The tax treatment of child and spousal support payments seems black and white. Spousal support payments are deductible for the payer and taxable for the recipient; child support payments made in agreements or orders executed after May 1997 are neither taxable nor deductible. But the legal interpretations of these rules involve many shades of grey.

The bulk of the confusion surrounds child support agreements and court orders made prior to the Canada Revenue Agency’s new tax treatment of child support payments in May 1997. Prior to this date, child support payments were treated the same as spousal support — deductible for the payer and taxable for the recipient.

Although child support has been considered tax-neutral for almost a decade, there are still clients whose payments fall under the old tax treatment.

“By far, the most significant source of litigation surrounds whether later agreements or court orders destroy the old tax treatment,” says Barry Corbin, a specialist in estates and trusts law and sole practitioner with Corbin Estates Law in Toronto.

That’s because payments made under an agreement or court order set prior to the new tax treatment aren’t automatically considered tax-neutral as of May 1997. Instead, a new commencement date must be created through an “external action” — such as a joint filing of CRA Form T1157: Election for child support payments — agreeing to a commencement date on or after May 1, 1997.

A variation to the existing agreement or order resulting in a change to the child support amount, or the creation of a new agreement or order that results in a change to the child support amount, can also trigger a new commencement date — but not always.

“There’s some ambiguity and inconsistency in the courts as to what constitutes a change,” says Corbin.

What doesn’t activate a new commencement date is an automatic increase to support payments — for instance, if an agreement or order contains a clause that child support payments must increase by the change in the annual cost-of-living index.

“People are still being caught by this,” says Ella Bernhard, a lawyer and family law mediator with Chappell Bush Stewart LLP in Toronto. “As a result, you’re going to have some very unhappy recipients still paying taxes on that support amount.”

In some cases, confusion may also exist over what actually constitutes a support payment. Payments made to a spouse or child are only considered support if the following criteria are met:

> they are payable under an agreement or order;

> the payer and the recipient are living apart as the result of a relationship breakdown;

> the money is strictly for maintenance;

> the amount is paid on a periodic basis;

> the payment is made directly to the recipient (or a court or agency);

> the recipient can spend the money as she or he sees fit.

Payments that don’t fit these criteria are — in most circumstances — neither taxable nor deductible. “The recipient may be delighted by this news, but the payer will be really upset,” says Bernhard.

Payments made directly to a third party, such as a leasing company or private school, and specific-purpose payments that the recipient must use to pay specific expenses, such as rent or the mortgage, are the exception to this rule. They can be considered deductible and taxable if specific conditions are met.

“This is the only area in which you can dictate the tax effect,” says Bernhard, noting that both parties must agree to the tax treatment, live separately and also specify the nature of the payment and make specific reference to sections 60.1(2) and 56.1(2) of the Income Tax Act in the agreement or order. The payment must also be clearly identified as being solely for the benefit of the recipient.

Failing to differentiate between spousal and child support in the order or agreement is another way individuals can run into trouble come tax time. “If you don’t differentiate between the two, the CRA will deem the entire amount to be child support,” says Corbin. “If you’re hoping to get a deduction for spousal support payments, you’re out of luck.”

Individuals who run into arrears with support payments for a period prior to May 1997 can also be taken by surprise by the CRA, which, for tax purposes, applies partial payments of arrears to the most recent date. For example, an individual who owes $15,000 in arrears after May 1, 1997, and $5,000 in arrears prior to May 1, 1997, won’t receive any tax deductions until he has paid the $15,000 in arrears. “People are shocked to find the arrears payments are applied to the tax-neutral situation first,” says Bernhard.

@page_break@Some divorced and separated clients also have experienced confusion over the equivalent-to-spouse tax credit. “It’s possible that both ex-spouses may qualify for it if they share joint custody,” says Bernhard. “But they can’t both have it. If they don’t agree on who is claiming it, neither can have it.”

Deducting legal fees also can be a contentious issue. Corbin explains that a payer who instigates litigation to eliminate or reduce payments will never receive a deduction, although a recipient who seeks support or asks for an increase in support probably will be able to claim legal fees.

The key is that the CRA will allow a claim only for fees directly related to support (as opposed to divorce or custody). “Clients need to ask lawyers to break down their fee — which can be tricky,” says Corbin.

Along with their lawyers, financial advisors can help clients wade through the quagmire of issues — tax-related and otherwise — related to support payments. “My biggest job is to provide a reality check of who is going to pay for what,” says Heidi Pullem, a certified financial divorce analyst at ZLC Financial Group in Vancouver.

Advisors’ fees may also be deductible, although the lawyer should act as the middleman in the transaction to increase the odds of deductibility, Bernhard says: “The advisor can be obtained and disbursed through the lawyer.”

For more information, see Guide P102 (www.cra-arc.gc.ca/E/pub/tg/p102/p102-e.html) and interpretation bulletin IT-530 (www.cra-arc.gc.ca/E/pub/tp/it530r/it530r-e.html) on the CRA’s Web site. IE