Who pays taxes on investment income when children invest? – The Globe and Mail

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To teach financial literacy, parents may encourage teens to try out investment trading with imaginary money in a practice account. But what are the tax implications when children graduate to trades that use real money?

When a child is under the age of 18, the answer depends on the source of the funds used to invest, says John Waters, vice-president, director of tax consulting services, at BMO Nesbitt Burns Inc. in Toronto.

Money that is the child’s – say, from a part-time job or an inheritance – can be invested and taxed in the child’s hands. However, if parents or other close relatives give money to the child to invest as a gift (or lend money at little to no interest), the attribution rules kick in and any interest or dividends are taxed in the giver’s hands.

“The idea is that you can’t split income generally by investing in your child’s name,” Mr. Waters says. “The one notable exception to that is capital gains. So, it’s possible to potentially invest on behalf of a child, earn capital gains, and have those gains attributable to the child who then pay taxes at their rate, which is often very low.”

When a child is over 18 years old, the attribution rules don’t apply to gifts of money – although they still apply to interest-free or low-interest loans if the purpose of the loan is to split income.

Setting minors up to invest

Minors aren’t generally allowed to open investment accounts in their own name, but there are workarounds with different tax consequences.

“A simple option, not ideal, is just to have the parent open up an account in the parent’s name,” Mr. Waters says. “In that scenario, of course, everything would be taxed in the parent’s hands.”

An alternative is to establish a formal trust for the child with the parents as trustees and the child as the beneficiary. In this case, the trust owns the assets, can invest them with (or without) the child’s input, and investment income is subject to tax within the trust, often at the highest marginal rates. When income is paid to the beneficiary, it’s taxable in the beneficiary’s hands.

Mr. Waters says that a trust’s complexity, including the requirement to file separate tax returns, makes this another less than ideal solution unless it’s set up to manage a larger inheritance.

“Probably the route that most people would go is an in-trust account or an informal trust,” he says. “Because it lacks the formal documentation to actually create a trust, there’s some question as to … what this is from a legal and, therefore, tax perspective. It’s a bit of a grey area.”

But the perspective that most people take is that the parent is an agent, acting on behalf of the child, and overseeing these funds for the benefit of that child, Mr. Waters adds.

However, if the informal trust is deemed to be a trust arrangement, it is subject to a further attribution rule. When the trustee also contributed the funds to the trust, all income – including capital gains – is attributed back to that trustee.

“Oftentimes, it makes sense to have, say, a grandparent make a gift and have the child’s parents be the trustee or agent controlling that account. Then, you bypass that,” Mr. Waters says. “But the concern would be if one or both of the parents makes that gift and then they are overseeing that account, you could have this additional attribution rule apply.”

Accurate recordkeeping is also essential to stay onside with the Canada Revenue Agency, and that may require parents to set up separate accounts for deposits to which the attribution rules apply.

Crypto trading adds another wrinkle

Teens may be especially attracted to the new kid on the block in investing: cryptocurrency. But trading in this space can introduce additional tax complications because cryptocurrency is treated as a commodity for the purposes of the Income Tax Act, says Vanessa Sarveswaran, vice-president, tax, retirement and estate planning, at CI Global Asset Management in Montreal.

“Any income from transactions involving cryptocurrency [can be] treated as business income or as capital gain, depending on the circumstances,” she says. “It’s the taxpayer’s responsibility to establish whether earnings from crypto are considered business income or capital gains.”

If the taxpayer holds the cryptocurrency for a long period of time, the sale of it is likely to be treated as a capital gain. In contrast, if the taxpayer trades cryptocurrencies actively, the sale of the asset is more likely to be treated as business income, she says.

While neither capital gains nor business income will be attributed back to parents, even if they provided the funds to trade (assuming that extra trust-focused attribution rule doesn’t apply), the distinction is important from a tax perspective because capital gains are taxed at a much lower rate than business income.

It also doesn’t matter whether a child is under or over 18. An active cryptocurrency trader of any age can be deemed to be earning business income.

As with other investment accounts, any interest or dividends earned in a cryptocurrency trading account set up for a minor but funded by a gift from parents will be attributed back to the parents.

Ms. Sarveswaran points out that not all cryptocurrency trading platforms provide tax slips, and some don’t even ask for a social insurance number. Therefore, it’s important for investors to track their transactions so they can report all taxable investment income on the appropriate tax return.

Beyond helping parents understand the tax issues related to teens and trading, advisors can encourage their clients to check in regularly on their children’s accounts, discuss the decisions they’ve been making, and ensure they can identify a scam, Ms. Sarveswaran adds.

“The kids should know the difference between reputable and untrustworthy sources before starting to trade on their own,” she emphasizes.

“Parents should also help children understand financial risk … meaning that crypto [and many other investments] can decline in value.”

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