Gary Joseph | Sep 2022

This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca), part of LexisNexis Canada Inc.

Payor spouses generally expect that their support obligation is determined by the income they declare in their tax return. Most are upset to be told that the tax return is merely the starting point for the income inquiry that will be conducted by our courts. Upset often turns to rage when the payor spouse is further told that not only is the income (for support purposes) not limited to the tax return, but certain portions of his/her income can be subject to a gross-up. What follows is a crash course in when and how gross-ups may be applied in support disputes.

A spouse's annual income, net of adjustments, is the primary measure used by courts when determining both spousal and child support amounts. In the case of child support, a spouse's income is applied to a statutory table formula per the Federal Child Support Guidelines (commonly referred to as the Guidelines). In the case of spousal support (assuming that eligibility for support has been established), a spouse’s disposable income is examined in the context in the range of amounts formula per the (non-binding) Spousal Support Advisory Guidelines (SSAG). In both cases, these guidelines (and formulas) are intended to bring a measure of consistency and predictability to decisions on support amounts, taking account of financial means and needs, as well as the circumstances of parents/spouses, including the existing standard of living. The formulas further account for the tax effects associated with support payments, including the non-taxable income for the recipients and non-deductible for the payors of child support, as well as the implications of tax policy governing inclusions and exclusions for taxes, deductions and credits associated with support.

Although the income tax return is the usual starting point when determining income for support purposes, It Is usually not the end. The income described on tax returns will almost always need to be adjusted to comply with the broader definition of income found in the Guidelines. This article focuses on a category of adjustment known as "gross-ups," with a particular focus on how gross-ups are applied when determining a spouse's income for support purposes.

The Guidelines employ a comprehensive concept of gross (or pre-tax) income that allows for comparisons between spouses. They accomplish this through a combination of imputing income to account for those types of income that are otherwise omitted from tax returns or taxed advantageously compared to employment earnings, and then applying gross-ups (to reflect imputed income or other income adjustments to the equivalent gross or pre-tax income).

The equation for a gross-up adjustment that adjusts net income (including imputed or net income) to a gross or pre-tax amount to determine support can be expressed in either of two ways.

There are various circumstances in which gross-up adjustments may be applied when determining income for support. The list below focuses on gross-up adjustments associated with tax effects when imputing (or attributing) income to a spouse- per s. 19 of the Guidelines.

• Where a spouse is intentionally unemployed or underemployed (or else not exerting reasonable efforts to be self-sufficient), an income may be attributed that is consistent with the spouse's education, training and experience, or living expenses (based on previous after-tax earnings).

The gross-up adjustment in this scenario entails adding the related income tax to adjust the imputed net income to the equivalent gross or pre-tax level using the spouse's applicable marginal tax rate.

• Where a spouse is statutorily exempt from paying federal or provincial income tax under s. 81(1) of the Income Tax Act, all tax-free earnings are recognized as net income and are then grossed up to the pre-tax amount to account for the tax savings. Other legitimate non-taxable income sources include disability benefits, workers' compensation, strike payments from unions, lottery winnings, capital dividends, social assistance, net federal supplements and certain foreign income. Where it can be identified, illegitimate under-reported or underdeclared income is also recognized and grossed up at the applicable marginal tax rate.

• Where a spouse works or resides in a foreign country with lower tax rates, the spouse's income is augmented to offset the tax differential, and this increase is attributed to income and is then subject to a gross-up adjustment. The gross-up reflects the pre-tax level on the net difference in taxes, deductions and credits under foreign tax laws compared to how these are treated under Canadian tax laws after being translated into Canadian dollars using the applicable average or effective foreign exchange rates. Other factors, such as differences in public services or benefits paid for by each government, may need to be considered when comparing these two outcomes.

• Where a spouse has diverted income or benefits to a third party for purposes of income tax planning, any diverted income is attributed back, and a gross-up adjustment will usually be applied to compensate for any gross tax savings linked to tax bracket effects. This provides for fairness between spouses who hold direct or indirect interests in businesses or other entities - which allows them to realize a range of personal tax benefits through deferrals or intertransfers - and those spouses who do not. The same corrective action may be applied where a spouse falling into a high tax bracket transfers/splits non-economic or discretionary income/benefits to/with a spouse, child(ren) or other related parties in lower tax brackets.

• Where a spouse is determined to have unreported cash sales or earnings, these will be recognized as income for support purposes, and a gross-up adjustment will be applied to adjust such imputed income equivalent to a gross or pre-tax amount. This may be considered even where there is limited evidence to support the allegation should the implicated spouse fail to supply the financial information or other evidence required to disprove the allegation.

• Where a spouse has lowered their tax burden through excessive or inappropriate tax deductions, some or all of their claimed deductions plus the taxes saved may be imputed as income, with a gross-up then applied. Per s. 19 (2) of the Guidelines, the "reasonableness of an expense deduction is not solely governed by whether the deduction is permitted under the Income Tax Act." In other words, even if appropriate for tax purposes, claimed deductible expenses may nevertheless be considered excessive/unjustified in the context of support determination. Further details on eligible employment expenses can be found in s. 1 of Schedule III of the Guidelines and s. 8 of the Income Tax Act

The courts retain discretion in the application of these gross-up adjustments (and imputing income), consistent with the objective of applying the law fairly and reasonably across many unique family circumstances.

Here is an example, based on a hypothetical 40 per cent flat tax rate on all income: