Support Issues With Backlash:

Sometimes Misunderstood Tax Implications of Support Awards

by Susan Roberts

Presented at the National Family Law Conference in LaMalbaie, Quebec,
 July 14, 2004
 

Support Issues With Backlash:

Sometimes Misunderstood Tax Implications of Support Awards

Frequently in the family law area, support issues are resolved without regard for the tax implications of the arrangements that have been made, or with a misunderstanding of those implications. The desired, expected or agreed upon outcome may not be achieved if it contravenes the provisions of the Income Tax Act (ITA). Without a general understanding of the relevant provisions of the ITA, including deductions, credits, benefits and subsidies, the parties to the support award (child, spousal, or both) may be disappointed to find that they did not get what they bargained for. Their counsel may have liability issues to address and the Court may inadvertently make Orders with unintended results.

For most spouses, the bottom line is what they will have left in their pockets at the end of the day after the payment or receipt of support. Our tax system plays a very large part in determining how much that will be. Most realize that tax law has an impact on spousal support in terms of the net amount one spouse will receive or the other spouse will pay, due in large part to the income tax inclusion and deduction rules that apply to most spousal support payments. The interrelated effects of other components, such as benefits and subsidies, appear not to be as well understood.

With respect to child support under the Federal Child Support Guidelines (Guidelines) and the provincial and territorial counterparts, the income tax inclusion and deduction rules no longer apply so there is often a misconception that this support will not be affected by tax issues. While tax does not have the same direct effect on the net amount of support retained by the recipient, nonetheless, the ITA does have a significant impact on the necessary calculations. For example:

Limitations and Constraints:

Tax can be very complex. This paper will cover selected tax areas and is intended to provide insight into certain issues only. In any particular case, many more areas may be involved or greater detail may be required, and researching the actual section(s) in the ITA is recommended. To reference sections, the same is readily available through links from the Canada Revenue Agency’s (CRA) website, even though the ITA is not the most user friendly document to read. This website also provides interpretation bulletins and information circulars outlining CRA’s policies on a variety of tax issues. Information is also available by contacting CRA, although CRA is not bound by any opinions that it gives, unless they are in the form of an advance tax ruling. Advance tax rulings may only be obtained for situations that are anticipated, but have not yet happened, and the rulings are only binding on CRA to the extent that the facts of the situation have not changed from those for which the ruling was made. If you are in doubt about the tax implications of a situation, then it may be well worth your while to consult a tax specialist, or have your client do so directly. This would not only be for your client’s sake, but also in relation to potential liability for you if your client’s expectations regarding benefits or net dollars do not match reality due to a misunderstanding of the tax treatments.

Tools, such as computer software programs, are available to aid in the calculation of both child and spousal support. But one should not be lulled into complacency by the use of these tools or assume that the software will some how "take care" of the tax complexities. Software cannot read minds; it can only do what it is told to do. A software program will either have input fields for the required tax parameters, such as indicating whether a spouse is remarried or living common law, or it will make an assumption that will deal with the issue. Either way it is critical that the software user understand the effect of the tax treatment on the calculations being made. In the first instance, the user must know how to answer the questions or set the tax parameters in the program for each case that is done. In the second instance the user must know what assumptions the program is making (e.g.: all spouses are single) in order to know whether the results may be relied upon. If assumptions are involved and even identified, it is still necessary to know how those assumptions may be affecting the results. None of this is possible without a basic understanding of the potential tax issues. How does the user know if the right or complete data has been entered into the software program if the user doesn’t understand what is required to begin with? How does the user know that the software has produced the appropriate answer if there is no understanding of what is involved? Regardless of who inputs the data, how can a decision based on the computer output be made if the decision-maker does not know what data was input or what assumptions were made? And how can the results of the calculations possibly be explained to anyone else – the client, opposing counsel, or the Court?

Tax rules and amounts change regularly. Software that calculates tax effects must be updated to stay abreast of these changes. Regardless of the tools used, it is important that they be current.

Does this mean everyone has to be a "tax expert" in order to calculate child support or effectively analyze spousal support alternatives? No. But the results, and their potential limitations, will not be understood if there isn’t at least a basic understanding of the necessary input. Further, the right questions will not be asked to obtain the information needed to do the calculations or analysis if there is no understanding of the basic, potential tax parameters.

The tax courts have made it very clear that misunderstanding the provisions of the ITA does not give anyone the ability to vary from or circumvent those provisions. Parties cannot agree that a certain party will claim the eligible dependent credit or collect the Child Tax Benefit if that party does not qualify under the appropriate legislation. Regardless of what an order from a family court says, provisions which conflict with the ITA can not be enforced. This fact is clearly expressed in any number of tax court cases. As an example, Tardif J., in Clark vs MHR [Tax Court of Canada, January 18, 2002, Docket: 2000-3983 (IT)], says at paragraph 14:

"An agreement, no matter how clear, has no effect against the Minister if it contains provisions contrary to the Act’s provisions; in other words, an agreement that binds the signatories does not bind the Minister against whom it cannot be raised. In the case at bar, although the appellant’s former spouse waived rights under the Act through an agreement, this had no effect on the Minister’s obligation to pay him all the benefits resulting from the Act. The Minister could not ignore or disregard reality…."

Currently there is no fixed formula for the determination of spousal support. Depending upon the circumstances, roles, and length of the marriage in question, an analysis of disposable incomes (or cash flows) may be considered when setting amounts. Spousal support payments, which fall within the ITA definition of "support", will be affected by the income inclusion and deduction rules in Sections 56 and 60 of the ITA. This means that anything that affects the individual’s income tax position will affect the tax and benefit components of the disposable income analysis. Omissions or errors could produce inaccurate tax results, distort the analysis and lead to unintended results. All of the major tax components discussed later could affect a spousal support analysis. Further, spousal support has an interrelated effect on child support under Section 7 of the Guidelines and on other areas, such as hardship analysis and income imputation. As well, other unconventional payments, as discussed under the heading "Specific purpose and third party payments", such as mortgage payments, will only be awarded the beneficial tax treatment if the Orders are worded to comply with the provisions of the ITA.

With the advent of the Federal Child Support Guidelines and the corresponding adoption by most of the provinces and territories of those Guidelines, there appears to be a misconception that there is no longer a need to consider the income tax implications when dealing with child support issues and calculations, because the taxation and tax deductibility of child support has been removed from the our tax system. Simplicity was the sales pitch. However, when all the areas of the Guidelines requiring computations are considered, the only amount not directly affected by current tax law is the support amount in Section 3 pursuant to the Guideline tables.

Often the ability to provide equity and fairness under the Guidelines is found in Sections 7 and 10 of the Guidelines, as this is where a child support amount may be "fine tuned" to meet the specific needs of a family. Both these sections require calculations that incorporate extensive tax criteria. In particular, with respect to special expenses, Section 7(3) of the Guidelines states:

"In determining the amount of an expense referred to in subsection (1), the court must take into account any subsidies, benefits or income tax deductions or credits relating to the expense…"

The standards of living test found in Schedule II of the Guidelines, to support a claim of undue hardship under section 10, requires the computation of "actual taxes payable" for each member of the household. Even the determination of income, which is the foundation of all calculations under the Guidelines, including the table amount, may require an understanding of tax and tax calculations. How can these requirements be fulfilled if there is no understanding of which tax parameters may affect a particular Section 7 expense, or the extent to which they may change the ratios that open the door to Section 10, or affect the analysis of income?

Under our Canadian tax system, different sources of income are taxed differently. In developing the Guideline tables, the assumption of employment or self-employment income was made. Many of the adjustments to income found in Schedule III of the Guidelines have been taken directly from the ITA, complete with the tax act definitions. If the tax terminology and implications are not properly understood, then the correct assessment and reasonable adjustments under the Guidelines may not be made in a particular circumstance. Further, when imputing income under Sections 17, 18, and/or 19, "grossing up" cash-based amounts for deemed tax effects may be required.

Due to the direction in Section 7(3) to "take into account any subsidies, benefits or income tax deductions or credits relating to the expense", the fact that tax will have an impact on this area of child support is obvious; however, the type of tax effect is not as clear.

As explained in greater detail under "Tax Deductions vs. Tax Credits", the type of tax effect an expense will have is dependent on whether it creates a tax deduction or a tax credit. The amount of the tax effect of an expense is specific to the tax position of the individual who has initially incurred the expense. For example, if the individual’s tax liability is already zero, the addition of a tax deduction to the calculation will not have any impact on that tax liability. If the individual has income that is being taxed in one of the higher tax brackets, a tax deduction will produce greater tax savings than if that income was only being taxed in the lowest bracket.

Of the six specific types of expenses detailed in section 7(1) of the Guidelines, all have potential tax effects, except 7(1)(f) "extraordinary expenses for extracurricular activities." The tax effects of the other five areas will be discussed in detail under the headings of the related tax areas as follows:

Tax areas of particular concern when dealing with support issues include:

Often items that are allowed for tax purposes are described as "deductions" without considering the question: "Deductions from what?" There is a significant difference between tax deductions and tax credits. In simplified terms, tax deductions reduce income and therefore reduce the base that the taxes, and perhaps other items such as benefits, are calculated on. For example, the person claiming the deduction may now qualify for a higher amount from a particular subsidy or benefit program. Further, the type of income that a deduction is applied to may be very important in determining the overall effect of the deduction. Remember, "income" is not a generic term. There are many different definitions of income and it is important to know which one is used for a particular purpose.

If someone says "My "income is $50,000" he or she may be referring to any one of a number of definitions of "income", such as:

Each one of these types of "income" is significantly different from the others and is used in a specific way in support calculations. For example, the definition of "total income per line 150 of a personal income tax return" is not the same as "income for purposes of the table amount in Section 3 of the Guidelines" because it does not include the adjustments under Schedule III of the Guidelines, nor does it include amounts imputed or adjusted pursuant to Sections 17, 18, or 19 of the Guidelines. Are there instances where the amounts (after applying the definitions) are the same? Certainly. Income for purposes of determining the Guideline table amount may be the same amount as total income per line 150 if all the other adjustments required by the Guidelines are zero. Can it be assumed that they will always be the same? Absolutely not. How tax parameters will affect "income" will depend entirely on which definition of "income" is being used.

With regard to tax considerations and support calculations, tax deductions may reduce either "total income" (definition #3, above) in determining "net income" (definition #4, above) or "net income" in determining "taxable income" (definition #5, above). For example, "child care expenses" under Section 7 of the Guidelines may create a tax deduction that would reduce "total income" in determining "net income." Spousal support paid may also be a tax deduction that has the same effect. This is significant as the definition of "net income for tax purposes" often governs the amounts to be dispersed through our various social programs such as the CTB, the GST credit, and provincial components to the CTB initiative. Therefore, tax deductions that reduce total income in determining net income often increase the amount received from these social programs. In so far as the calculation of child support is concerned, this has a direct bearing on the application of the Section 7(3) directive to take into account any subsidies and benefits. Tax deductions that reduce net income in determining taxable income would not have an effect on the amounts received from these social programs at all, unless the program specifically included consideration of the deduction in the benefit calculation.

In contrast to tax deductions, tax credits do not change "income" amounts. They only offset taxes otherwise payable and in some cases may produce a refund. Therefore, the effect of a tax credit is generally limited to income tax savings without the added benefit of an increase in amounts from subsidy or benefit programs. Items such as medical expenses or post secondary tuition costs do not reduce total income, net income, or taxable income, and will not change the amount received from a particular social program, unless the program is designed to factor in the tax credit. However, tax credits may change the ultimate amount of tax owing, but normally the balance owing cannot fall below zero, unless the particular tax credit is refundable. For example, the federal refundable medical credit may produce a refund over and above reducing income taxes owing to zero.

Section 7(3) of the Guidelines states that the courts must take into account

"…any eligibility to claim a subsidy, benefit or income tax deduction or credit relating to the expense" (emphasis added).

How should "eligibility to claim" be interpreted? Does this phrase have a different meaning under the Guidelines than it does for tax purposes? The fact that a certain expense may provide a tax deduction or credit under the ITA, does not mean that all taxpayers incurring such an expense are "eligible" to claim the amount for income tax purposes. For example, the fact that an individual paid daycare expenses does not necessarily make him or her "eligible" to claim a tax deduction for that expense if it was incurred so someone else could go out to work. Similarly, if a child care expense is incurred, which would otherwise be "eligible" for a tax deduction, but a receipt is not obtained, clearly, the tax criteria is not met, but does this also mean the "eligibility" criteria is not met for purposes of the child support calculation? As explained later under the heading "Child Care Expenses", to be deductible for tax, child care expenses must be supported by receipts issued by the payee. In "Laviolette v Koe" [[1998] N.W.T.R. 337, [1998] N.W.T.J. No. 42], Vertes J. determined at paragraph 20 that "eligibility to claim" under Section 7(3) of the Guidelines meant:

"…it is irrelevant if the applicant does not claim the day care expense as a deduction because of the lack of receipts. The availability of such a deduction must be taken into account. If the respondent is responsible for any portion of this expense, then it must be based on the after-tax cost to the applicant" (emphasis added).

On the other hand, Gass J. in Mundle v Mundle [2001 NSSF 15, 14 R.F.L. (5^th) 364, 192 N.S.R. (2d) 297, 599 A.P.R. 297] stated that:

[12] "…In other words, it would not be fair to apportion the full cost of child care when in reality the full cost is not actually incurred. Conversely where there is no deduction to the claimant, it would not be fair for the payor to pay only that portion of after tax cost when in reality the claimant is responsible for the actual full amount of child care costs for their child.

[13] Here I have considered the availability of the deduction and conclude that there is no deduction available and there is no eligibility to claim the deduction because there are no receipts provided" (emphasis added).

"Availability" in Laviolette was not tied to the actual criteria required by the ITA; whereas, in Mundle it was. The different treatment in caselaw may be rationalized by the notions of choice and reasonability, having regard to the premise, under the Guidelines, that the support amount must be "fair." In Mundle, even though the child care provider would not provide receipts, it was determined that this was the best choice of care for the children. This resulted in a lack of "availability" for the tax deduction pursuant to the ITA criteria. The payor was thus required to pay his proportionate share of the actual cost incurred by the recipient spouse. In other cases, however, the Court has found that there was potential "availability" that could be realized by the support recipient if he/she elected to obtain receipts. The choice not to obtain receipts was not reasonable in the particular circumstances. Thus, for purposes of determining the additional amount of child support, the amount was calculated as though the availability was realized. It is therefore important that the necessary enquiries be made to determine whether there is actual availability for tax purposes and if not, why not. Is it due to the choice of the recipient spouse or a condition imposed by the child care provider? While this unrealized potential can make a difference to the Guideline child support, the decision in a support analysis will not change the reality of the tax outcome. If there is no receipt there will be no tax deduction.

If an amount is characterized as a "reimbursement" and tax law precludes a claim for a reimbursed amount (as it does in virtually all circumstances), the individual is not "eligible" to claim that portion of the amount for tax purposes, and it, arguably, should not be included in the tax impact for Guidelines purposes either. Even establishing "eligibility" does not necessarily determine the amount of the tax effect. In tax calculations the sum of the parts may be greater than the whole. Individuals may have many credits and deductions available to them, but may only be able to use a portion of them due to their income levels.

In a support situation, the fact that one or both of the parties is remarried or living in a common-law relationship may impact the income tax and benefits calculations. If the quantum of spousal support is based on an assumed after tax amount, calculated as if the recipient was single, the actual after tax amount may be different if the recipient is considered to have a spouse for tax purposes. For example, where the person had a child, the fact that he or she now had a common-law spouse would preclude the ability to shelter income with the "amount for eligible dependent" tax credit (discussed later) and result in a larger portion of the spousal support being taxed; thus less being retained on an after tax basis. With respect to child support, having a spouse will not change the table amount of support under Section 3 of the Guidelines unless it changes the analysis of income, but it could change the results of the net amount of Section 7 expenses, or the household income ratio in an undue hardship argument. It could even change the result that would be determined where a cash-based source of income was grossed up to a pre-tax amount.

The fact that an individual is remarried or living common-law may also affect support analysis and calculations through the impact this situation has on the eligibility to receive benefits, such as the GST credit or the CTB and related provincial/territorial programs. The income limitations in most social programs are based on a concept of "family net income." In addition to increased taxes, thousands of dollars may be foregone because the individual no longer qualifies for benefits that would have been available had he or she been single. For example, a single parent earning less than $22,000 per year, with one child, will receive approximately $2,958 from the CTB program in 2004/2005 ($4,611 if the child is disabled) and the amount will increase if there are more children. When a new spouse’s income is considered in the determination of "family net income", the entitlement may quickly drop. If this is not considered in support calculations, outcomes may be misleading. For example, disposable income may be overstated in a spousal support analysis where the party would receive more CTB if there were no new spouse. In a child support calculation, where the new spouse has income, the net tax effects in Section 7 applied to child care expenses may be wrong because the individual now receives fewer benefits and has less tax-sheltered income due to the new spouse.

Where there is a new spouse, there may be the potential for claiming the "spouse or common-law partner amount" for tax purposes. This claim:

The criteria for claiming the "spouse or common-law partner amount" is found in Section 118(1)(a) of the ITA under the heading "married status." It is a non-refundable tax credit available to a taxpayer who, at any time in the year:

The spouse or common-law partner must have "net income for tax purposes" (for 2004) of $7,484 (or less) for federal tax purposes, as the maximum credit is $6,803 and begins to be reduced when "net income for tax purposes" is greater than $680. The income level for the corresponding provincial or territorial credit varies depending on the province or territory. This credit is subject to indexation federally and in most provinces and territories, so the amount of income it may shelter from tax is increasing each year. For 2004, the provincial/territorial credit ranges from $6,055 for Newfoundland and Labrador to $14,337 for Alberta.

What constitutes a "common-law partnership" may vary depending on the legislation being applied. For income tax purposes, "common-law partner" is defined in Section 248(1) of the ITA and means a person who:

In order to end a common-law partnership for tax purposes, once it is established per the rules above, the taxpayer and person must be living separate and apart for a period of at least 90 days, including the time in question, because of a breakdown in their conjugal relationship. In applying the definition of "common-law partnership" it is important to note that the ITA has the benefit of hindsight, whereas the Guidelines operate on a prospective basis.

The CTB is a government program designed to assist low and low-middle income families with the cost of raising children. It provides tax free benefits based on family size and income levels. CRA issues an excellent guide called "Your Canada Child Tax Benefit" (T441), which outlines the federal and many of the related provincial and territorial programs. The federal portion of the program has three components:

The last component is the most recent change and is available for "qualified dependants" (as defined below) for whom a disability credit may be claimed. It is effective as of July 2003 and payments were to have begun by March 2004.

In situations where the child(ren) reside primarily with one parent, the ability for one party to meet the CTB eligibility criteria discussed below is relatively straight forward. However, in a growing number of cases, the Court is awarding, or parties are agreeing to, a shared arrangement with time and responsibility falling equally on both parents. Unfortunately, the eligibility criteria for receiving the CTB and related programs does not easily accommodate shared parenting arrangements. Administratively, it is CRA’s position that true "equality" rarely exists when it comes to parenting situations, and on balance, one parent expends more than the other parent with respect to the factors listed in point (c) below.

In support calculations, CTB may affect any analysis of disposable incomes and will impact the calculation of net child care expenses used in determining Section 7 child support. However, there will be no affect on the household income ratios per Schedule II of the Guidelines because that calculation does not include any consideration of benefits and subsidies.

The following summarizes the criteria that must be met to receive the CTB:

1. the person must be an "eligible individual" as defined by Section 122.6 of the ITA, which means all of the following conditions must apply:

2. where the child resides with the female parent, the female parent is presumed to fulfill the responsibility for the care and upbringing of the child. This is not mentioned in the CRA guide, but is in the definition of "eligible individual."

3. Regulation 6302 of the ITA lists the factors that constitutes "care and upbringing" as follows:

4. per Regulation 6301 of the ITA, the presumption in (b) above does not apply where:

Where more than one (otherwise qualifying) person applies for the CTB for the same child, the Minister will determine the "eligible individual" based on an assessment of the factors described in (c) above. Given the factors, there are rarely any circumstances where more than one person meets the criteria to the same degree. For example, often only one of the parties has a job or lifestyle that allows for tending to the child at a moment’s notice.

5. a "qualified dependant" is defined as:

In situations where it is determined that a person has been paid the CTB in error, the legislation considers the person’s eligibility status at the beginning of the month or months in question per Section 122.61. Where there is a change in status mid-month, the change would not apply until the beginning of the next month. If the person has become eligible to receive the CTB, he or she has up to eleven months from the end of the month he or she became eligible to notify the Minister. Payments retroactive to the first full month of eligibility will be made. On the other hand, if a person ceases to be eligible, the Minister must be informed by the end of the following month. Unfortunately, when relationships break down and the child moves from one parent to the other, parents often fail to notify the Minister. The issue comes to light when the other parent applies for the CTB and by then a significant amount of overpayment may have accumulated. Because the amounts may be significant there is an incentive for the other parent to apply. Even if the parent, with whom the child is now living, agrees not to apply for the CTB, the first parent no longer qualifies to receive the money.

The amount of the CTB basic entitlement is based on the number of children with supplements for three or more children and for children under the age of 7. The supplement for children under the age of 7 is reduced by 25% of the total child care expenses claimed. This will have a very direct effect on the calculation of net child care expenses under Section 7(1)(a) of the Guidelines, as discussed later. In most provinces and territories the base amount is the same for each child; however, in Alberta, the base amount increases with the child’s age.

The NCBS provides decreasing amounts for the first, second and three or more children, in addition to the basic entitlement discussed above. The CDB provides a flat amount per disabled child, which is added to the other two components.

Since the CTB is designed to primarily benefit low income families, all three elements of the entitlement are also reduced at specified income levels. In this regard, the definitions of "adjusted income" and "base taxation year" are important. Under Section 122.6 of the ITA, "adjusted income" means the total of all amounts which would be income for the year for the taxpayer or the taxpayer’s spouse or common-law partner (as defined previously). Generally this equates to "family net income" and most of the CTB forms and guides refer to it as that. However, Section 3 of the ITA discusses income in positive terms and 3(f) deems a negative amount to be zero; therefore, one spouse’s loss can not be used to reduce the other spouse’s income.

For CTB purposes, the income used in the calculation is determined by the "base taxation year" which creates a lag in the income effect. The "base taxation year" is defined as:

Essentially, this results in the income reduction being based on the last filed tax return. For example in 2004 the "base taxation year" for January to June is 2002 and for July to December is 2003. Where a spouse dies or the spouses are living separate and apart for a period of at least 90 days due to a break down in the relationship, the benefit will be recalculated to exclude that spouse’s income, upon notification to the Minister.

In terms of the effect of support awards, the amount of CTB entitlement will potentially be reduced by taxable spousal support received and increased by taxable spousal support paid. This is a direct effect of the income reductions being based on "net income" and spousal support being taxable/tax deductible. With respect to child support under the Guidelines, there is an interrelated effect on a claim under Section 7(1)(a) – child care expenses. As discussed later, "child care expense" is a potential tax deduction that reduces net income and may increase an individual’s CTB entitlement as a result. Where there are children under the age of 7, this entitlement may be reduced due to the erosion or loss of the supplement for children under age 7, discussed previously. In calculating the Section 7 amount "net of subsidies, benefits…" these factors will come into play and directly affect the amount on which the pro-rata sharing, per Section 7(2) of the Guidelines, is based.