Published by BMO Wealth Exchange on December 20, 2017 at 11:26 a.m.
As outlined in our previous publication Tax Proposals Affecting Private Corporations – Initial Government Response Following Consultation Period, the federal government released a tax consultation paper in July 2017 affecting private corporations. The consultation paper outlined proposed policy responses for certain tax planning strategies involving private corporations that it perceives unfairly reduce personal taxes of high income earners through a variety of tax reduction strategies unavailable to other Canadians. On December 13, 2017 revised draft legislation regarding one of these targeted strategies, income sprinkling, was released to take effect beginning in 2018.
In October 2017, the government made several announcements with respect to these proposals affecting private corporations, including that it would not move forward with some measures outlined in the consultation paper, namely measures to limit access to the Lifetime Capital Gains Exemption (LCGE) and measures relating to the conversion of income into capital gains. On the other hand, the government also announced at that time that it would be proceeding with measures to limit tax deferral opportunities related to passive investments on a go-forward basis, the details of which will be included in Budget 2018.
In addition, the consultation paper addressed income sprinkling, a strategy which can reduce income taxes by causing income (such as dividends and capital gains) that would otherwise be realized by an individual facing a high personal income tax rate to instead be realized by family members who are subject to lower personal tax rates. At the time of the October 2017 announcements, the government acknowledged the complexity and the potential impact of these draft legislative proposals on small family businesses. It noted that the measures could create uncertainty as to how amounts received from a family business would be taxed. As a result, while it reiterated that it intends to move forward with these measures to limit income sprinkling using private corporations, it indicated that it would simplify these income sprinkling proposals and ensure that the rules will not impact businesses to the extent there are clear and meaningful contributions by spouses, children and other family members. At that time, the government committed to releasing revised draft legislative proposals, which remain effective for the 2018 and subsequent taxation years. This revised draft legislation regarding the measures limiting income sprinkling involving private corporations was released on December 13, 2017 and is the subject of this publication.
Income sprinkling is a tax strategy designed to shift income that would otherwise be taxed in the hands of one individual (often a principal shareholder of a private corporation) subject to high tax rates, to another individual (often family members of the principal business owner) subject to lower tax rates, in an effort to achieve a reduction in the overall family tax burden. This is commonly achieved using private corporations by structuring family members of the principal business owner as shareholders (either directly or through a family trust) so that they can receive income, such as dividends, from the corporation. Current tax legislation, known as “kiddie tax” or tax on split income (TOSI), eliminates the ability to achieve any benefit of income splitting by imposing the highest marginal tax rate on certain income received by minors under the age of 18. Under these existing rules, TOSI is narrow in its application as it only applies to certain income (commonly dividends), and only to minor children. The tax proposals initially released by the government contained draft legislation that would significantly expand the TOSI rules to capture income splitting strategies involving private companies and family members of any age. Effective for 2018, the original proposals sought to expand the types of income subject to the TOSI rules and introduce a “reasonableness” test to determine their applicability. Specifically, the expanded TOSI rules originally sought to tax distributions from a private corporation at the top marginal rate, where such income received by an adult family member was not “reasonable” taking into account the individual’s labour and capital contribution to the business and previous returns/remuneration, in light of appropriate compensation commensurate with what an arm’s length individual would receive for comparable contributions. These reasonableness tests would be stricter for individuals aged 18 to 24 years.
As noted above, concerns were raised during the consultation period about the complexity of the proposed measures and how they may create uncertainty in relation to how amounts received from a family business would be taxed. The government’s subsequent release of revised draft legislation now is aimed at simplifying and better targeting its proposal to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business.
Summary of Income Sprinkling Rule Changes
The revised draft legislative proposals introduced on December 13, 2017 to address income sprinkling maintain the overall structure of the original proposals released on July 18, 2017, but with important changes to simplify and better target the rules, and to reduce the potential compliance burden in their application. Consistent with the original July 2017 proposals, the new draft legislative proposals will extend the TOSI rules to potentially apply to individuals aged 18 and over in respect of amounts that are received either directly or indirectly, from a related business. Moreover, these tax changes (which remain proposed to be effective for the 2018 and subsequent taxation years) are intended to clarify the process for determining whether a family member is significantly involved in a business, and thus is excluded from potentially being taxed at the highest marginal tax rate under the TOSI rules outlined previously. The revised legislation further seeks to simplify and clarify the reasonableness test, address potential unintended consequences and ensure that the TOSI rules do not limit access to the LCGE. Specifically, the changes include clear, “bright-line” tests to automatically exclude from the potential application of TOSI, individual members of a business owner’s family who fall into any of the following categories:
• The business owner’s spouse, provided that the owner meaningfully contributed to the business and is aged 65 or over – in an approach similar to the existing pension income splitting rules.
• Adults aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hours per week) to the business during the year, or during any five previous years.
• Adults aged 25 or over who own 10 per cent or more of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation. Owners of private corporations that do not currently apply under this exclusion will have until the end of 2018 to adjust to the new exclusion for non-service businesses.
• Individuals who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they would not be subject to the highest marginal tax rate on the gains under existing rules (regardless of whether or not the LCGE is claimed in respect of the taxable capital gain arising from the disposition). This exclusion parallels the October 2017 announcement by the government that it will not be moving forward with proposed measures that would have limited access to the LCGE.
Individuals aged 25 or over who do not meet any of the exclusions described above would be subject to a reasonableness test to determine how much income, if any, would be subject to the highest marginal tax rate. Specifically, the TOSI on amounts derived directly or indirectly from a related business will only apply to the extent that the amounts exceed a “reasonable return”, which is defined as an amount that is reasonable having regard to the contributions of the individual to the related business relative to other family members who have contributed to the business. It is intended that an amount will not qualify as a reasonable return from a related business only in cases where it is clearly evident that the amount received from the business is disproportionate relative to the contributions made – including labour contributions, capital contributions and risks assumed – in light of any previous compensation.
In addition, special rules will apply to individuals aged 18 to 24 who do not meet the above “bright-line” tests. Specifically, for these individuals who have contributed their own capital to a family business, a prescribed rate of return will be allowed (or in certain cases, a “reasonable return” on the contribution).
Other changes to the July 2017 proposals
The revised draft legislative proposals released on December 13, 2017 make other important changes to the original July 2017 proposals. For example:
• the revised legislation will not apply the TOSI to compound income (i.e., income earned from the investment of an initial amount of income that is subject to the TOSI or attribution rules); and
• The class of related individuals for the purposes of the TOSI rules will not be extended to aunts, uncles, nieces and nephews.
For additional clarity, the Canada Revenue Agency (CRA) has released guidance with respect to these measures. The CRA’s guidance is intended to help businesses and family members understand the operation of the measures and correspondingly reduce their compliance burden in relation to these new rules.
The revised income sprinkling measures are proposed to be effective for the 2018 and subsequent taxation years. The measures will be legislated as part of the federal 2018 Budget process, along with the other (passive income) proposals affecting private corporations which the government also intends to proceed with.
The remaining income tax measures outlined herein are still only proposals at this stage, and may not ultimately be enacted into law. As these proposals are very complex and wide-ranging, and may have significant implications to your particular tax situation, you should consult with your tax advisors for specific advice and direction on how your particular situation may be affected by these potential changes in the tax law.
Please stay tuned for future developments regarding these income tax proposals. Please reach out to your BMO Financial Professional for future developments regarding these income tax proposals.