Income Sprinkling – The Revised Proposals

The federal government has quickly made good on its promise to release revised draft legislation with respect to its “income sprinkling” proposals.

The government’s objective in releasing this legislation now is to ensure that it takes effect for 2018 as originally envisioned.

The centerpiece of the proposals is the idea that the Tax on Split Income (“TOSI”) will be applied to adults in addition to minor children. The original proposals were heavily criticized as being extremely complex and unwieldy. The Minister of Finance has reworked the rules and they are now extremely complex and unwieldy; however, they are a bit narrower in scope, offering some more objective exceptions. The Canada Revenue Agency has concurrently published a guide on how they will apply the rules.

Extension of TOSI application to adults
If none of the exceptions applies, TOSI rules will be extended to all taxpayers over the age of 17 with respect to certain income (mainly dividends) from a “related business”. Generally, a business is a related business if an individual who is related to the taxpayer is either actively engaged in the business or owns more than 10 per cent of the equity in the corporation that carries on the business.

Extension of TOSI to capital gains
TOSI will apply to taxable capital gains on dispositions of property where the income from that property would be TOSI.

Now let’s explore the main exceptions to TOSI treatment. As we can see, there are different exceptions available to different age groups:

“Excluded Business” – all adults
There will be no TOSI treatment where an adult individual is “regularly and continuously” working in the business. This is a subjective test, but if the taxpayer can show an average of 20 hours of activity per week, he is deemed to qualify for this exclusion. The exclusion applies if the work qualifies in the year or in any five previous years (not necessarily consecutively).

“Excluded Shares” – 25 or older
The TOSI will not apply to a taxpayer aged 25 or older who directly owns shares representing at least 10 per cent of votes and value of the company. The company must not be a professional corporation or earn more than 90% of its income from the provision of services. As transitional relief, taxpayers have until the end of 2018 to reorganize their corporate shareholdings to fit within these rules.

General reasonableness test – 25 or older
For taxpayers aged 25 or older there is a general “reasonableness” test that could apply to income received. TOSI will not apply to amounts paid if they are reasonable in the circumstances based on a number of factors including work performed, capital contributed or risks assumed in respect of a related business.

General prescribed rate of return – 18-24 years
For taxpayers aged 18-24, there is a general prescribed rate of return test that could apply. That is, TOSI will not apply to an amount equal to a prescribed rate (currently 1%) that would be allowed as a return on capital contributed to the company.

Retirement income splitting
The TOSI will not apply to income received by the spouse of a contributing individual where the contributing individual has reached the age of 65 years.

Capital gains exclusions
The TOSI will not apply to taxable capital gains realized on death, or on the disposition of property to the extent that the gains would otherwise qualify for the enhanced capital gains exemption. This is true regardless of whether the exemption is actually claimed.

Inherited property
The TOSI exemptions will carry over to property inherited by a taxpayer to the extent that the deceased qualified for the exemptions. In other words, the heir will step into the shoes of the deceased for the purposes of the rules.

Year-end planning
The new rules are not in effect for 2017. Accordingly, these next few days may offer the opportunity for one final dividend payment to take advantage of income splitting benefits before they disappear.

2018 planning
In the next year, current corporate structures should be reviewed to determine if the TOSI will apply to future dividends paid. Any reorganization required to fit within the “excluded shares” exemption must be completed before the end of 2018. If shares are currently held through a family trust, consider distributing to the beneficiaries.

For taxpayers who work in the business, time records may be recommended to ensure evidence that they meet the 20-hour per week threshold.

Morneau Proposals – Take Two

Morneau’s Tweet

As most readers are aware, the federal government’s small business July 18 tax proposals created an enormous backlash, with many groups and individuals, including yours truly making submissions to voice their concern. It appears the government heard the outcry as it has softened its stance to varying degrees on its new proposals. Here is a summary of how things now stand:

Income Sprinkling

The original proposals would extend the Tax on Split Income (“TOSI”) to dividends received by adults, unless they can show that the dividends are reasonable in light of their labour and/or capital contributions to the business.

The response by the tax and business communities focused mainly on the uncertainty of what might be considered “reasonable” and how this might translate into an acceptable dividend.

The finance minister has announced that it intends to move forward with the income sprinkling proposals. It intends to ensure that the rules will not impact businesses to the extent there are clear and meaningful contributions by family members. It will introduce reasonableness tests for adults in two categories – those aged 18-24 and those aged 25 and older. Adults will be asked to demonstrate their contribution to the business based on four basic principles:

  • Labour contributions
  • Capital or equity contributions
  • Financial risk, such as co-signing a loan, and/or
  • Past contributions of labour, capital or risks

While no new draft legislation has been released, the government states that the concerns surrounding uncertainty have been heard and they will simplify the proposed measures and reduce the compliance burden. Stay tuned to see what the specific legislation will contain.

Multiplication of the Capital Gains Exemption (“CGE”)

The original proposals would have disallowed the lifetime capital gains exemption on the sale of Qualified Small Business Shares and Qualified Farming Property as follows:

  • Elimination of CGE for minor children
  • Imposing TOSI reasonableness tests on availability of the CGE
  • Elimination of CGE for property held in a trust

After review, the government has backed off on all of the above proposals and will not be going forward with any of them.

Converting Income into Capital Gains

These proposals were designed to curtail what the government perceived as abusive “surplus stripping”.  It would have extended the rules in section 84.1, to any non-arm’s length sale of shares to a corporation. It would also have applied dividend treatment to any such sale, even where tax had already been paid on a previous capital gain on the same shares.

These proposals would have eliminated the “pipeline” strategy, widely used to limit the incidence of taxes on the death of an individual shareholder to a single capital gain in the hands of the deceased. It would have greatly increased the chances of gains on private company shares being taxed twice.

Thanks to the concerns expressed by the tax and business communities, the government has backed off completely on these proposals and will not be going forward with them.

This is great news for those who still have reservations about the legitimacy of implementing the Pipeline strategy on the death of a private company shareholder as the government specifically mentioned that it was responding to concerns about taxation on death.

Holding Passive Investments

The initial proposals addressed concerns that shareholders of private corporations are able to defer the ultimate taxation on their savings, thereby creating a larger pool of capital to be invested for retirement. This is an advantage that a shareholder of a private corporation enjoys compared to a person without a company and is to be eliminated.

After consulting with the public, the government, while not abandoning the proposals, has agreed to relax them.

First, any capital already in existence will not be affected by the new rules. They will not apply retroactively to existing retained earnings.

Second, there will be a base amount of $50,000 of passive income that a corporation may earn each year while still not having the rules apply. This is the equivalent of $1 million of capital invested at a 5% rate of return. Any income above that amount will not benefit from the tax deferral.

There is still no draft legislation to indicate exactly which mechanism will put in place. The new year should bring new announcements and more details in this important area.

The Morneau Massacre of 2017

loopholes

If you’ve just returned from vacation and wondering what’s new in the tax world, you’d better sit down and take a pill. On July 18, finance minister Bill Morneau rolled out the federal government’s proposals designed to “close loopholes and deal with tax planning strategies that involve the use of private corporations”. In short, Finance is proposing to tax an axe to many of the tax strategies that have been available to small business owners and professionals up until now.

The proposals are complex, comprehensive and wide-ranging, covering the following main areas of tax planning:

  • Income sprinkling
  • Multiplication of the capital gains exemption
  • Converting a private corporation’s regular income into capital gains
  • Holding investments inside a private corporation

Income Sprinkling

This strategy involves the splitting of income to take advantage of lower marginal tax rates available to family members. Many rules have been put in place over the years to curtail this practice. Most notably, the tax on split income (TOSI), or “kiddie tax” applies the highest marginal tax rates to certain dividends paid to minor children.

With the new proposals, the TOSI will no longer be limited to minor children. Complex new rules will apply the TOSI to dividends paid to adult individuals unless such dividends are reasonable in light of that individual’s labour contributions and/or capital contributions to the corporation.

The TOSI will also be expanded to apply to capital gains on property, the income from which was subject to the TOSI. Further, it will also apply (for individuals under age 25) to “compound income” that was previously subject to attribution rules or the TOSI.

These proposals are scheduled to apply to for the 2018 and later years.

Multiplication of the capital gains exemption

A capital gains exemption (CGE) of up to $800,000 (indexed) is currently available to any individual on the sale of qualifying shares of a private company. Issuing shares to family members, either directly or through a trust, is a common way to multiply this tax benefit.

The finance minister has proposed a three-pronged approach that will eliminate the multiplication of the CGE:

Age limit: The CGE will no longer be available to individuals where the gain occurs in any year before the individual reaches the age of 18 years.

Reasonableness test: In essence, this rule will deny the CGE on any gain on the sale of shares if the gain from those shares is subject to the TOSI measures described above.

Trusts: With exceptions for spouse or alter ego trusts the GCE will no longer be available on any gain on a share that is held by a family trust.

These proposals will apply to dispositions after 2017. However, there will be transitional rules that will allow an elected deemed disposition at any time in 2018. The fair market value of the shares would have to be determined, and the qualification criteria for the CGE will be treated as being satisfied if they are met at any time in the preceding 12 months.

Converting a private corporation’s regular income into capital gains

Normally, a distribution of a corporation’s retained earnings is considered a dividend and taxed as such. The top rate on dividends is approximately 44%. Strategies have been used with varying degrees of success to arrange for dividends to be transmogrified into capital gains, which are taxed at 25%. This involves the utilization of the high cost base on shares that have been acquired through a non-arm’s length transaction that had previously triggered a capital gain. Current rules are in place to curtail such “surplus stripping” in limited circumstances. Section 84.1 effectively forces a return to dividend treatment where the capital gains exemption was claimed on the previous capital gain.

The government proposes to extend these rules to any situation where a non-arm’s length transaction involved even a fully taxable capital gain. This proposal is meant to address what has become known as the “pipeline” transaction.

The pipeline has been used extensively in recent years as a post-mortem planning tool to avoid double-taxation where the capital is deemed to occur on the death of a corporate shareholder. Unless the current proposals are altered, the pipeline strategy will no longer be available to an estate.

These proposals will take effect for all dispositions that occur after July 18, 2017. There will be no room for transitional planning.

Holding investments inside a private corporation

One of the long-standing advantages of incorporation is the tax deferral that comes with lower rates on business income. Once the retained income has accumulated over time, the company will have a larger amount available for investment. This has been a great contributor to the retirement of many small business owners. However, it is an advantage that salaried persons or those who don’t incorporate cannot access. Accordingly, the government proposes to eliminate it.

Of all the proposals announced, this is the only one that is not fully developed with draft legislation. The Minister has included some suggested strategies to deal with the issue, each one complex in its own right, and generally altering the system of integration currently in place by eliminating the effect of the corporate tax deferral for future passive investment.

The Minister acknowledges that there currently exists a significant amount of capital invested within private corporations, and it is not his intent to affect these holdings. Any new rules will have effect on a going-forward basis.

These proposals are subject to a consultation period which will end on October 2, 2017. Interested parties should write to the Minister of Finance with any concerns before that date. I suspect that it will be an interesting and eventful autumn for the tax community.