Clients navigating separation or divorce often seek guidance from their advisors about the short- and long-term effects on lifestyle and finances. In Part 1, we covered challenges around dividing assets and tax credits. Here, we look at the tax impacts of property settlement and estate planning.
Tax impacts of property settlement
Equalization of family property typically results in the higher-net-worth spouse making an equalization payment to the other spouse so both leave the relationship in a similar position. Equalization payments to settle property rights typically occur without tax consequences.
From a tax perspective, during the relationship and when settling property rights when the relationship ends, assets can transfer between spouses or common-law partners (CLPs) at tax cost via a spousal rollover. Rollovers aren’t available for post-settlement transfers.
If a client rolls property to a spouse or partner during the relationship, any related income attributes back to the client for tax purposes (spousal attribution). When the relationship ends, attribution of income such as dividends, rent and interest ceases.
Where a married couple is separated but not yet divorced, the parties must file a joint election1 in their tax returns to ensure attribution won’t apply to capital gains of any subsequent sale of transferred property. If the election is not made, then the capital gain arising from a subsequent sale of the transfer of property, while the individuals are separated and not yet divorced, will attribute back to the transferor.
Matrimonial home. Regardless of title, married spouses have equal right to remain in the home. Rights for CLPs to remain in the home vary by province. In many provinces, CLPs aren’t automatically entitled to division of the matrimonial home.
Clients can have more than one matrimonial home. Primary residences, secondary residences and vacation properties alike can all be considered matrimonial homes. Unlike other property owned by one spouse prior to the relationship, the entire value of the matrimonial home(s), not just the growth during the relationship, may be divisible as family property. Depending on the jurisdiction, the spouse owning the property may or may not receive credit for the value of the property at the start of the relationship in the property division calculation.
Pensions. Ontario and Saskatchewan tend to favour equalization of pension assets as part of overall equalization of family property at time of separation. Other provinces treat pension asset equalization as one of several alternatives.
For pension equalization, fair valuation includes pre-retirement inflation indexing, age of retirement, duration applicable (from the later of relationship or employment date to date of valuation), severance and other benefits, and a tax adjustment. A key advantage of equalization of family assets is that pensions are dealt with at separation. Other pension treatments tie couples together financially for years.
Pension income splitting and CPP credit splitting. Spouses are no longer eligible for pension income splitting in the year of separation. However, cumulative Canada Pension Plan (CPP) contributions during the relationship can be divided equally between spouses/CLPs upon divorce or separation—even if only one partner contributed. To split CPP credits, spouses must have lived together for 12 consecutive months and subsequently been separated for at least 12 consecutive months (24 months in total). The divided credits accumulated during the relationship are attributed to the record of earnings for each partner. These credits subsequently determine the current or future CPP benefits each partner will be entitled to receive.
RRSPs, RRIFs and TFSAs. RRSP and RRIF transfers made directly between plans by issuers via CRA (Form T2220) occur without tax consequences, including no impact on either spouse’s contribution room. Plan withdrawals to compensate a former spouse in cash are taxable to the transferring spouse in the year of withdrawal, and a tax-adjusted payment amount should be negotiated. On the flip side, the future tax impact to the recipient spouse when he or she ultimately withdraws from the plan may also be considered in calculating the tax adjusted “equalized” amount.
TFSA transfers completed directly by the issuer are also qualifying transfers and occur without affecting either person’s contribution room. If one person chooses to receive a settlement amount in cash and, subsequently, contributes part or all of it to their own TFSA, the amount becomes a regular contribution subject to available contribution room. TFSA plan withdrawals to make an equalization payment can create new contribution room for the transferor in the following year.
The tax deferral and preservation of contribution room for RRSPs, RRIFs and TFSAs require that the former spouses or partners lived apart due to the breakdown at the time of transfer and the transfer is ordered or agreed to in settlement of related property rights.
RESPs. These plans don’t have to be divided upon separation or divorce, and spouses can remain as joint subscribers through post-separation and divorce, each contributing independently. Once separated or divorced, they can’t enter into a new RESP contract as joint subscribers but can individually create an RESP for children.
Unlike RRSPs, RESPs aren’t creditor protected. If this is a concern, clients can split the RESP into separate plans. Money can be transferred from one plan to the other without tax consequences where the transferring and receiving plan have the same beneficiary or the beneficiaries are siblings.
If a child is the beneficiary of more than one RESP, each qualifying contribution will attract grants in order of contribution, until the beneficiary’s lifetime maximum is met. The lifetime contribution limit is aggregated across all plans and monitored through the beneficiary’s SIN. Separation agreements should spell out obligations to continue contributions as agreed, confirm when the subscriber(s) may withdraw from the RESP, prevent withdrawal of funds except for post-secondary education of the beneficiary, instruct who bears the tax liability/penalties, if any, and outline who can be named a successor subscriber in the event of either parent’s death.
Private company shares. Spouses are non–arm’s length parties for tax purposes, as are corporations controlled by each. Depending on the facts, individuals may still be considered non–arm’s length after separation or divorce. Where a corporation controlled by one spouse acquires shares in a corporation controlled by the other during division of assets on relationship breakdown, timing is critical to avoid negative tax implications including denial of capital gains treatment and lost opportunity to apply capital gains exemptions. Properly planned transactions, before divorce is final, can split corporate assets into two corporations without tax consequences. Often one party can receive passive assets and the other active assets, but the transaction must be completed while the couple is still non–arm’s length for tax purposes. If couples can’t work together to accomplish this, an option is available where parties are arm’s length for tax purposes. It is more complicated and less flexible, typically requiring both parties to take a share of business and non-business assets.
Divorce impacts estate planning
Separation or divorce doesn’t revoke power of attorney documents. In many provinces, divorce or separation also no longer revokes a will. Provincial estate law may remove a former spouse’s or partner’s entitlement to inherit or act as the client’s representative under their will or upon intestacy. This relief isn’t available for beneficiary designations. If a client doesn’t want a former partner as beneficiary of a registered plan or insurance policy, they must remove the designation on the plan contract or under the will.
Anyone undergoing separation or divorce must revisit their will, power of attorney documents, beneficiary designations and shareholder agreements to ensure alignment with separation agreements. All legal documents should reflect the appropriate planning and agreements intended.
Rebecca Hett, CPA, CGA, TEP, is vice-president, Tax, Retirement and Estate Planning at CI Investments.
1 ITA Subsection 74.5(3)(b).