What are Contingent Taxes in Family Property Division?
Often towards the end of a divorce, a family property statement (“FPS”) will be prepared. This sets out who is keeping which assets, who will be responsible for which liabilities, what the values of those assets and liabilities are, and also consider the impact of exemptions, contingent taxes, and a host of other factors. Often multiple versions of the FPS are prepared, as more information becomes available, people change their minds as to what they want to keep, or just to help explore different options.
At the bottom of the FPS, there will be a somewhat mechanical calculation that sets out how much one person owes the other (the “Equalization Payment”), such that each person retains a fair, but not necessarily equal, value of net family property. Coming to an agreement on the Equalization Payment is a significant step, sometimes the final hurdle, in finalizing the divorce.
The eventual sale of some assets will attract income tax, while others will not. These taxes, which are contingent on the asset being sold, should be included on the FPS. Contingent taxes are often not well understood, and we’ll use a simplified example to demonstrate the impact of contingent taxes on the Equalization Payment.
John and Mary are divorcing, and they only have two assets: the family home that they agree has a value of $500,000 which has no mortgage or other debt, and an RRSP worth $300,000. They have also agreed that John is keeping the house, and Mary will keep the RRSP.
Before considering contingent taxes, the initial Equalization Payment would have John paying Mary $100,000 [($500,000 – $300,000) / 2]. After doing so, they would each have $400,000 of net assets, and that seems fair.
However, when John eventually sells the house (which we’ll assume is a principal residence), he won’t have to pay any income taxes. Ignoring realtor and legal fees, John will have $400,000 of after tax cash in his jeans after the sale.
When Mary eventually cashes in her RRSPs, the redemption will be included in her taxable income and she will pay some income taxes. In 2025, the tax could be as has high as 48%, and that would leave Mary with $256,000 [$300,000 x (1 – 48%) + $100,000] of after tax dollars. This is $144,000 less than the $400,000 John has, and now this doesn’t seem so fair.
Now, Mary likely won’t cash in her RRSPs until for some period of time, perhaps when she retires. Even then she may withdraw the funds over a number of years at a lower tax rate each year. When we consider the impact of these two factors, contingent taxes should be discounted to something less than 48%. For purpose of our example, let’s assume 20% is appropriate.
The contingent taxes associated with Mary’s RRSPs is estimated to be $60,000 ($300,000 x 20%), and that liability should be included on the FPS. This means Mary is keeping net family property worth $240,000 ($300,000 – $60,000).
If John is keeping $500,000 of value, and Mary is keeping $240,000, the revised Equalization Payment should be $130,000 [($500,000 – $240,000) / 2], after which they both would have $370,000 of net assets. Again, this seems fair.
When considering the discounted contingent taxes associated with the RRSPs that Mary is keeping, the Equalization Payment increased by $30,000 (half of the $60,000 of contingent taxes).
RRSPs aren’t the only assets that will attract income taxes when their value is realized. Rental properties, non-registered investment accounts, the shares of privately held companies, and other assets may all incur tax when sold, and the contingent taxes on each may be calculated differently. In particular, the contingent taxes associated with privately held companies can be complex, and the amounts often have a meaningful impact on the Equalization payment.
Selecting an appropriate contingent tax rate is difficult, is somewhat dependent upon the facts of each situation, and involves professional judgment. A detailed discussion of this is beyond the scope of this article, and readers are advised to consult legal and tax advice before taking any actions.
