Written on behalf of Shariff & Associates
In Canada, if certain conditions are met, spousal support can be tax deductible for the party paying support and is considered taxable income for the recipient. However, there are requirements that must be met before a payor can deduct support amounts from their taxable income. There must be periodic payments that are made to the recipient pursuant to a court order or written agreement. So, what type of written agreement will be considered sufficient?
Spousal Support Payments May be Tax Deductible
In Hovasse v. The Queen the appellant appealed a decision denying deductions for support amounts. At issue was whether the appellant made the payments pursuant to a written agreement, as required by section 56.1(4) of the Income Tax Act. The appellant argued that a Summary of Mediated Agreements that resulted from mediation sessions could satisfy the requirement of a written agreement. In response, the respondent claimed that the document could not satisfy the requirement as it was not intended to be a final and binding agreement between the appellant and his former spouse. The judge explained that Canadian tax law generally “prevents spouses from splitting income in such a way as to produce lower overall taxes.” However, an exception is available in section 56.1(4). That enables certain support amounts that are paid to a separated spouse to be deducted from the payor’s income and to be taxed in the hands of the recipient.
Justice Hogan noted that the Income Tax Act’s requirements are intended to prevent parties abusing the support payment provisions and splitting income. The conditions are included in the definition of “support amount” in the Income Tax Act, and require that support be paid to the recipient on a periodic basis if the recipient and payer are living separate and apart and is payable under a court order or written agreement. The decision in Shaw v. The Queen provided guidance on how to determine whether an agreement satisfied the Income Tax Act. That case held that what was required was evidence that the parties “intended to be legally bound by the obligations” they “set down in writing.” A signature could prove this, however, it was not the only way.
Ultimately, the evidence that might suffice would depend on the facts in each case. In Shaw v. The Queen, the judge decided that written agreements do not need to be signed in order to comply with 56.1(4), rejecting the idea that Parliament, in drafting the Income Tax Act, intended to strictly apply the requirement of a written agreement. This was because a strict interpretation was not required in order to meet the purpose behind permitting the deduction of support payments. However, in Foley v. R., it was held that an agreement required at least a binding obligation. Consequently, for the appellant to satisfy the requirements of the Income Tax Act, and be able to deduct support amounts, he had to show that the mediated agreement obligated him to make the support payments.
Payments Must be Made Pursuant to a Written Agreement
In contrast, the respondent argued that the summary of the mediated agreement was not an agreement as the appellant’s former spouse asked for a greater support amount in a motion to institute divorce proceedings. However, for Justice Hogan, this did not demonstrate the absence of a written agreement. It could show that the agreement was a temporary one pending divorce proceedings. Importantly, such interim agreements would be acceptable if they met the other requirements under the Income Tax Act. The lack of finality was not grounds to dismiss a written agreement.
Overall, there was nothing to suggest that the appellant was trying to abuse the Income Tax Act and split income with his former spouse. Instead, the evidence indicated they were separated at the time he was making the payments, had remained separated, and did not have the “economic benefit of a unified household.” Moreover, they both understood the payments were being made according to a binding obligation. These were circumstances in which Parliament intended that the entitlement to deduct support payments should be available.
Fully Executed Separation Agreement Not Required
A fully executed separation agreement may not be required for a party to be permitted to deduct support payments if the terms of their separation agreement are clear. So what happens if the separation agreement is flawed? In Vohra v. The King the appellant appealed a decision to deny a claimed deduction of $42,000 in support payments on the basis they did not meet the definition of “support amount” under the Income Tax Act, and more specifically, that they were not made pursuant to a written agreement. The Court agreed that the agreement was flawed as the signatures of the spouses were not witnessed and the agreement had a handwritten clause that stated it was subject to approval by legal counsel. However, there was no evidence this approval was ever obtained. Nevertheless, the appellant paid support and the parties honoured the agreement’s terms.
The appellant argued that although the obligation to make support payments pursuant to the separation agreement expired in 2014 and was not updated, an implied contract continued to exist, which would cover the support payments made after that date. The appellant pointed to the principle that an implied contract may exist when the parties have an express contract that lasts for a fixed term, but they continue to act as if bound by those contractual terms after the contract expires. In contrast, the respondent alleged that the separation agreement expired in 2014, so no agreement obligated the appellant to pay spousal support in 2018, which was when he claimed the deduction. Justice MacPhee noted that the requirement for a written agreement is necessary to prevent fraudulent tax avoidance. However, this was clearly not a fraudulent scheme. The parties overlooked the need to update the contract when it expired even though the appellant continued to make support payments.
Courts Concerned With Fraudulent Tax Schemes
Importantly, an implied contract was not a basis that would permit the appellant to claim the deduction. The judge disagreed with the appellant’s argument, finding that an implied contract, like a verbal contract, would not meet the requirements of the Income Tax Act. However, the appellant’s appeal was still successful as the payments were found to be made pursuant to a written agreement. Justice MacPhee found that “the formal requirements of a properly drawn up contract should not overwhelm” the analysis. The parties did have an agreement in writing even though it was flawed. They considered themselves bound by that agreement through 2018, which mean that the payments were made pursuant to the terms of a written agreement.
Consider the Tax Consequences When Settling Spousal Support
When a relationship ends, the parties may negotiate a separation agreement dealing with financial matters such as the payment of spousal support. However, parties should be mindful of the possible tax consequences they may face when settling the agreement’s terms to ensure they are not caught off guard while their obligations are enforced.
Contact the Family Lawyers at Shariff & Associates for Trusted Advice on Domestic Agreements and Support Obligations
At Shariff & Associates, our team of compassionate family lawyers work with clients to navigate the financial uncertainties following a separation or divorce. We help clients prepare and review domestic contracts, including separation agreements, to ensure that they understand their rights and responsibilities following the breakdown of their relationship, particularly in relation to spousal support obligations and entitlement. We provide clients with trusted representation in various disputes and ensure that their rights remain protected until the matter is resolved. To schedule an initial consultation with a member of our team, please reach out to us online or call us at 905-591-4545.