction, as separation agreements and court orders before the amendments to section 60.1 would have been made on the basis of a different set of rules on the deductibility of payments, and presumably would not have been based on these payments being able to be deducted by the payor. 4. Ownership of the House re: Mortgage Payments Section 56.1(4)(a) defines "owner-occupied home" as a housing unit owned by the taxpayer, whether jointly with another person 18

21 or otherwise. (The definition also extends to shares in cooperative housing corporations, however, we will ignore that provision for the purpose of this discussion.) In section 56.1, "taxpayer" means the recipient of the payment. As a result, in order for mortgage payments to be deductible to the payor under the deeming provisions in section 60.1, the spouse or former spouse who receives the payments must at least be a joint owner of the property. It appears that it would not be sufficient for the payor spouse to be the sole registered owner of the home, even if the recipient spouse had an order for exclusive possession under The Matrimonial Property Act. 5. Other Criteria If all of the above criteria are met, the amount of the qualifying expenditures will be deemed by section 60.1(2) to have been paid by the taxpayer and received by the beneficiary as an allowance payable on a periodic basis. If all of the other requirements in section 60(b}, (c), or (c.1), as the case may be, are met, the payor will obtain a deduction for tax purposes under section 60 and the beneficiary will be taxed on the amount under section 56. It should be kept in mind, however, that section 60.1 does not itself give a deduction for these qualifying payments. It merely deems certain payments, even though not in fact an allowance payable on a periodic basis, to be an allowance payable on a periodic basis, in order to make amounts which would otherwise not be deductible under section 60 into deductible sums. 19

22 D. ALIMONY & MAINTENANCE DEDUCTION v. DEPENDENT SPOUSE & CHILD DEDUCTION Section 109(4) of the Income Tax Act prohibits a taxpayer from claiming a a deduction for a dependent spouse or child where that taxpayer is entitled to a deduction for alimony or maintenance payments pursuant to section 60(b) or (c). Section 109(1)(d) allows a taxpayer a deduction for each child who, during the year, was wholly dependent upon the taxpayer for support. Section 109(1)(a) permits a married person deduction to an individual who, during the year, supported his or her spouse. The wording of section 109(4) would lead one to believe that whenever a taxpayer was entitled to a deduction under section 60{b) or (c), whether or not the taxpayer chose to claim that deduction, there would be no ability to claim a deduction under section 109(1) for a spouse and dependent children. However, it appears that the Department's assessing practice is to allow the taxpayer, in the year of separation, to choose to claim either the alimony or maintenance deduction, or the dependent spouse and child deduction. E. LEGAL FEES The principles for the deductibility of legal fees paid to obtain alimony or maintenance payments are discussed in the case of The 20

23 Queen v. Burgess, [1981] CTC 258, 81 DTC 5192 (FCTD). In the Burgess case, the recipient of the alimony payments, which were ordered pursuant to a decree nisi of divorce, alleged that by virtue of her marriage, she had a right to maintenance, which fell within the definition of "property" under the Income Tax Act. On that basis, then, legal fees paid to assert, declare or enforce that right would be deductible. The Court found, however, that the right to maintenance which exists during marriage is a right which terminates upon the dissolution of the marriage. As the payments in the Burgess case were made pursuant to a decree nisi of divorce, it was held that the legal fees incurred were incurred to establish the right to the payment, which arose not by virtue of the marriage (which was terminated by the divorce) but rather by the court order. The legal fees were therefore not deductible as they were paid to establish or ~reate a right, not to enforce an existing right. On the basis of the reasoning in this case, while legal fees paid to secure a maintenance order in a divorce decree would not be deductible, legal fees incurred in negotiating maintenance payable pursuant to a separation agreement, or pursuant to an interim maintenance order, would be deductible as it would merely be enforcement of the recipient's right to maintenance which arose as a result of the marriage. Further, any legal fees paid to enforce maintenance payments, whether those payments were payable under an order in a divorce decree or pursuant to a separation agreement or interim maintenance order, would also be deductible, as they would not be paid to create the right to 21

24 income, but rather to enforce that right. The recent Tax court of Canada decision in John McCombe v. M.N.R. 85 DTC 268 confirms, on the basis of the reasoning in Burgess, that legal fees paid by the payor of alimony, in the course of an attempt to reduce or eliminate the obligation to pay are: "incurred in order to bring into being a future or potential right of exemption to which he had, at the time, no legal entitlement whatever. The expenses cannot be said to have been incurred for the purpose of ga1nlng or producing income from a property and they do not come within the meaning and intent of paragraph l8(1)(a) and subsection 248(1) and are therefore not deductible". It may be argued, however, on the reasoning in Burgess, that a deduction would be available if the reason for the legal expense was merely to have alimony payments reduced as opposed to eliminated. Only the latter would extinguish the right. II. DISTRIBUTION OF PROPERTY A. ROLLOVER TO SPOUSE Section 73(1) of the Income Tax Act allows property to be transferred from one spouse to another, or to a former spouse in settlement of rights arising out of their marriage, on a rollover basis. This means that no capital gain would be recognized by the transferor spouse on the transfer of the property, and the transferee spouse would take the property at the transferor's 22

25 cost base for tax purposes. The word "transfer" has been interpreted in several tax cases as requiring some action on the part of the "transferor".[l] As a result, but for section 73(1.1) of the Income Tax Act, court orders awarding an interest in property, or vesting title to property in a spouse, where no action on the part of the other spouse is required, may not have come within the scope of section 73(1), as they did not involve an active transfer. However, section 73(1.1) essentially extends the meaning of "transfer" for the purposes of section 73(1) to include the provisions of the prescribed laws of a province, or court orders made pursuant to those provisions, where a person acquires, is awarded or has vested in him or her property formerly owned by that person's spouse. Sections 5, 8, 21, 22, 23(4), 26 and 42 of The Matrimonial Property Act, 5.5. c. M-6.1 are prescribed in Regulation 6500(2) for the purposes of section 73(1.1). The transferor spouse can elect to have the rollover available by section 73(1) not apply to any particular transfer of property. If the transferor spouse so elects in his or her tax return for the year in which the property was transferred, the rollover will not apply and the transfer of property will be subject to the 1. Hansen, Bryan J. "The Definition of 'Transfer' in Sections 74 and 75 - Judicial Nonsense", The Canadian Tax Journal Volume 24, No.6, Page 612. The court in the Boardman case, infra, casts some doubt on the meaning of 'transfer' as discussed above. However, the definition of "transfer" was not part of the ratio of the Boardman case. 23

26 usual rules in the Income Tax Act relating to dispositions of capital properties. If the transferor and transferee are still married at the time of the transfer, then they are deemed for the purposes of the Income Tax Act not to deal with each other at arm's length (section 251 of the Income Tax Act) and accordingly section 69 would apply to deem the transferor to have received proceeds of disposition equal to the fair market value of the property at the time of the transfer. The transferor would then be taxed on any capital gains inherent in the property. As a result, the combined effect of section 73(1) and (1.1) is to make it very easy to transfer property from one spouse to another, whether during marriage or on the breakup of a marriage, on a tax deferred basis. Further, through an election in the transferor's tax return, capital gains can be recognized immediately. This may be useful where the transferee intends to dispose of the property very soon, but the agreement is that the transferor is to pay the capital gains tax on the disposition. B. ATTRIBUTION OF INCOME 1. The Basic Rules The Department of Finance does not like the idea of a high income-earning person transferring income producing property, or property on which capital gains could be recognized, to a lower income spouse, if the result is to have the income or capital 24

27 gain taxed in the hands of the lower income spouse at a lower tax rate. This would result in a net loss of revenue to the Treasury, as less tax would be paid overall. Accordingly, sections 74.1 to 74.5 inclusive of the Income Tax Act (most of which are new provisions) contain extensive rules to ensure that the income or loss, or the capital gain or capital loss, respectively, on property transferred or loaned between spouses is included in the income of the transferor (lender) spouse. As a result: (a) If an income generating property (such as a rental house) were transferred from husband to wife, the net rental income from that house would be included in the taxable income of the transferor husband, rather than in the income of the transferee wife; and (b) If the house was subsequently sold, yielding a capital gain, that capital gain would be taxed in the hands of the transferor husband rather than the transferee wife. Transfers for fair market value are an exception, if the transferor elects not to have the rollover apply, as discussed under II A above. 2. Exceptions: separation & Divorce The Department of Finance is making a concerted effort, with the new amendments, to ensure that income cannot be passed on to the lower income spouse in the course of an ongoing marriage. 25

28 However, this same theory does not apply in the case of separated or divorced spouses, and accordingly, the attribution rules can be avoided in those circumstances: (a) Naturally, the attribution rules cease to apply upon divorce. In the above example, rental income earned after the divorce is taxed in the hands of the transferee rather than the transferor. Also, if the house is sold after the divorce, the gain is taxed in the hands of the transferee. (b) Section 74.5(3)(a) provides that income or loss (but not capital gains or losses) is not attributed to the transferor spouse where it is earned while the parties are living apart and separated pursuant to a court order or written separation agreement. It should be noted, however, that section 74.5(5) removes the exception, and would retroactively provide for the attribution of income or loss back to the transferor, where the parties were separated pursuant to a written separation agreement and commenced living together again within 12 months of the date of the agreement. (c) The attribution of capital gains and capital losses can be avoided, for dispositions of property occuring prior to divorce, where the parties are separated pursuant to a court order or written separation agreement, if the parties sign a joint election pursuant to section 74.5(3)(b) that the attribution rules not apply, and that election is filed with the tax return for the year in which the parties commenced to so live apart. It 26

29 appears on the wording of this section that the relevant year is the year in which the court order or written separation agreement is obtained. Again, if the parties are separated pursuant to a written separation agreement and reconcile within 12 months of the date of the agreement, section 74.5(5) removes the saving provision and would apply to tax the capital gains or capital losses arising from any disposition of transferred property in the hands of the transferor spouse. (d) The attribution rules in general apply only to "transfers or loans" of property. As mentioned above, the word "transfer" has been interpreted to require some action on the part of the transferor. The extended meaning of "transfer" as set out in section 73(1.1). does not apply to the attribution rule sections. Accordingly, the attribution rules as a whole may be able to be avoided by having the property pass from one spouse to the other pursuant to a court order in which the property is vested in the transferee spouse. The vesting order, if properly drawn, (being an order directed to the Registrar of the appropriate Land Titles Office to change the registered owner of the property, rather than merely an in personam order directed to the "transferor" requiring that person to execute a transfer of land in favour of the "transferee"), will doubtless mean that there is no action on the part of the former owner of the property and accordingly there would be no "transfer". It would also be prudent for the "transferor" to object to the granting of the order. The result would be a complete avoidance of the attribution rules, regardless of whether the parties were living together or apart 27

30 at the time of the order, at the time the income was earned, or at the time the property was disposed of. A vesting order will not always be a complete answer, though. In the recent Federal Court Trial Division decision in Boardman and Sask-Can Investments Ltd. v. M.N.R. 85 DTC 5628, a vesting order failed (at least at this level - the case is under appeal) to prevent adverse tax consequences. In that case, the husband was the main shareholder of a corporation, though the wife owned one share in the company. The husband and wife divorced in 1977, and in the course of that proceeding, the court ordered the Registrar of Land Titles to register title to two houses owned by the corporation to the wife as a division of property. The Federal Court Trial Division held that the court order constituted a "transfer of property made pursuant to the direction of, or with the concurrence of, [the husband to the wife] for the benefit of the [husband] within the meaning of section 56(2) of the Income Tax Act, and in addition, was a benefit conferred on the taxpayer within the meaning of section 245(2) of the Act." As a result, the company recognized a capital gain on the properties, and the value of the properties was included in the husband's income. There are a number of sections under the Income Tax Act that can be applied by Revenue Canada to produce tax consequences where property is removed from the ownership of a corporation and placed in the hands of another person. These include section 15(1), section 56(2) and section 245(2). Caution should be 28

31 exercised if part of a matrimonial property settlement involves property owned by a corporation. However, in many situations, it is possible that the assets of a corporation may be able to be divided between separate corporations owned by each spouse, all on a tax deferred basis, using a "butterfly" reorganization. The details of such a reorganization are beyond the scope of this paper, however, a good discussion can be found in Kellough, Howard H., "Splitting up the Business of a Private Corporation", which article is published in the papers from the 1984 Corporate Management Tax Conference, sponsored by the Canadian Tax Foundation. If there will be a significant delay between the date of the transfer of the property and the ultimate divorce, the following suggestions should be considered to avoid the potential application of the attribution rules: (e) A court order, as opposed to a separation agreement, will avoid potential tax problems resulting from a reconciliation. If there is a subsequent reconciliation, there will be no retroactive change in the tax treatment of income or capital gain during the period of separation. Naturally, upon the reconciliation, the usual tax treatment would once again apply, and income and capital gain would be attributed to the transferor, however, during the period of separation the income would be taxed in the hands of the transferee. (f) Ensure that the parties complete a joint election pursuant 29

32 to section 74.5(3)(b), in order to protect the transferor spouse from the attribution of capital gains on dispositions of property occuring during the period of separation. Alternatively, the transferee spouse could be prohibited from selling the property until the divorce, however, that may not be appropriate if the transferee spouse needs the proceeds of the disposition of the property to meet expenses. (g) If possible, have the "transfers" of property, including land, be accomplished by opposed vesting order rather than by way of a document signed by the "transferor". 3. Details of the New Attribution Rules The Old Rules The attribution rules that were in effect before May 23rd, 1985 applied to certain transfers (whether direct or indirect) of property to a spouse. The rules applied to include in the income of the transferor only income or loss from property and capital gains or capital losses, but not income earned from the re-investment of attributed income, nor business income or losses. These old rules continue to apply to transfers which occurred before May 23rd, However, for transfers after that date, and for loans and other types of transactions not formerly covered, a new, broader and infinitely more complex set of rules applies. 30

33 Income from Property The new section 74.1 extends the attribution rules to cover loans [1] as well as transfers. Not only are loans and transfers to a spouse or minor covered; the section also extends to loans or transfers for the benefit of a spouse or minor.[2] The rules only add amounts to the income of an individual who is resident in Canada throughout the year. Also, if a minor who is a recipient turns eighteen in the year, there is no attribution in respect of income earned by the minor for that year. Capital Gains and Losses In addition to income from property, capital gains and capital losses, and gains and losses from listed personal property, are by section 74.2(1), attributed. The capital gains exemption is, however, available to the person who is taxed on the capital gain. (See section 74.2(2)). Section 75.1 also attributes to the transferor the capital gain or capital loss on property transferred to a child, grandchild or great grandchild if the property is disposed of before the year 1. There is an exemption (see the note under "History" under section 74.1 in Appendix III) for loans outstanding on May 22nd, 1985 and repaid by the end of There is no attribution on such loans, or on income earned, during that period even if the loan is not repaid by the end of This provision extends to any minor, not just a minor who is a child or other descendent of the transferor/lender. 31

34 in which the minor turns eighteen. Section 74.1(3) ensures that the attribution rules cannot be circumvented by the lower income spouse bank, and the higher income spouse giving borrowing money from the or lending property to payout or reduce the debt. This section attributes all or a pro rata amount of the income from the property acquired with the loan (depending on the value of the gift compared to the cost of the property acquired with the bank loan) to the person who made the gift. Of course, loans and gifts, direct or indirect, to or for the benefit of the spouse or minor are covered by this subsection. Trusts Section 74.3 sets out rules for the attribution of income where property is loaned or transferred to a trust in which a spouse of the transferor/lender or minors (whether or not they have any connection to the transferor/lender) are beneficially interested. corporations Section 74.4 provides for the attribution of income where property is transferred or loaned by an individual to a corporation. This section does not apply where the transfer/loan 32

35 is to a small business,corporation,[1] but would apply where the orporation is, for example, an investment corporation. In order for attribution to apply, there must be a "designated shareholder" of the corporation, being a spouse, a minor, or a partnership, trust or non-small business corporation in which such a person is a partner, beneficiary or shareholder, as the case may be. As usual, direct or indirect transfers or loans are covered. The calculation under section 74.4 is quite complex, but it basically includes in the income of the transferor/lender: a. Whenever dividends are paid to a designated shareholder, an amount which can be equated to interest on the value of the property transferred or loaned to the corporation. The calculation of the attributed amount is complex. However, if the income earned by the corporation exceeds the prescribed interest rate under the Income Tax Act, the amount in excess can be earned by the designated shareholder without attribution to the transferor/lender. b. Whenever capital gain is realized by the individual's 1. "Small business corporation" is defined in section 248(1) to include a holding company if all or substantially all of its assets were shares or debt of a connected active business corporation. 33

36 spouse, an amount equal to the share of the capital gain reasonably attributed to an increase in the value of the transferred property. Exceptions to the Rules Section 74.5 sets out some exceptions to the attribution rules, and some provisions which extend their application. The exceptions are: a. Section 74.5(1) which contains an attribution rules in sections exemption from the 74.1 and 74.2 for transfers at fair market only if: value. The exception applies i. The fair market value of the consideration was greater than or equal to the fair market value of the property transferred; ii. If debt was part of the consideration received by the transferor, A. Interest must be charged on the debt at the least of the interest rate prescribed the Income Tax Act at the time the debt under was incurred, or a commercial interest rate between arm's length parties at the time the debt was incurred; 34

37 B. In each year that the loan was outstanding up to and including the year in question, interest must have been paid no later than 30 days after the end of the taxation year; iii. If the transfer was to a spouse, the rollover provisions under section 73 must not have been applied. Note that this exception does not apply to transfers to a corporation. b. Section section above. 74.5(2) also 74.1 and 74.2 exempts from attribution under loans which comply with (ii) c. Section 74.5(3)(a) exempts from the attribution rules income or loss from property earned by a spouse during a period of separation pursuant to a court order or written separation agreement. d. Section 74.5(3)(b) exempts capital gains during a period of separation if the transferor spouse files an election with his return in the year in which the spouses commenced to live apart. e. Section 74.5(4) also terminates attribution under section 74.4(3) (being in relation to dividends paid by 35