In July 2017, the Minister of Finance (Finance) announced proposed tax rule changes designed to prevent income sprinkling (including restrictions on who could claim the lifetime capital gains exemption) and to eliminate planning that converted dividends and other income paid out of a private corporation into capital gains (sometimes known as surplus stripping rules). Those tax proposals, which Finance framed as an attack on high-income earning Canadians who were taking advantage of “loopholes,” gave rise to an almost unprecedented backlash from the Canadian business community. That backlash was no doubt fuelled by the fact that the biggest proponents of these tax proposals were none other than Prime Minister Trudeau and Finance Minister Morneau, both men of considerable wealth and privileged upbringing. Their hypocrisy in attempting to introduce tax proposals that were ostensibly designed to level the tax playing field between high-income earners – a group that includes Trudeau and Morneau – and middle-class Canadians was not lost on much of the general public.
This public spectacle ultimately resulted in considerable backpedalling by Finance. By mid-October, in an effort to mollify small business owners in Canada, Finance had proposed a reduction to the corporate small business tax rate and also announced that previously proposed changes to the surplus stripping rules and restrictions on who could access the lifetime capital gains exemption would not proceed. In addition, Finance stated that it would go back to the drawing board and revisit the manner in which the income sprinkling restrictions should apply.
On December 13, 2017, Finance announced revised rules on income sprinkling that will apply in 2018 and future years. These new rules are aimed primarily at family-controlled private corporations and their shareholders. Income sprinkling is a strategy used by high-income owners of private corporations to divert (or sprinkle) income, often in the form of dividends, to family members who have lower personal tax rates. The new rules expand the “tax on split income” (TOSI) rules so that certain types of income in certain circumstances will be taxed at the highest marginal income tax rate applicable to an individual, whether or not the individual receiving the income would otherwise be in the highest tax bracket. While a detailed review of these rules is not practical, what follows is a summary of those situations where the new TOSI rules do not apply (which is a good thing), such that income sprinkling can still take place:
- The new TOSI rules do not apply in a circumstance where dividends are paid by a private corporation to the spouse of a business owner where that owner has been actively engaged in the business or owns 10% or more of the equity of the corporation and is age 65 or older. This exception is designed to align the income sprinkling rules with the pension income sprinkling rules.
- For adults who are 18 or older who have been actively engaged on a regular, continuous, and substantial basis in the activities of the business (which generally means an average of at least 20 hours per week during the particular year or any five previous years), dividends paid by a private corporation will not be subject to the new TOSI rules (the “excluded business” exception). For those businesses with seasonal operations (farms, for example), Finance has stated that the 20 hours per week labour contribution requirement is to be applied only for that part of the year in which the business operates.
- For adults who are 25 or older and who own shares that represent 10% or more of the votes and value of the corporation (the “excluded shares” rule), dividends received on those shares will not be subject to the TOSI rules provided that
– the corporation in question is not a professional corporation (which for income tax purposes includes the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian, or chiropractor);
– less than 90% of the corporation’s business income for the last year was from providing services; and
– less than 10% of the corporation’s income for the last year was from another related business.
It is not yet clear what Finance intends to catch in terms of service businesses. For example, if the business of the corporation is providing advice in connection with insurance products and/or the sale of insurance policies, is the corporation in the business of providing services?
- Individuals who realize taxable capital gains from the disposition of qualified small business corporation shares or qualified farming or fishing property will not be subject to TOSI on that income (for individuals under age 18, to avoid TOSI the disposition giving rise to the taxable capital gain must be to an arm’s length person). This exclusion is broad enough to preserve the ability of a discretionary family trust to hold and sell the aforementioned property and allocate and pay the resulting taxable capital gain to multiple individual beneficiaries who are resident in Canada, who can then each claim their lifetime capital gains exemption.
Finance announced revised rules on income sprinkling that will apply in 2018 and future years.
There are still several areas of uncertainty. For example, if an individual owns multiple share classes in a corporation that in aggregate represent 10% or more of votes and value, is that sufficient to meet the excluded shares exception to the TOSI rules? It may be that the threshold test of 10% or more of votes and value must be represented by ownership of shares in one share class. Also, if multiple classes of common shares exist and dividends on those share classes can be paid at the discretion of the company’s board of directors, this may raise a valuation issue. For example, assume that a corporation has two individual shareholders, one of whom owns 90 Class A voting common shares and the other owns 10 Class B voting common shares. These are the only issued shares in the corporation. If dividends can be paid on one share class independently of the other, can it be said that the Class B shareholder owns 10% or more of the “value” of the corporation?
There is no doubt that these new rules impose greater restrictions on income splitting than was the case in previous tax years. Having said that, there is more clarity with the December 2017 proposals than existed last summer in terms of some “bright line” tests as to when the new rules apply and, perhaps more importantly, when they do not.
First published in the March 2018 edition of The Business Advisor.