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Among the challenges of separation and divorce is determining whether spousal and child support will be payable, and, if so, how much and for how long. For anyone going through this process, it’s important to take the tax consequences into account when structuring a separation agreement.
The Income Tax Act distinguishes between spousal support and child support, with different tax rules for each. Spousal support includes any amounts paid on a periodic basis, under a court order or agreement, for the support of a former spouse or common-law partner. Child support, on the other hand, includes any support payments that are not specifically identified in that order or agreement as being only for the former spouse’s or partner’s use. In both cases, the former spouses or partners must be living apart after the breakdown of their marriage or relationship.
If the court order or separation agreement only provides support for a spouse or partner, then the payments are fully taxable to the recipient and tax deductible to the payor. To ensure tax deductibility, the order or agreement must be registered with the Canada Revenue Agency. To do so, the former spouses or partners should complete CRA Form T1158 Registration of Family Support Payments and include a copy of the order or agreement.
If, on the other hand, the order or agreement is solely for the support of children, the payments are neither taxable to the recipient nor tax deductible to the payor, so there is no need to register the agreement with the CRA.
If the agreement contains both spousal and child support, and it clearly indicates a separate amount for a spouse or partner, then this portion of the payments will be deductible and taxable. But how formal does the agreement need to be for the support payments to be tax deductible? A recent tax case dealt with this specific issue.
The case involved a taxpayer who got married in 2006, and legally separated on Dec. 8, 2010. In March 2011, the couple entered a separation agreement, signed by both parties. The couple chose to prepare the separation agreement on their own without using lawyers. In the section dealing with spousal support, the agreement stated: “Party 1 shall pay spousal support to party 2 in the amount of $3,500 monthly commencing Dec 8/10 and ending Dec 8/14.”
The dispute with the CRA, however, involved the 2018 taxation year because the taxpayer continued to make spousal support payments beyond the 2014 end date in their agreement. On his 2018 tax return, he deducted spousal support payments of $42,000 (12 times $3,500), while his ex-spouse included the $42,000 on her return as income.
The CRA reassessed the taxpayer and denied his deduction for spousal support on the basis that the payments did not fall within the definition of “support amount,” because, in the CRA’s view, the spousal support payments were not made by the taxpayer pursuant to a written agreement.
The judge reviewed the 2011 separation agreement and called it “flawed from the outset.” He noted the signatures of the spouses were not witnessed, and there was a handwritten clause at the bottom of the contract stating the agreement was “subject to approval by legal counsel.” There was no indication such approval was ever obtained.
Nonetheless, the reality is that the two separated spouses honoured the terms of the written agreement, with the taxpayer paying $3,500 per month in spousal support throughout the term of the agreement and for several years thereafter.
The taxpayer took the position that the March 2011 separation agreement, despite not being properly updated after 2014, constituted an agreement in writing under which he made support payments in 2018.
The CRA argued the support payments in question were not made pursuant to a written agreement. The previously existing separation agreement had expired in 2014, and, therefore, no agreement obliging the taxpayer to pay spousal support existed in 2018.
The judge noted in his analysis that there has been a lot of litigation concerning the issue of whether support payments were made pursuant to a written agreement. As to why a written agreement is necessary, he quoted a prior decision of the Federal Court of Appeal that concluded: “The rationale for not including separated spouses involved in payments made and received pursuant to a verbal understanding is readily apparent. Such a loose and indefinite structure might well open the door to colourable and fraudulent arrangements and schemes for tax avoidance.”
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The judge then turned to the facts of this case, which he noted “is clearly not a fraudulent scheme.” The parties agreed in 2011 in writing to an amount to be paid as spousal support. They “incorrectly overlooked” the need to update the contract in 2014 in order to properly reflect the taxpayer’s continued support obligations.
But since the two parties continued to consider themselves bound by their 2011 separation agreement through the 2018 taxation year, such conduct supports the conclusion that a “meeting of the minds continued to exist concerning spousal support obligations.” In other words, the support established in the 2011 separation agreement was treated by the parties as continuing to be in force up to, and including, 2018.
The judge, “guided by the plain meaning of the words of the act,” concluded the payments were, indeed, made pursuant to the terms of a written agreement. The payments satisfied the requirements under the Income Tax Act that the support was “an amount payable … on a periodic basis for maintenance … under a written agreement,” and thus should be tax deductible to the taxpayer on his 2018 return.
Jamie Golombek, CPA, CA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. Jamie.Golombek@cibc.com.
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