Revised Rules for Splitting Income In Canada

Finance Canada released updated draft legislation impacting the taxation of private companies and their shareholders.

Let’s refresh our memory…

On July 18th, 2017 the Liberal government shook up the current taxation system when it announced proposed reforms to address areas of perceived unfairness. These tax reforms were intended to address the following:

Increase the effective tax rate on income received from a family member’s business in which they were not actively involved or contributing to. These are often referred to as the income sprinkling rules or the “Tax on Split Income”.
Limit the multiplication of the lifetime capital gains exemption by family members who were not contributing to that qualifying business.
Restricting the ability of taxpayers to extract corporate funds on a lower tax or a tax-free basis.
Modify the taxation of passive assets held in a private corporation.

For a detailed analysis of these proposed rules refer to our previous articles listed below

The feedback from taxpayers was significant and overwhelming. For many reasons, including the fact that many of these proposed rules had unintended consequences well beyond the stated purpose, the Liberals decided that they would not be proceeding with the reforms as originally announced.

In short, the Liberals announced that they would walk away from the proposed changes to the lifetime capital gains exemption and (for now) the proposed rules with regards to extracting corporate surplus.

They further announced that they would proceed with the intention to alter the taxation policy of passive assets held in a private corporation. This draft legislation is expected in the spring 2018 budget.

Lastly, they said that they would continue ahead with their proposed changes to the tax on split income, but that they would simplify and enhance the rules from those originally proposed. Today those revised rules have been released.

Release of Updated Legislation on Tax on Split Income

Overview

The draft legislation released on December 13, 2017, removes all references to changes to the capital gains exemption rules and the corporate surplus rules. The updated legislation also modified and simplified the July 2017 rules on the tax of split income (“TOSI”).

The TOSI rules are intended to impact only those individuals that receive income from another family member’s business or corporation. These rules are intended to tax the income at the highest tax bracket if that individual did not make a meaningful contribution to the family business or is being paid beyond a reasonable rate for the contributions made to the family business. The intention of these rules has not changed since they were originally proposed in July 2017.

The new legislation announced today will be applicable for the 2018 taxation year. Frankly, this does not leave a lot of time for taxpayers to plan for the implications of these new tax laws.

Exclusions and Simplification

The most newsworthy highlight from the December 13th legislation is that there are more exclusions for income that will not be considered to be split income and therefore not subject to the TOSI rules. Many of these exclusions address some of the issues identified with the original proposed legislation.

Some of the exclusions from split income include:

Income received by an adult individual from a business where the individual works an average of at least 20 hours a week in that business, or worked to that extent in any previous 5 taxation years.
Any deemed capital gains as a result of an individual’s death owning shares of a corporation where the income on those shares might have previously been subject to the rules.
Any income received or capital gains realized on shares where the individual owns 10% of the voting rights of the company and 10% of the value of the company. However, this will exclude shareholders of either professional corporations or those corporations that primarily earn their income from providing services.
A business owner’s spouse where that business owner meaningfully contributed to the business (more than 20 hours/week) and is now over the age of 65.
The capital gain realized by an adult upon the disposition of qualified farm property, qualified fishing property, or shares of a qualified small business corporation will be specifically excluded from tax on split income. Practically speaking, this means that non-active adult shareholders of qualifying businesses will still be able to claim their lifetime capital gains exemptions, even if those shares are held through a Trust or sold in a non-arm’s length transaction.

Thankfully these exclusions will apply to a significant number of privately owned corporations and as a result, will not apply as broadly as those previously announced in July. In addition, originally announced proposals to tax compounding income from split income and to expand the definition of related individuals to include aunts, uncles, nieces, nephews, and cousins have also been eliminated. The family members of concern for these rules will be parents, children, grandchildren and siblings.

Notably, there are still some populations of taxpayers that will need to be wary of these new rules, specifically:

Adults between the ages of 18 and 24 inclusive will have more stringent tests applied to them with regards to split income if they do not meet the bright-line test of working in the business at least 20 hours/week. Any income distributed to these adults will have to be carefully considered with regards to the tax on split income.
Adults who receive income from a family business through a Trust will need to meet the same bright-line test of working in the business at least 20 hours/week; otherwise, they could be subject to the application of the split income.
Individuals who receive income from a professional corporation or from a corporation whose primary income-earning activity is the provision of services will again need to meet the bright-line test of 20 hours/week. It is not immediately clear why corporations who provide services have been specifically targeted in this new legislation, while the targeting of professional corporations is not much of a surprise to those who have been following some of the political discourse on these proposals.

Reasonableness Test

If individuals don’t meet any of the above exclusions, it does not mean that the split income rules will automatically apply to tax them at the highest rate. For adults over the age of 25, the income will not be considered to be split income unless the income received is in excess of a reasonable amount given their level of contribution to the business.

Items to be considered in determining whether the income is reasonable will be:

Labour contributions
Property contributions
Risks assumed
Historical payments (i.e., total amounts paid)
Any other relevant factors

Canada Revenue Agency has already published its guidance and interpretation on these new rules, of note they have indicated that taxpayers should be prepared to support the reasonableness of the income being received if they don’t otherwise have any exclusions to rely on.

Conclusion

Given the proposals from July 18th as a comparison, I’m sure there are many taxpayers who are quite pleased with the scaled-down version of the new legislation that was released today. Having said that, the split income rules are still extremely complex to understand and interpret with a significant number of new definitions to understand and evaluate when applying this new law. The addition of a bright-line test to evaluate whether an individual is sufficiently contributing to a business is a welcome addition – as those with at least 20 hours/week won’t have to worry about the possibility that these rules might apply to them, the legislation provides this line in the sand. In addition, many of the excluded items are obviously a welcome change from the previous version.

Certainly, there will again be some collateral damage in the new legislation, of concern are those individuals involved in service-based businesses. It is not immediately clear why the government felt they had to expand the scope of the law beyond professional corporations whom they’ve been targeting since the election. Additionally, it is unclear why those owners who hold their shares through a Trust as opposed to direct ownership have been scoped out of some of the exclusions provided. This will have ramifications for many businesses that are owned through Trusts where family members don’t meet the 20 hour/week test.

We Are Here To Help

Your Manning Elliott business advisors will continue to evaluate and plan for these new split income tax laws. For assistance with business or corporate year-end tax planning, specifically, as it relates to this new tax law, contact the Manning Elliott Tax team.

The above content is believed to be accurate as of the date of posting. Tax laws are complex and are subject to frequent changes. Professional advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.