Fort Group Analysis of December 12, 2017 Income Sprinkling Revised Legislation
DECEMBER 22, 2017
On December 13, 2017, The Department of Finance, in conjunction with the Canada Revenue Agency, released an updated Technical Backgrounder and new draft legislation related to the draft income sprinkling legislative proposals released on July 18, 2017.
It is the position of the Department of Finance that these modifications will service the government’s objectives related to income sprinkling, including:
- Ensuring high income earning Canadians cannot shift income to family members who do not actively participate in the business in an attempt to reduce income taxes;
- Ensure that all family members who make meaningful contributions to the business are not affected by the provisions imposing higher tax rate on split income.
- Encourage gender equality in the workforce by encouraging female family members to participate in the business (currently 68% of sprinkled income is received by females).
Tax on Split Income, also know is TOSI, is tax paid at the highest marginal tax rate which will now be applied to dividend and interest income received by family members that are not actively contributing to the business.
In order to avoid this new TOSI, the income must qualify for certain exclusions, discussed below. If the income received does not qualify for the exclusions it will be subject to a reasonableness test. If, pursuant to that reasonableness test, the income received by the family member is determined to be unreasonable with respect to the contributions of the adult individual (taking into account labour contributions, capital contributions, risks assumed etc.), the portion of the income that exceeds a reasonable amount will be subject to TOSI, or tax paid at the highest marginal tax rate.
The three separate exclusions are as follows:
- Excluded Businesses
- Excluded Shares
- Retirement Income/Inherited Property
Income will not be subject to TOSI when the recipient is an individual with meaningful and direct contributions to the business on a continuous basis in the current year or ANY five cumulative previous years (the five years do not necessarily have to be consecutive to qualify for this exclusion). The Department of Finance’s definitions of “meaningful contribution” and “excluded business” are meant to be flexible and take into account inherent differences in all individual businesses such as seasonality factors.
For individuals wanting greater certainty however, working 20 hours per week during the year (or the part of the year that the business operates in the case of a seasonal business) will generally mean that they are meaningfully contributing to the business and therefore their income is exempt from TOSI.
Frances worked for her parents' manufacturing business on a full-time basis throughout the year in which she turned 22 until the year in which she turned 28. Frances then stepped back from being involved in the business for three years. Frances received dividend income from her parents' manufacturing business during the years she worked for the business, as well as the three years when she did not participate in the business.
The TOSI would not apply in respect of any of the dividends Frances receives. With respect to the dividends received by Frances in the years she was working full-time, the TOSI would not apply, on the basis that she was actively engaged in the business on a regular, continuous and substantial basis in the year that the dividend was received (she would also satisfy the "bright-line" test of working an average of 20 hours per week). With respect to the dividends received by Frances in the years after she stepped back from the business, the TOSI would not apply as the business would be an "excluded business" on the basis that she was actively engaged in the business on a regular, continuous and substantial basis for at least five prior years (the years from 22 until 28).
TOSI will not apply to income received from “Excluded shares.” “Excluded Shares” are shares of a corporation where:
- The individual shareholder has attained the age of 25 years in or before the year;
- The individual shareholder owns outstanding shares of the corporation that make up at least 10 per cent of the corporation’s votes and value; and
- The corporation:
- Earns less the 90% of its income from the provision of services; and
- Is not a professional corporation; and
- Is not an intermediary corporation earning income primarily from a non-excluded business in respect of the individual.
It is important to note that current draft legislation specifically states that when determining if 90% of a corporation’s business income is from the provision of services (directly or indirectly from a related business in respect of the specified individual) it is the business income of the corporation for the most recent taxation year of the corporation that is taken into account.
A holding company owns a piece of land and a building in addition to shares of a professional corporation. Instead of owning shares of the professional corporation which would not qualify as excluded shares the professional individual owns shares of the holding corporation, the professional corporation pays the holding company rent for use of the building and the holding company pays dividends to the professional.
The shares of the holding company would not be considered excluded shares because the holding company earns more than 90% of its income shares from a related business with respect to the specified individual that are not excluded shares.
If however, the holding corporation did not earn any income in the last taxation year prior to paying out the income to the shareholder then that income might not be subject to TOSI.
Retirement Income / Inherited Property
In an attempt to create fairness to small business owners that do not get pensions, the Department of Finance has updated the income sprinkling rules with respect to certain “retired” individuals and those with inherited property.
TOSI will not apply to income received by an individual from a business if it was the individual’s spouse who made the contributions to the business as long as the spouse has attained the age of 65 years in or before the year the income is received.
In terms of inherited property it is the Department of Finance’s intention that with respect to TOSI rules, people inheriting property will generally not be in a worse of tax position then the people from whom the property was inherited.
Gary dies at the age of 50. Immediately prior to his death, he owned a 20 per cent interest in a corporation that operates a restaurant. Gary was not involved in the business. The shares owned by Gary qualified as excluded shares before his death because he owned 10 per cent or more of the shares of the corporation and the corporation does not carry on a services business. Gary leaves all of his shares to his 22-year-old niece, Alex. Alex works full time as a painter and does not intend to work in the business.
The shares can be excluded shares for Alex even though she has not attained the age of 25 (which is a requirement for the excluded shares test) because Gary had attained the age of 25.
If none of the above exclusions apply to income received by an individual from a business (excluded business, excluded shares or retirement/inherited property) then TOSI will apply to income received unless the individual has attained the age of 25 years in or before the year and the amount received reflects a “Reasonable return.”
The Department of Finance states that a “Reasonable Return” is an amount that is reasonable having regard to the contributions of the specified adult individual to the related business relative to the family members who have contributed to the business. The Department of Finance states that the contributions relevant to the analysis include labour contributions, capital contributions, risks assumed and other factors such as previous amounts received from the business.
It is important to note that only the portion of the income received that is deemed to be unreasonable by these tests will be subject to TOSI, not necessarily the total amount of income received.
In general these revisions to the draft legislation proposed by the Department of Finance are optimistic in that they are less restrictive then the original draft proposal released in July and provide for some new planning opportunities to split income among family members if certain conditions are met.
This information bulletin is not meant to be a comprehensive analysis of the proposed legislation as it applies to each individual business and family. We recommend that you consult a tax professional with respect to how these tax changes affect your business and your family and what sort of planning can be implemented. If you have any questions about these changes and how they affect your business please feel free to contact one of our advisors.