Attribution rules and section 74.5(3)(b) of the Income Tax Act in a separation

Overview of an Income Tax Act issue

When a married or a common law couple’s relationship breaks down, individuals must be aware of the relevant Income Tax Act provisions related to property. For instance, if spouse 'A' owns the matrimonial home as well as a cottage, a solution might be to transfer the cottage to spouse 'B' for purposes of equalization. If the transferee then sells the property, this may create a taxation issue consequent Canada's attribution rules. The Income Tax Act may "attribute" some or all the capital gain of the cottage in the hands of the transferor rather than the transferee by reason of section 74.2 of the Income Tax Act in certain circumstances. This may not be the intention of the parties who are living separate and apart.

Legislation

The Income Tax Act, specifically section 74.5(3)(b), remedies this issue by allowing spouses, who are living separate and apart, to jointly opt out of section 74.2 of the Income Tax Act. The result is that the capital gain will be attributed to the transferee or the spouse receiving the property, not the spouse transferring the property:

Spouses or common-law partners living apart

74.5(3) Notwithstanding subsection 74.1(1) and section 74.2, where an individual has lent or transferred property, either directly or indirectly, by means of a trust or by any other means whatever, to or for the benefit of a person who is the individual’s spouse or common-law partner or who has since become the individual’s spouse or common-law partner,

…

(b) section 74.2 does not apply to a disposition of the property, or property substituted therefor, occurring at any time while the individual is living separate and apart from that person because of a breakdown of their marriage or common-law partnership, if an election completed jointly with that person not to have that section apply is filed with the individual’s return of income under this Part for the taxation year that includes that time or for any preceding taxation year.

Conclusion

When there is a property transfer between spouses who are separated, it is important to consider the tax consequences that may arise. Canada's attribution rules mean that the capital gain may be attributed to the transferor rather than the transferee despite the property being sold in the transferee spouse’s name. If this is not the intention of the parties, they can jointly elect to opt out of this scenario so that the capital gain is taxed in the hands of the transferee.