The intersection of tax law in the context of divorce or separation is a complicated topic not easily understood. The Income Tax Act is an extensive piece of legislation that frequently undergoes changes and amendments.
In the context of spousal support, there are several issues that warrant consideration. Unless spouses specifically turn their minds to dealing with the tax features of their separation, it may become another source of friction – along with the prospects of an unwelcome tax bill, or income adjustments by the Canada Revenue Agency – that both spouses failed to foresee. This situation readily presents itself when it comes time for spouses, who historically filed joint returns, to file their first set of individual tax returns following separation.
As a rule, the following tax principle apply to Spousal Support Payments:
- Periodic support payments are tax deductible to the payor and deemed to be taxable income to the recipient.
- Spousal support payments paid by the estate of a payor is tax neutral: the payor’s estate cannot claim a tax benefit nor is it deemed taxable income to the recipient.
- Lump sum spousal support payments (generally) are not tax deductible to the payor.
In terms of payment of lump sum support, there may be a variety of reasons, financial or otherwise, that a payor wishes to issue a lump sum amount to a former spouse. It is critical for the payor to recognize that payment of lump sum support does on its face attract the taxable benefits of periodic support. From a financial perspective, it is vital for the payor to also consider whether an adjusted discount ought to be made to notionally equalize the benefits conferred upon the recipient on account of lump sum payments to the other spouse.
The workaround to lump sum support, and to achieve a more level tax field (particularly for the payor) is to adopt the following language in writing by either court order or agreement that:
(a) payment of the lump sum amount paid and received in that specific year is taxable income of the recipient and tax beneficial to the payor;
(b) periodic amounts of support and the specific periods in which those payments represent are specifically identified in a court order or agreement; and
(c) the relevant sections of the Income Tax Act be specifically acknowledged in that agreement or court order.
Apart from the tax considerations of spousal support itself, the CRA also permits a spouse who receives spousal support to claim a tax deduction for all legal and accounting fees related to establishing, maintaining (including regular adjustments), or enforcement of spousal support. The current tax regime does not afford the same tax break to the payor.
For these reasons it is essential that separating spouses seek proper legal and tax advice to ensure that each spouse takes full advantage of the tax credits and deductions each maybe be eligible for.
