With taxpayers in eight out of 10 provinces facing a 2024 top marginal personal income tax rate exceeding 50 per cent, it should come as no surprise that some couples are looking at ways to income split, especially when one spouse or partner is in a much higher tax bracket than the other. Consider, for example, a British Columbia high-income taxpayer facing a top marginal rate of 53.5 per cent. If their spouse or partner earns under about $55,000, their marginal rate is only 22.7 per cent — a spread of more than 30 percentage points.
There’s a variety of ways to legally split certain types of income with a spouse. For example, when it comes to retirement income, pension income splitting or CPP/QPP sharing can be effective. For investors, using a prescribed rate spousal loan to have any excess returns above the prescribed interest rate taxed in the hands of the lower-income spouse was the way to go when the prescribed rate was only one per cent or two per cent. With that rate now at five per cent as of July 1, 2024, finding an investment with a guaranteed return in excess of that rate is challenging, which is why we’ve seen very few new spousal income splitting loans set up in the past year.
But one method of income splitting that’s often tried, but doesn’t always pass muster with the Canada Revenue Agency, is to “hire” your spouse or partner to either work in your business or, if you’re an employee, to become your “assistant.” While this can be a tax-effective strategy when it involves legitimate work and appropriate pay, the CRA is often quite skeptical of spousal employment arrangements, as one taxpayer recently found out in a tax case decided last month.
Under the Income Tax Act, an employee is permitted to deduct any “salary” paid to an assistant provided their employment contract “required” the employee to incur the expense and this is certified by the employer on CRA Form T2200, “Declaration of Conditions of Employment.” Where an expense is not explicitly required to be incurred by an employee in their employment contract, it can still be deductible if it’s found to be an implied requirement. In making this determination, the courts have reviewed whether the failure to meet this requirement could result in the employee’s termination, a poor performance evaluation or other disciplinary action on the part of the employer.
The most recent tax case dealing with spousal employment involved a commissioned employee who wrote off a variety of employment expenses, including motor vehicle expenses (which were allowed) and amounts paid to his spouse, which were disallowed.
The taxpayer was in the business of selling air conditioners, furnaces and heat pumps, and other similar appliances. He had a contractual arrangement with Costco and an exclusive territory. At the Costco entrance, there was a kiosk with blank pre-printed forms that prospective clients could fill out to express their interest in these products. These forms were collected, and calls were made to qualify the prospective purchasers. If qualified, an appointment was scheduled. The taxpayer would then meet with the prospective client and prepare a proposal. If it was accepted, the customer signed a contract, and the taxpayer was entitled to a commission.
During the years under review, 2016 and 2017, the taxpayer reported employment income of approximately $80,000 and $90,000 respectively, of which about $33,000 each year was commission income. Among the employment expenses the taxpayer claimed were $20,000 “alleged to have been paid” to his spouse for each of the 2016 and 2017 taxation years.
The taxpayer claimed that it was his wife who made the calls and scheduled the various appointments, and accordingly was paid for her services as a self-employed contractor. While the taxpayer admitted that she was not paid directly, he stated that approximately $35,000 in total was paid to her in 2016, and $31,000 in 2017. The payments were “paid” to her as her share of mortgage payments, cash withdrawals or other debit transactions from a joint bank account.
In denying these expenses, the CRA maintained that the taxpayer didn’t have a contract with his spouse, and failed to submit any other details or documents that demonstrated that he paid commissions (or salaries) to her, or that a working relationship existed between them. These could have included proof of payments, tasks description, timesheets, employee log book, T4 slips, etc. The taxpayer did produce some documentation, including a Form T2200, as well as joint bank account statements.
During cross-examinations, the taxpayer admitted that he had not kept any records of the payments made to his spouse and that, although the amount claimed on his returns for the two years in question was less than the amount alleged to have been paid to her, he had no understanding as to how it had been quantified as he relied solely on his accountant to determine the appropriate amount to be claimed. He also admitted that the cash withdrawals and debit transactions were for “ordinary household expenses” and were not necessarily specific to his spouse. No deposits were made to her personal bank account.
The CRA’s position was that any amounts that were alleged to have been paid to his wife were, in fact, “joint family expenses not directly related to her.” In addition, there was no evidence of any services performed by her, and the taxpayer could not produce a log or note book or list of customers allegedly contacted by her at any time in 2016 or 2017.
The taxpayer argued that there was no need to produce an actual contract and that his testimony alone ought to be sufficient to establish the status of his wife as an independent contractor, as well as the amounts paid to her.
The Tax Court judge rejected these arguments, and agreed with the CRA as there were no books and records and no supporting documentation to back up the taxpayer’s assertion that the amounts claimed on his return were incurred or actually paid to his wife. On that basis, the judge ruled that the CRA correctly denied these employment expenses.