By Jamie Golombek
Do you have clients who are living common law? Do they continue to report themselves as "single" on their tax return to get access to higher Child Tax Benefits and higher GST credits? Be forewarned - the Canada Revenue Agency (CRA) is starting to challenge these cases. But let's get at the heart of the matter. What exactly is a "conjugal relationship" anyway?
Chocolates, roses, romantic dinners - it must be February. But what could the annual Valentine's Day ritual, where couples celebrate their intimate relationships, possibly have to do with tax planning? Furthermore, what interest does the taxman have in affairs of the heart? A lot more than you might think.
For starters, take a closer look at that seemingly innocuous question on page one of the personal tax return: "Check the box that applies to your marital status on December 31, 2004". You have a number of choices, including: single, married, divorced or common-law partner. It's this last option that seems to cause the most confusion and misunderstanding.
The common-law conundrum
Under Canadian tax law, "common-law partners" are defined as two people, regardless of sex, who cohabit in a conjugal relationship and have done so for a continuous period of at least one year. In other words, two adults who are "living together" in a relationship of some permanence (even if just for one year) must report themselves as living common law. Sounds straightforward, so why the fuss?
Under the Income Tax Act, common-law couples are treated exactly the same as spouses who are legally married. As a result, two people living together who are not legally married may be tempted to continue filing as "single" taxpayers to avoid losing certain government benefits, such as the GST credit, certain provincial tax credits and, in some cases, the Child Tax Benefit, whose amounts are all based on the combined net income of both partners. Meanwhile, other tax rules, such as spousal RRSPs and inter-spousal rollovers of property, may only benefit couples.
Going to the courthouse and ...
Each year, there are several reported cases (and presumably dozens more that get settled before trial) that make their way to Tax Court dealing with this issue. In these cases, the court is asked to determine whether two people were, in fact, living in a "conjugal relationship" in a particular year. In most of the cases, the couple is claiming they are merely living together as roommates. Consequently, each individual has indicated a filing status of "single" so they can each collect higher government benefits.
In such cases, the big question that always arises is how the Canada Revenue Agency can possibly determine whether two people are indeed living in a "conjugal relationship" since, unlike legally married spouses, their relationship is not automatically registered in a public document, such as a marriage certificate.
Rather than sneaking behind bushes and peeping in windows, the CRA has responded that it relies on a "self-assessment system" in which Canadians "are expected to tell the truth and in which persons who make false declarations can be penalized". (Whew! That's a relief.) Whether or not two people are living in a conjugal relationship is a question of fact, and this can include whether or not the couple presents itself publicly as a conjugal couple or has claimed couple status for purposes of a pension or health plan, among other factors.
Roby v. The Queen
One amusing case was the 2001 Tax Court decision in Roby v. The Queen [2002 DTC 3811] in which one of the factors that the judge looked at was the frequency of sexual relations. The issue in this case was whether the taxpayer, Mr. Roby, should have been entitled to the equivalent of spouse amount, child tax benefits, GST credits and childcare expense deductions during 1997, 1998 and 1999.
Mr. and Mrs. Roby were married and seven years later, after they had three children together, the marriage turned sour. He claimed that at this point, he and his wife were "living separate and apart ... by reason of the breakdown of his marriage" even though they were living in the same house for the sake of the children.
The frequency of sexual relations came up in the testimony. "Sexual relations continued between the two of them, although the evidence is contrary about the frequency. The husband admitted to four times in 1998 to 2000 while Ms. Roby said that they had sexual intercourse regularly in the period in question".
Although the judge didn't comment on whether or not three or four times in a year was considered "regularly", he felt that "such activity casts some doubt on both the separation of the spouses and the breakdown of the marriage".
The judge denied Mr. Roby's appeal, concluding that the couple was not living separate and apart and that the marriage had not broken down, although, in his words, "it was unquestionably fragile".
Is it, or isn't it?
Judges who must decide such cases often rely on the Ontario District Court's seminal 1980 decision in Molodowich v. Penttimen [17 R.F.L. (2d) 376], which was later endorsed by the Supreme Court of Canada. In the Molodowich decision, the judge provided some guidance as to what constitutes cohabitation in a conjugal or marriage-like relationship. The judge identified seven factors that may be indicative of a common-law relationship:
Shelter: Do the parties live under the same roof and what are the sleeping arrangements?
Sexual and personal behaviour: Do the parties have sexual relations and do they maintain an attitude of fidelity to each other?
Services: What is the conduct and habit of the parties in relation to domestic services, such as preparing meals and performing household maintenance?
Social: Do the parties participate together in social activities?
Societal: How does the community view the parties, both individually and as a couple?
Economic support: What are the financial arrangements of the parties in terms of their relationship?
Children: What is the attitude and conduct of the parties concerning any children?
In assessing a specific case, the CRA or a judge would consider the above factors to determine whether or not a couple is involved in a conjugal relationship, however, the final determination is always a question of fact.
Tax implications and you
If you have clients who clearly meet the definition of common-law partners for income tax purposes, claiming "single" for tax reasons is simply not an option. It amounts to tax evasion. Tread cautiously when advising such clients on income tax matters. Below, you'll find a general summary of some of the tax rules as well as planning strategies to bring up with your common-law partner clients.
Transfers of property to a common-law partner
Transfers of capital property made to a spouse or common-law partner automatically "roll over" at the adjusted cost base, although a spouse or partner can "elect out" of the rollover on his or her tax return and request a transfer at the fair market value. Note, however, that the attribution rules may also apply.
Income splitting and the attribution rules
Income attribution rules generally block attempts to shift income from a higher income person to a lower-income person by attributing the income back to the higher-income earner.
Generally, where an individual has transferred or loaned property to or for the benefit of the individual's spouse or common-law partner, any income (loss) from the property and any capital gain (loss) on the disposition of the property will be attributed back to the individual.
Common-law partners may consider the strategy of having the higher income partner pay all the household expenses, thus preserving the lower income partner's income, which can be used solely for investing, as any returns on such investments would then be taxed in the hands of the lower income partner.
Loans at prescribed interest rates
One of the exceptions to the above attribution rules applies where an individual makes a loan to a spouse or common-law partner to allow the spouse or partner to invest. As long as interest is charged on the loan at a rate at least equal to the CRA's prescribed interest rate at the time the loan was made (three per cent for the first quarter of 2005), the attribution rules will not apply. The interest, however, must be paid each year or within 30 days after the end of the year for the attribution rules not to apply.
Spousal RRSPs and RRIFs
Contributions made to a spousal RRSP are deductible by the contributing spouse or common-law partner within the applicable contribution limits. When funds are withdrawn, they will be taxed in the hands of the annuitant spouse or partner.
Even though the term "spousal RRSP" continues to be used throughout tax literature, the rules certainly permit a common-law partner to take advantage of this significant income-splitting opportunity. A spousal plan generally makes sense where one partner's income is significantly higher than the other's and, therefore, the higher income partner can claim the deduction for the contribution on his or her return. The lower income partner may pay little or no tax on the ultimate withdrawal of the funds from the RRSP or its successor (an annuity or RRIF).
Note, however, that the spousal attribution rules for RRSPs or RRIFs also apply to common-law partners. These rules state that if the annuitant spouse or partner withdraws any funds from a spousal RRSP or withdraws more than the minimum amount from any spousal RRIF within three years of any contribution being made to any spousal RRSP, the withdrawal will be attributed back and taxed to the contributing spouse or partner.
Any capital loss on a capital asset that is sold and repurchased by the individual or that individual's spouse or common-law partner within 30 days from the date of sale is denied and added to the adjusted cost base of the repurchased asset.
Principal residence exemption
A principal residence is generally a residence that is owned by a taxpayer and was inhabited during the year by the individual or certain family members. A gain on the sale of a principal residence is exempt from tax. Married or common-law couples can designate only one property between them as a principal residence.
Home Buyers' Plan (HBP)
The HBP permits first-time home buyers to withdraw funds from an RRSP for the purchase of a home, without the withdrawal being included in income. A first-time home buyer is an individual who has not occupied a principal residence owned either by him or her or by his or her spouse or common-law partner during the period that begins January 1, five years prior to the year of withdrawal, and ends 31 days before the withdrawal.
Tax planning on death
Generally, upon death, an individual is deemed to dispose of all of his or her capital property at fair market value. There is one main exception to this rule: Any property that is left to a spouse or common-law partner may be transferred at its adjusted cost base without incurring a capital gains tax liability upon death.
Transfers under the refund of premium rules of a deceased's RRSP to a spouse or common-law partner, shift the income inclusion from the deceased to the spouse or partner. The spouse or partner may obtain an offset for this income inclusion by investing the proceeds into his or her own RRSP or RRIF. This opportunity is available to common-law partners who can avoid the significant tax burden often levied on the fair market value of the RRSP or RRIF upon death. Common-law partners should carefully review their RRSP or RRIF beneficiary designations to ensure that, where appropriate, their partner is named as the beneficiary on the plan.
Finally, a spouse or common-law partner can receive, tax-free, the first $10,000 of a death benefit, which is an amount paid by a former employer after an individual's death, usually in recognition of the former employee's service.
Testamentary spousal trusts
Common-law partners are also able to achieve post-mortem income splitting. A partner who is planning to leave money to his or her partner, who is also earning income, can take advantage of an extra set of graduated tax rates for this purpose.
Don't neglect family law issues
Finally, keep in mind this discussion focuses only on the federal income tax rules for common-law partners. Each province in Canada has legislation granting rights to partners in a marriage or spousal common-law relationship when that relationship ends, whether because of relationship breakdown or the death of one of the partners. Legislation may also extend to same-sex relationships, depending on the province. So be sure your common-law clients also obtain professional legal advice in these areas too.