Michael S. Penner , B.B.A., C.A., C.B.V., A.S.A., C.F.E.
Steve Ranot , C.A., C.B.V.

In theory, tracing of an exclusion claim is simple. In order to claim an exclusion with respect to net family property (NFP), the titled spouse must be able to trace the excluded asset(s) in question at the valuation date (V-day) to the source of the exclusion (e.g. inheritance, gift or proceeds from a personal injury suit).

Where excluded proceeds are invested in equities which increase or decrease in value, the tracing procedure may be as simple as the following example.

Joe receives a gift of $100,000 from his uncle during his marriage to Jane. He invests $50,000 each in shares of ABC Ltd. and XYZ Inc. Neither of these investments yielded any dividend between the date of Joe's acquisition and his date of separation. At V-day, the ABC shares are worth $1,000 while the XYZ shares are worth $150,000. The value of Joe's excluded assets is $151,000, the aggregate value of the two investments directly traceable to the $100,000 gift.

Where excluded proceeds such as an inheritance are invested in securities that yield income in the form of interest and/or dividends and the terms of the inheritance do not specifically indicate that income generated by the proceeds of the inheritance are themselves to be considered excluded property for the purposes of the Family Law Act, the task of tracing becomes more complicated. Consider the following example:

Neil inherits $100,000 from his cousin during his marriage to Nancy. Neil invests the proceeds in a mutual fund with a portfolio including treasury bills, dividend-yielding blue chip equities and growth stocks. His original $100,000 investment was used to purchase 10,000 units of a mutual fund at $10 each. After one year, the value of the mutual fund units has risen to $10.50 each. Neil has also received $5,000 of interest and dividends which were reinvested by the fund for 480 additional units. At V-day, Neil owns 10,480 units worth $10.50 each for a total value of $110,040. Unlike the previous example, all of this amount is not excluded property. As $5,000 of income which is not specifically indicated as being excluded property was reinvested to buy 480 additional units, only 10,000 units remain excluded. As these units are now worth $10.50 each, the value of Neil's excluded property is $105,000 ($10.50 x 10,000 units). The remaining value of $5,040 ($110,040 - $105,000) represents non-excluded income and capital growth thereon. Income tax considerations as discussed below should be considered on the $5,040.

Although interest and dividends generally do not continue to be excluded property despite their traceability, stock splits are treated differently and are considered to be excluded.

Where a liability relates to what otherwise would be excluded assets, the value of the liability might be considered in determining the value of the exclusion. Consider the following example.

Jack successfully sued his favourite bistro for damages following a nasty bout of food poisoning. Being a shrewd investor, Jack parlayed the original $10,000 damage proceeds into $100,000 by short- selling Acme shares. At V-day, Jack's excluded asset is worth $100,000. However Jack has yet to pay any tax on this unrealized gain. As Jack's marginal tax rate on capital gains is 40%, the related income tax liability is $36,000 (40% of $100,000 - $10,000). Based on the foregoing, the value of Jack's excluded property is $64,000 ($100,000 - $36,000 related tax liability), or $100,000 if the income tax liability does not attach to the excluded property claim. It will be interesting to see how the courts interpret this issue.

The ability to trace the excluded assets and liabilities in the examples above has been relatively easy to follow. In reality, the number and complexity of the transactions may be greater but the theory remains the same. A difficulty in tracing arises when what would otherwise be excluded property is co-mingled with other property. Consider the following example:

Michael has a chequing account with a balance of $20,000. During his marriage, Michael receives a gift from his mother of $30,000 which he deposits in this account. Shortly thereafter, Michael spends $10,000 from this account on tennis lessons which so infuriates his wife, Michelle, that she leaves him. How much of the remaining $40,000 in the account is excluded property?

Michael might argue the Clayton approach that the tennis lessons were paid from the original $20,000. Accordingly, the $30,000 gift is still intact and fully traceable therefore it should be excluded.

Michelle might take the view that the tennis lessons were paid from the gift proceeds and accordingly only $20,000 remains traceable and excluded.

The pro-rata approach adopted in Duff might indicate that once assets are co-mingled, a proportionate amount of each is utilized in each subsequent transaction. Accordingly, as the gift comprised 60% ($30,000 out of a total of $50,000) of the cash in the account after it was originally deposited, 60% of the tennis lessons were paid with proceeds from the gift. Accordingly, $6,000 of the gift is no longer excluded and the remaining excluded property is $24,000.

As can be seen from the example of Michael and Michelle, where there is only one gift and one subsequent transaction, there can be three different views with respect to the value of the excluded property. One can only imagine the difficulties with respect to tracing excluded property when gifted property is co-mingled with other property for an extended period of time involving numerous transactions. Obviously, if you are able to segregate excluded funds from funds which would be included in NFP, you will encounter fewer problems in tracing.