Gary Joseph & Jen Capuno  July | 2022

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

Despite the fact that the Child Support Guidelines have been with us tor approximately 25 years, certain issues continue to bedevil counsel and clients. In this article we remind readers that the Guidelines treat capital gains and losses in a manner different from that of the Income Tax Act. This fact and others relating to treatment under the Guidelines often come as a surprise to clients. We provide details below to assist counsel in advising clients.

Under the Guidelines, the income that a spouse reports for support purposes must include all sources of income received, before taxes and deductions. This article focuses on capital gains and losses, and how these are treated under the Guidelines. Capital gains are realizable where net proceeds from the disposition of capital property are greater than the adjusted cost base upon disposition. Conversely, capital losses are realizable where net proceeds are less than the adjusted cost base upon disposition. Capital property Includes marketable securities, business interests, personal use property, rental property, depreciable property other properties used for Investment and to generate income.

Under Canadian tax law, the taxable portion of capital gains (less any capital losses) Is based on the prescribed inclusion rate, which currently stands at 50 per cent. To illustrate, where a taxpayer realizes $1,000 in capital gains (net of capital losses) on capital property disposed of during a tax year, the income reported for tax purposes would be $500 (that is, the "taxable" or "net capital gains"). While capital loses can only be deducted from income originating In capital gains, unused capital losses in a given tax year can be carried forward indefinitely to offset capital gains in future tax years, or can be applied retroactively against capital gains realized in the three most recent tax years.

The Treatment of capital gains under the Guidelines differs from the their treatment under the Income Tax Act. Per s. 6 of Schedule III of the Guidelines, when calculating gross income for support purposes, capital gains must be reported in full, without any inclusion rate deduction as allowed form when filing taxes. The Guidelines are concerned with total income and, thus, when looking at capital gains (net of capital losses) they require that the 50 percent portion of capital gains income that is omitted from reported income in the tax filings be added back. In short, the Guidelines lead us to a more comprehensive picture of income linked to capital gains and, by extension, a more complete picture of each spouse's means and ability to provide support.

Beyond requiring a full reporting of capital gains, the Guidelines also empower the courts to factor in the tax savings a spouse enjoys as a result of the 50 per cent inclusion rate (which leaves 50 percent of capital gains income untaxed). This imputation of income Is often applied where one spouse derives a significantly higher proportion of their income through capital gains per s. 19 (1) (h) of the Guidelines. Such adjustments are referred to as "gross-ups" and, in the case of capital gains, gross-ups are meant to factor in the tax savings on the non-taxable portion of capital gains equivalent to the gross pre-tax level.

The effect of these income inclusions, along with income tax gross-ups, can be quite significant (and contentious), especially for spouses receiving a substantial portion of income sourced as capital gains or dividends (in lieu of salary) from their direct or indirect interests in corporate holdings. The courts retain considerable discretion in the application of these adjustments based on principles of fairness and reasonableness.

For instance, where a spouse receives tax-exempt capital dividends (that is, income related to the tax-free portion of a capital gain following disposition of capital property through a corporation), the entire amount of those tax-exempt capital dividends is added to income for support. In addition, the courts may consider the appropriateness of applying an income tax gross-up to account for the tax savings on the entire capital dividends received tax-free. Further income inclusions and tax gross-ups might also be applied where a spouse is able to convert taxable dividends into a lower-taxed capital gains, or else to benefit from tax-free status under the lifetime capital gains exemptions ("surplus stripping").

For tax purposes, a special category of capital losses is realizable upon disposing of shares of, as well as losses resulting from non-recoverable debts from, small business corporations. The Act allows a taxpayer to claim 50 per cent of these losses as allowable business investment losses (ABIL) that is deductible from any source of income, which can be carried back three years and forward 10 years or becomes deductible from taxable capital gains thereafter. Per s. 7 of Schedule III of the Guidelines, the total business investment losses incurred by a spouse during a given year are deductible from the calculated income for support purposes. Any losses in the form of ABIL that are reported for tax purposes are therefore doubled (that is to say, to reflect the full amount of the loss, rather than simply deducting the 50 per cent that is reported as ABIL within a tax filing). And, since ABIL only represents 50 per cent of business investment losses, the other 50 per cent of investment losses not deducted for tax purposes may then be subject to a tax adjustment to account for that portion of losses not originally deducted due to the tax rules.

The Guidelines afford the court discretion in a number of other matters relating to income determination for support purposes. The Guidelines acknowledge the need for exceptions to hard and fast rules and set out circumstances wherein the initial income figure arrived at may not be a reliable measure of financial means to provide support.

Under s. 17 (1) and (2) of the Guidelines, the determination of annual income as set out under s. 16 may not always offer a fair or else reasonable representation of income for support. Accordingly, the Guidelines empower the courts to consider a pattern of income, including fluctuations or nonrecurring income events. The court may further choose not to factor in adjustments per s. 6 and 7 of Schedule III and adjust the amounts of capital losses and business investment losses to arrive at a figure that seems fair and reasonable for support purposes.

There are a variety of situations under which a capital gain or loss might be deemed as fluctuating or non-recurring and thus might be revisited to fairly reflect income for support purposes. Among those capital gains and losses likely to be subject to such considerations include:

• One-time capital gains (or losses) generated from the sale of a business share interest or rental property, which produces a one-time material increase (decrease) in personal income.
• Capital gains reductions upon notional or actual dispositions of small business corporation shares or specific investments or properties, resulting in a lowering of capital gains reported under personal tax filings in a given year.
• Capital losses (including ABIL) that are carried forward from prior years to reduce capital gains (income) in those years.
• Capital gains deferral upon claiming a reserve, allowing for tax recognition for a portion of capital gains upon receipt of payments or up to a maximum period for tax purposes.
• Capital gains resulting from the disposition of an investment property where the capital gain income year (or years) follows numerous prior years of investments into the property.
• Capital gains upon a deemed disposition linked to a change in the use of a rental property to a principal residence, where the disclosure is not required until the actual sale of the property as elected for tax reporting.
• Capital gains exclusion upon gifting capital property to a registered charity or qualified donee (inclusion rate of 0 per cent), resulting in lower income while generating non-refundable tax credits and limiting income-generating capital base upon gifting.

The courts retain further discretion in how to treat capital gains generated through a disposition of capital property that has been deemed excluded, or else has fallen under a prior equalization settlement. In these cases, courts may see tit to include or exclude the related income upon its disposition, based on the means and needs of the parties.

Gary S. Joseph is the managing partner at MacDonald & Partners LLP. A certified specialist in family law, he has been reported in over 350 family law decisions at all court levels in Ontario and Alberta. He has also appeared as counsel in the Supreme Court of Canada. He is a past family law instructor of the Ontario Bar Admission course and the winner of the 2021 OBA Award for Excellence in Family Law. Jen Capuno specializes in asset and business valuations, litigation support and forensic accounting. She practises at VFDR Inc., focusing on matrimonial disputes and damage quantification. Jen is accredited as a chartered professional accountant, chartered financial analyst, chartered business valuator, chartered investment manager, certified fraud examiner and certified in financial forensics.

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