Expanded Horizons: Revised proposals limiting income sprinkling

The need to curb “abuses” of the Canadian tax system by owners of private corporations has been a predominant theme since the last Federal election.  The initial attempt at “consultation” by the Department of Finance elicited a high degree of frustration and anger from business owners and tax planning professionals across the country.  Much of the frustration and anger can be traced to a combination of poor communication, badly written legislation, and questionable timing for both the release and implementation for the pending legislation.  Over the course of the 75 days consultation period over 21,000 written submissions and several petition websites were drafted.  Few, if any, in support of the rushed overhaul to the Canadian tax system.

The sentiment expressed by this community was echoed in a paper released by the Standing Senate Committee on National Finance. The report, based from true consultation, engaged “…138 witnesses and 32 written submissions … from government officials, academics, tax specialists, think tanks and most importantly, organizations that represent tens of thousands of Canadian small businesses, workers, farmers and physicians”[1] and concluded:

“[M]ost witnesses told our committee that the proposed changes should be withdrawn in their entirety.  We are inclined to agree. We are not convinced that the government has made a good case for its proposal.” 1

On December 13, 2017 the Department of Finance continued the trend for questionable timing when it released draft legislation shortly after the report from the Senate and on the last day the House was scheduled to sit before the winter recess.

The revised proposals released by the Department of Finance target concerns over the ability of owners of private corporations to lower their overall family tax obligation by distributing income to family members in a lower tax bracket. This particular “abuse” is affectionately referred to as income sprinkling. The new rules are to take effect January 1, 2018 and adopted several “bright-line” tests providing much needed clarity. The rules are an improvement over those originally released on July 18, though they still leave room for improvement.

According to the Department of Finance, these revised rules will impact fewer than 3% of Canada’s 1.8 million Canadian-controlled private corporations. I find the number of corporations impacted questionable especially given that the new rules directly attack professional corporations (more on this later).

 

Proposed Income Sprinkling Rules

The revised proposal expands the existing tax on split income (TOSI) rules and clarifies the process for determining whether a family member is significantly involved in a business, thus excluding certain income from potentially being taxed at the highest marginal tax rate.  The “bright-line” tests are broken into age categories:

For family members aged 18 to 24:

The rules applied to these individuals are the most stringent and are based solely on contributed labour.  To qualify as an “excluded business” the individual must have made meaningful contributions of labour in the current year or in any five previous taxation years.[2] The definition of meaningful contribution of labour is deemed to be met where the individual works an average of at least 20 hours per week with the test prorated for seasonal businesses. 

For family members over the age of 24:

The rules for this age category are less stringent and, in addition to the “excluded business” rules, include income from “excluded shares”. To qualify the individual[3] must own at least 10% of the votes and value of a corporation that meets the following conditions:

  • Earns less than 90% of its ‘business income’ from the provision of services;
  • The corporation is not a professional corporation; and
  • All or substantially of the corporation’s income is not derived directly or indirectly from another related business.[4]

A transitional period will be adopted whereby taxpayers have until the end of 2018 to meet the ownership conditions.

For spouses:

The revised rules include changes to better align with the existing pension income splitting rules. The TOSI rules will not apply to income received by an individual where the individual’s spouse made contributions to the business and has attained the age of 65 in the year or before the amount was received. Furthermore, special rules will apply to ensure income from the shares continue to qualify from the exemption upon the death of the shareholder. This exemption will ensure the surviving spouse continues to benefit. Similar rules have been drafted to ensure children will also benefit in the event they inherit the shares.[5] 

 

Other Changes

  • The proposed extension of the TOSI will not apply to capital gains from the disposition of property that can qualify for the Lifetime Capital Gains Exemption.
  • The original proposed measures to apply TOSI to compound income (i.e. income earned from property originally subject to the TOSI rules) will not proceed.
  • Income derived from property acquired by virtue of the breakdown of marriage (or common-law partnership) will be exempted from the application of the TOSI rules.

In coordination with the release of the revised rules on income sprinkling, the CRA issued further guidance on how the rules are to be applied.     

 

Final Thoughts

The government has continued to target professionals and would deny the benefit of “excluded shares” to professional corporations. The singling out of professional corporations is consistent with previous rhetoric that professionals, especially doctors, are systematically abusing the Canadian tax system.

While you might disagree--and many do--the reality is the government has found a way to target professionals.  Caught in this, however, and surprise to most, is the denial of the benefit of “excluded shares” to service-based businesses. This exclusion is presumably the Department of Finance’s attempt to capture “professional-like” businesses. The service-producing sector comprises 78.5% of all employer businesses operating in Canada.[6]  Basically, the new rules are saying a plumber who starts a business with their spouse should be treated differently than the business set up to supply the piping. 

The rules are extensive and will change how many private businesses distribute income.  If you are the owner of a private corporation and distribute income to family members now is the time to talk to your trusted advisor.   


January 2018

This article was provided courtesy of Chris Geldert, CPA, CA, CEA. 

Chris Geldert joined Financial Horizons Group in 2013 and is excited to be able to continue providing first class resources advisors should come to expect from their MGA. As a Chartered Accountant with over a dozen years in the insurance industry, Chris works to bridge the gap between client’s professional advisors. From developing and presenting strategies, to providing independent recommendations on products suited to the client’s needs and risk comfort levels, Chris works to assist advisors grow their practice. 

The writer can be contacted at:

Disclaimer: This article is intended to provide general information only and should not be considered as legal, accounting or taxation advice. Before acting on any of the information contained within this article, or before recommending a course of action, make sure your clients seeks advice from a qualified professional. Any examples or illustrations used in this article have been included to help clarify the information presented in this article and should not be relied on by you or your client in any transaction.


[2] The five previous years do not need to be consecutive or after 2017.  Thus, once the sharesqualify under the definition of “excluded business” they will forever qualify.  

[3] From our reading and information provided by the CRA shares held indirectly, i.e. through a family trust, would not qualify.  More research is required in this area.

[4] An example of this would be a corporation established to collect rental income from a professional corporation.

[5] The inheritance rules will apply to individuals who have attained the age of 18.

[6] Source: Statistics Canada, Business Register, December 2015