As people start to get back to their normal routines after the holidays and catch up on news they may have missed between school holiday concerts, client or work events and family commitments, they may have noticed that the Department of Finance also had a busy December.
This is the first in a series of articles that will be published on this topic.
The 2017 Federal Budget included an announcement that the Government would be reviewing tax planning strategies used by private corporations, such as sprinkling income, holding a passive investment portfolio inside a private corporation and converting a private corporation’s regular income into a capital gain. On July 18, 2017, draft legislation (the “July Proposals“) was released, and the public was invited to make submissions. What followed was a very lively national discussion involving tax practitioners, small business owners, professionals and the various organizations and associations that represent them. An overview of this announcement can be found in this previous article.
Following the brief consultation period, the Government made a series of announcements in mid-October 2017, including with respect to their “intention to simplify the 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.” On December 13, 2017, the Department of Finance released the much-anticipated revised draft legislation regarding income sprinkling (the “December Revisions“).
July Proposed Legislation
The July Proposals, in part, sought to amend section 120.4 of the Income Tax Act (Canada). As summarized previously, section 120.4, colloquially known as the “kiddie-tax” or tax on split income (“TOSI“), applied to certain sources of income, called “split income”, received by individuals under the age of 18 years. If TOSI applies, the split income is taxed at a top personal tax rate and personal tax credits are generally denied.
The July Proposals sought to extend the application of the TOSI rules, such that the TOSI regime would also apply to spouses, adult children and other family members (including aunts, uncles, nieces and nephews), and to additional sources of income (including income earned from reinvested split income or compounded income, income from certain debt obligations, and a capital gain or profit realized from certain dispositions of shares of a private corporation, interest in a partnership, interest as a beneficiary of a family trust, or debt obligation). A reasonableness test was also introduced, which would consider whether the income received by the family member was reasonable given their contribution to the business, considering labour and capital or equity contributions and/or risk undertaken. To the extent split income was reasonable in the circumstances, the TOSI rules would not apply.
December Revised Proposed Legislation
Pursuant to the December Revisions, income considered to be “split income” will be subject to the TOSI rules unless the amount is also considered to be an “excluded amount”. The December Revisions narrowed the scope of amounts considered split income, and reinvested split income or compounded income will no longer be considered split income. Further, the extended meaning of related family members in the July Proposals was not included in the December Revisions. However, income from certain debt obligations, and a capital gain or profit realized from certain dispositions of shares of a private corporation, interest in a partnership, interest as a beneficiary of a family trust, and debt obligation remain included in the expanded definition of split income. The reasonableness test was also preserved.
If certain other conditions are met, and the income is not an “excluded amount”, the following types of income may now, generally speaking, be considered “split income” and be subject to the TOSI rules:
(a) Taxable dividends, other than from public companies or mutual fund corporations;
(b) Shareholder benefits;
(c) Partnership income;
(d) Amounts received from a trust;
(e) Debt income, such as interest; and
(f) Income or capital gain from the disposition of certain property described above, other than shares in public companies or mutual fund corporations.
Income will be considered an “excluded amount” to the extent the amount falls into one or more of several categories, including:
(a) Retirement exception. Split income received by the spouse of the business owner will not be caught by the TOSI rules if the business owner is aged 65 or older and the amount would be an excluded amount in respect of the business owner. This change was made so that the TOSI rules are better aligned with the pension income splitting rules.
(b) Excluded business exception Split income received by adults aged 18 or over will not be caught by the TOSI rules if the adult made a substantial labour contribution to the business during the year or during any five previous years (does not need to be consecutive). Working an average of 20 hours per week is deemed to be a “substantial labour contribution”.
(c) Excluded share exception. Split income received by adults aged 25 or over will not be caught by the TOSI rules if the income was from an “excluded share”. Excluded shares are shares of a corporation owned by the individual that meet certain conditions, including:
(i) less than 90% of the business income of the corporation is from the provision of services;
(ii) the corporation is not a professional corporation;
(iii) the individual’s shares represent
(A) 10% or more of the votes that can be cast at an annual meeting of the shareholders of the corporation, and
(B) 10% or more of the fair market value of all of the issued and outstanding shares of the capital stock of the corporation; and
(iv) all or substantially all of the income of the corporation is income that is not derived from a related business.
(d) Qualified capital gains or qualified farm of fishing property exception. The capital gain resulting from the sale of qualified small business corporation shares or qualified farm or fishing property will generally not be subject to the TOSI rules, even if the available capital gains deduction is not claimed.
(e) Other exceptions. There are several other categories of income falling within the definition of “excluded amount”. These exceptions will be addressed in a future article.
The December Revisions do simplify the rules announced in the July Proposals. However, much like 5°C is considered warm because it was -25°C a few days earlier, it is relative. While there are some welcome changes, the new rules still represent a significant change to the taxation of shareholders of private corporations, and many outstanding questions remain.
To fall into the excluded business exception, the adult needs to work an average of 20 hours per week throughout the year or any previous five non-consecutive years. Businesses will need to track hours the family member worked and the duties they performed. Records will need to be maintained and will need to be kept well beyond the mandatory six-year period in the event of an audit.
To fall into the excluded share exception, the shares must be held by an individual. Shares held by a trust do not appear to satisfy the conditions. HoldCo/OpCo structures may also be jeopardy as typically all or substantially all of the income of HoldCo is income from a related business, being OpCo’s business. Further, it is unclear what income will be considered from the provision of services. A wide variety of businesses are likely affected, including health and wellness professionals, mechanical or trade contractors, oilfield services providers, and technology support personnel. Unfortunately, the December Revisions did not include a definition.
Another condition that must be met to fall under the excluded share exception is that the shares held by the individual represent 10% or more of the fair market value of all of the issued and outstanding shares of the corporation. This test may be difficult to meet after a freeze transaction where there are outstanding preferred shares issued with a high redemption amount. As a practical matter, will business valuations be necessary before a dividend can be declared to ensure the value condition is met? It is also noted that businesses have until the end of 2018 to restructure to meet the excluded share exception.
While interpretive guidance was published at the same time as the release of the December Revisions, there is still some uncertainty about how the rules will be interpreted and applied by the CRA and the courts. The December Revisions are effective as of January 1, 2018, unless there are additional amendments prior to enactment.