Tax Planning by Private Corporations
Finance Minister Morneau Announcement Regarding Income Sprinkling for Shareholders of Private Corporations
The government believes shareholders of private corporations are receiving unfair benefits since they can set up lower income, related family members as shareholders allowing the opportunity to split income and reduce the overall tax burden when dividends are paid.
Under the current rules, the Income Tax Act applies "tax on split income" (TOSI) to address the payment of dividends (as well as other certain types of income) to minors, resulting in top flat rate personal income tax applied on those payments . This prevents splitting certain income with minors but does not prevent sprinkling income to other related adult family members. In July 2017, the government introduced proposals that would extend the TOSI rules to dividends paid to these individuals, but only to the extent those dividends were not reasonable. Additionally, the July 2017 proposals also extended the definition of "related" to include other family members such as aunts, uncles, nieces, and nephews, which the government has now eliminated as of today.
Today, the government released details of its proposals designed to simplify and improve the treatment of income sprinkling by limiting the shareholders' ability to lower their personal income tax through family members who do not contribute to the business. These proposals are scheduled to come into effect on January 1st, 2018. The Canada Revenue Agency (CRA) has also released guidance with respect to these measures which we will expand upon in a separate white paper. Consistent with the July 2017 proposals, the revised draft legislative changes will extend TOSI to individuals aged 18 and over (specified adult individuals) when they receive directly or indirectly, certain income from a related business .
Family members who make a meaningful contribution to the business will not be affected by the new measures. The purpose of the revised rules is to provide further guidance in 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).
To help simplify the process, the government has introduced four automatic exclusions where TOSI will not apply for individual members of a family business. In these cases, the new reasonableness tests do not need to be considered.
1) Excluded Business
TOSI will not apply when a specified adult individual is deemed to be actively engaged on a regular, continuous and substantial basis for the year (or in any five previous taxation years) when working an average of 20 hours per week during the part of the year that a business operates. Even if the test cannot be met by an individual aged 25 or older only unreasonable amounts will be subject to TOSI on a going forward basis and not retroactive for payments made prior to the effective date.
2) Excluded Shares
TOSI will not apply to income received from a share (including from the disposition of the share) if:
- the specified adult individual is aged 25 years or older in or before the year the income or disposition occurs;
- owns at least ten per cent of the outstanding shares in terms of votes and value,
- the corporation earns less than 90 per cent of its income from the provision of services; the corporation is not a professional corporation (i.e., a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor); and
- All or substantially all of its income is not derived from a related business in respect of the specified individual.
Taxpayers wanting to rely on this exclusion will have until the end of 2018 to meet the condition of owning at least ten per cent of the outstanding shares of a corporation in terms of votes and value.
If an individual aged 25 years or older receives amounts that are not derived from excluded shares (or from an excluded business), TOSI will apply to the extent amounts received are unreasonable as defined below.
3) Retirement and Inherited property
TOSI will not apply to income received by an individual from a related business provided the individual's spouse (65 years or over) made business contributions similar to pension income splitting requirements. Special rules will apply in respect of a deceased individual, so that the surviving spouse continues to benefit from the contributions made by the deceased individual.
New rules for inherited property will also apply to people who have attained the age of 18. For the purpose of applying TOSI exclusions in respect of income from inherited property, the person inheriting the property will generally not have TOSI apply where the deceased individual made business contributions.
4) Lifetime capital gains exemption (LCGE)
TOSI will not apply to taxable capital gains from the disposition of property that can qualify for the LCGE (i.e., qualified small business corporation shares and qualified farm or fishing property). This exemption from the application of the TOSI will apply even if the LCGE can be claimed in respect of the taxable capital gain arising from the disposition.
As mentioned above, CRA has developed criteria based on four principles to determine if an amount is reasonable, which include:
- labour contributions
- capital contributions
- risks assumed; and
- historical payments received from the business.
as well as some other factors. The proposals provide that the reasonableness of an amount will be evaluated based on one or more of the criteria on an individual basis.
Generally, individuals aged 18 to 24 will be permitted a prescribed rate of return on capital contributed to a related business. In certain cases, however, such as where the individual earned the capital contributed from an unrelated business, the individual will be permitted a reasonable return on the contribution.
Other proposed changes to the July 18, 2017 proposals
Following the proposed measures of July 2017, the Government indicates that:
- The TOSI would not be applied to compound income;
- Income derived from property acquired as a result of the breakdown of marriage or common-law partnership will be exempted from the application of the TOSI rules.
Under the proposals set out above, taxpayers and their financial advisors have an opportunity to review the structure, shareholders and income-splitting in place for clients. For those affected by the measures, taxpayers should be prepared to support their position that the amount of the payment is a reasonable amount not subject to TOSI.
Mackenzie Investments will prepare a white paper providing tax strategies to help you assist your clients shortly.
1 Known as "kiddie tax".
2 Generally, a business will be a related business if an individual who is related to the specified adult individual either is actively engaged in the business or owns a significant portion of the equity in the corporation that carries on the business.
This should not be construed to be legal or tax advice, as each client’s situation is different. Please consult your own legal and tax advisor.