With the kids settling back into school and parents returning to regular work schedules, what better time to review the rules surrounding the child-care expense deduction, its limits, as well as a recent tax department technical interpretation that may preclude some parents from claiming a deduction.
When can you deduct child-care expenses?
If you spend money on child care to enable you to work, carry on a business, or to attend school, you may be able to get a tax deduction on your return for the cost of child-care expenses. Under the tax rules, you can generally deduct money you paid to caregivers providing child-care services, day nursery schools and daycare centres, as well as fees for child-care services offered through educational institutions, day camps and day sports schools where the primary goal of the camp is to care for children.
The expense must be specifically incurred to allow the parent to work (or go to school) as opposed to hiring a babysitter for a night on the town. That being said, a judge in a 2007 tax case involving a couple who claimed child-care expenses for their son with autism for babysitting on Saturdays, when the parents were not at work, found that there “does not specifically require that there be a connection between the time when the child-care services are given and the time when employment duties are performed.” In that case, the judge allowed the child-care expenses incurred on Saturdays as the child’s parents were unable to perform the usual domestic tasks such as groceries or cleaning without care for their son. As he wrote, their son “has to be taken into care on Saturdays to allow (the parent) to hold full-time employment from Monday to Friday.”
How much can you deduct?
The child-care expense deduction is limited to $8,000 annually for a child under the age of seven, $5,000 for other eligible children aged seven to 16, and $11,000 for a child who qualifies for the disability tax credit.
While most 15- and 16-year-old kids are typically able to stay home alone after school until mom or dad comes home from work, the law used to restrict child care expenses to kids 14 and under. The age limit was increased to age 16 in 1996 in response to concerns raised by single parents who must be away from home at night for their work, such as airline attendants, nurses and other shift workers, and who wish to hire evening or overnight child-care providers.
Interestingly, the child-care expenses incurred do not need to be paid for each eligible child. For example, let’s say you have three kids. The 15-year-old and 13-year-old do not require any child care but you also have a toddler who is two and requires either daycare or the supervision of a nanny during the work day. You could still claim up to $18,000 of child-care expenses, based on the ages of your three kids and the respective limits (i.e. 2 X $5,000 + $8,000).
The “earned income” limitation
As I discussed in a recent column, a specific rule requires that where a couple incurs deductible child-care expenses, the deduction must generally be claimed by the lower-income partner and is limited to two thirds of the lower-income spouse’s “earned income.” The term earned income is defined in theIncome Tax Actand includes “all salaries, wages and other remuneration, including gratuities, received by the taxpayer in respect of, in the course of, or because of, offices and employments.”
Last month, the Canada Revenue Agency responded to a technical interpretation request regarding the deductibility of child-care expenses and the CRA’s interpretation of the term earned income. In the scenario, the spouse with the lower income is a 50 per cent shareholder of a Canadian controlled private corporation, and is its only active shareholder and director. In their capacity as director, the taxpayer worked an undisclosed number of hours per week on a regular and steady basis, for which they were compensated with dividends.
The CRA was asked whether the dividends paid to the taxpayer could possibly be considered “other remuneration” that would count toward earned income for the purposes of claiming the child-care deduction.
Unfortunately for the taxpayer, the CRA stated that where a director of a corporation receives a dividend in lieu of director’s fees, “the nature of the amount received is altered, and so would be its tax treatment. This is because dividends are generally paid to shareholders as a return on their investment in a corporation.” The CRA distinguished between director’s fees, which are considered to be employment income, and dividends, which are considered to be property or investment income. The distinction is important since investment or property income are not part of the inclusions in earned income for the purpose of determining the child-care deduction limit.
The question goes to the heart of the characteristics of dividends. In its response, the CRA cited the Supreme Court of Canada which, commenting on the nature of dividends, has stated that: “It is a fundamental principle of corporate law that a dividend is a return on capital which attaches to a share, and is in no way dependent on the conduct of a particular shareholder.” The CRA also cited a Tax Court decision confirming that “in law, the allocation of a corporation’s profits to shareholders by dividends does not constitute remuneration for their work, any more than that work constitutes consideration for dividends received.”
The CRA therefore concluded that dividends received by a shareholder of a corporation do not qualify as “other remuneration” and thus in a two-parent family where the low-income spouse is a shareholder whose income consists solely of dividends from the corporation, the family will generally not qualify for the child-care expense deduction as the lower-income spouse would have no earned income.
This can be an important planning consideration for incorporated professionals who generally have the choice to be remunerated from their professional corporation via salary or dividends.
Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Financial Planning & Advice Group in Toronto.