Tax Forum
Changing Tides
Recent changes to legislation concerning child support payments shifts the tax burden from the recipient to the payer, but not without some confusion.
FROM: MAY-JUN 2003 ISSUE | BY DON GOODISON
There is an old saying that a little knowledge is a dangerous thing. Nowhere is that more true than in the world of income tax. Taxpayers will read an article or hear a guru share some "wisdom" and immediately think that it will apply to them. Or legislation will change, and taxpayers will automatically think the change applies to all years before and after.
One fairly recent change in legislation that has been causing some confusion among taxpayers concerns the inclusion of child support payments in income. In May 1997, paragraphs 56(1)(b)and 60(b) were repealed for the taxation years after 1996.Paragraph 56(1)(b) required the inclusion in income of child support payments received, while 60(b) permitted the payer of child support a deduction of the same amount. The repeal of these two paragraphs meant that there was no income inclusion by the recipient and no deduction for the payer. The legislation applied to child support agreements entered into after May 17, 1997. Agreements established before May 17, 1997, continued to be taxable to the recipient and deductible by the payer.
Recently, the Tax Court of Canada heard two cases on the subject: Jacqueline J. Marchand (appellant) v.Her Majesty the Queen (respondent) [2001-4103(IT)(I)] and Kelli Marie Clemens (appellant) v. Her Majesty the Queen (respondent) [2002-1476(IT)(I)]. In both of these cases, the appellants appealed amounts included in their 1999 incomes.
Agreement Timing
Jacqueline Marchand and her husband divorced in 1994. Under terms of the divorce agreement, she received $600 per month in child support. In 1999, she did not report the $7,000 she received from her former spouse; however, the tax department added the amount to her 1999 income. Marchand appealed to the Tax Court of Canada.
In dismissing her appeal, the court held that the child support payments were made according to a 1994 court order. Since the agreement had been entered into prior to the change in the legislation and there had been no changes to the agreement since, the payments received were taxable.
In the second case, Kelli Marie Clemens and her husband also separated in 1994. Their separation agreement provided for child support payments of $705 per month. In 1996, they reconciled and lived together until August 1998, when they again separated. At that time, they verbally agreed to continue the child support payments established in the 1994 agreement. As well, all other provisions of the 1994 agreement were to remain in effect. Clemens did not report the $8,460 in child support payments she received in 1999; however, the tax department added the amount to her income. She appealed to the Tax Court of Canada.
Once again, the question in this case was whether the agreement was pre- or post-May 1997. Clemens argued that there was a new agreement, saying her husband had not complied with the terms of the original separation agreement so it should be ignored. The husband testified that he had complied with the conditions. While it was clear that the second separation took place after the change in legislation, the court held that the agreement was reached in 1994, prior to the change. As such, the amount had to be included in Clemens' income, and her appeal was dismissed.
Rights Infringement?
The change in the inclusion/deductibility of child support has its origins in the Supreme Court of Canada decision in The Queen v. Thibaudeau et al. [1995 [1] CTC 382;1995 DTC 5273]. Thibaudeau argued that, by imposing a tax burden on money she used exclusively for her children's benefit, paragraph 56(1)(b) infringed on her right to equality guaranteed by subsection 15(1) of the Canadian Charter of Rights and Freedoms. The Tax Court of Canada [1992 [2] CTC 2497,1992 DTC 211] found that paragraph 56(1)(b) was not discriminatory and dismissed Thibaudeau's appeal. The Federal Court of Appeal [1994 [2] CTC 4,1994 DTC 6230] reversed this decision, concluding that paragraph 56(1)(b) infringed subsection 15(1) and could not be justified under section 1 of the Charter. In so finding, the court stated the following:
Although the deduction/inclusion scheme is designed to improve the situation of the family upon divorce or separation and in many cases succeeds in achieving this objective, it does so at the cost of placing an unequal and unjustifiable tax burden on the shoulders of custodial parents like Ms. Thibaudeau.
I conclude that the requirement of s. 56(1)(b) that child support be included in the custodial parent's income infringes the right to equality guaranteed by the Charter and that this infringement is not justified by s. 1.
The Crown appealed this decision to the Supreme Court of Canada, which in a five-to-two decision found that paragraph 56(1)(b) did not violate Thibaudeau's rights under subsection 15(1) of the Charter of Rights and Freedoms.Judges Cory and Iacobucci made the following comment:
The amount of income taxable under ss. 56(1)(b)and 60(b) is determined by the family law system and, unless it operates in a defective manner, the amount of child support will include grossing-up calculations to account for the tax liability that the recipient ex-spouse will incur on the income. If there has been an error, the family law system provides avenues to revisit the support order to correct the situation. Any disproportionate displacement of the tax liability between the former spouses lies in the family law system, not in the ITA. Therefore, in light of the interaction between the ITA and the family law statutes, s. 56(1)(b) does not impose a burden upon the respondent within the meaning of s. 15(1).
Despite this victory, the Department of Finance saw fit to change the legislation in 1997, which illustrates that pressure from some groups can be effective when dealing with government.
Caught in the Rules
When the legislation changed, the media widely reported that payments for child support made after 1996 would not be taxable to the recipient or deductible by the payer. What much of the media failed to stress was that existing agreements were not affected by the changes. The result was a lot of confusion for those already paying and receiving child support. It made for a very interesting tax season watching recipients' joy turn to dismay and anger, while at the same time watching payers' dismay and anger turn to joy, when the rules were explained.
However, some taxpayers have unwittingly been caught by the new rules even if their agreement was entered into prior to May 1, 1997. Any change to the existing agreement means, for tax purposes, that a new agreement has been created. The new rules will then apply; the payer will no longer be able to deduct child support, and the recipient will no longer have to include it in his or her income. For example, a client and his former spouse decided to increase the amount of support. Having listened to my dire warnings in years past that everything should be specified in writing in the agreement, they had their agreement amended to show the new amounts. However, in doing so, they fell under the new rules — no deduction for my client and no income inclusion for his ex. This has to be one of the few times a client actually listened to me — and it backfired on him!
And it has the potential to backfire on others, too, if the nature of the support isn't clear in the agreement. The new legislation applies only to child support; it does not apply to spousal support. If the agreement specifies that the payments are spousal support, they will continue to fall under the old rules. However, if the agreement does not specify whether the payments are child support or spousal support, they will be considered child support. So it pays to be as clear as possible in these agreements. A few months ago, someone at the CCRA informed a member of my firm that a client's claim for alimony would be disallowed because it did not specify the payments as spousal support. The tax department quickly backtracked when my associate pointed out that there were no children in the marriage, so the payments could not have possibly been for child support.
It is difficult to say what the net effect of the new rules has been on those directly involved. Professionally, there hasn't been a huge difference for me. Now I just hear complaints from the payers rather than the recipients.
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Don Goodison, CFP, FCGA, is a partner of Kemp Harvey Goodison, Certified General Accountants, in Burnaby, B.C. E-mail goodison@axionet.com.