On December 13, 2017, the Department of Finance released a revised draft legislation addressing the government’s concerns with private company tax planning involving “income sprinkling”. Effective income sprinkling reduces personal tax when income is shifted from higher tax rate individuals to one or more taxpayers in lower tax brackets. The new measures limit opportunities for a family’s tax burden to be reduced via the payment of dividends or interest to adult family members who are in lower tax brackets. Since 1999, income sprinkling limitations have been applied to the payment of dividends to minors.
The key effect of the new tax measures is to limit opportunities for private company groups and their shareholders to engage in effective income sprinkling arrangements. Where the income sprinkling limitations apply, the recipient of the income is subject to the highest personal tax rate on the income – we refer to this as tax on split income or “TOSI”. The effective tax rate, in Ontario, on TOSI is 45.3%; this rate will increase in 2018 and 2019.
The revised rules take effect January 1, 2018 and are in response to the feedback received in respect of draft legislation proposed on July 18, 2017. Please click here to see our previous articles on the topic for more insight on the original proposals and implications.
The revised proposals clarify the process for determining whether a family member is significantly involved in a business such that TOSI would not apply to the individual. In particular, TOSI will not apply to individuals in the following situations:
- A business owner’s spouse, provided that the owner meaningfully contributed to the business and is 65 or older. This exception is intended to align the TOSI regime with existing rules that allow for pension income splitting.
- Adults aged 18 or over who are actively engaged on a regular, continuous, and substantial basis in the activities of a business during the year, or during any five previous years. This is referred to as an “excluded business” of the individual. Finance has indicated that this would generally involve working at least an average of 20 hours per week during the years in question.
- Adults aged 25 or over who own shares representing at least 10% of a corporation’s total votes and value, provided that the corporation earns less than 90% of its business income from the provision of services and is not a professional corporation (i.e. carrying on the professional practice of a dentist, medical doctor, veterinarian, chiropractor, accountant, or lawyer). The shares of such a corporation are referred to as “excluded shares”. For 2018, taxpayers seeking to rely on this “excluded shares” exception will have until the end of 2018 to meet these conditions.
The revised proposals also remove certain changes that had initially been proposed in July 2017, including:
- TOSI will not apply to compound income (i.e. income earned from income that has been subject to the TOSI or income attribution rules).
- Individuals will not be considered related to aunts, uncles, nieces and nephews for purposes of the TOSI rules.
- Income derived from property acquired as a result of the breakdown of marriage or common-law partnership will not be subject to the TOSI rules.
- Individuals aged 18 to 24 will be permitted a reasonable return on capital contributions where that capital was earned from an unrelated business. Otherwise, these individuals will be granted a return limited to the prescribed rate of interest.
Individuals who do not meet the relevant exceptions will be subject to TOSI on any amounts received that exceed a “reasonable return”. In determining whether an amount is reasonable relative to an individual’s contributions to a business, relevant factors include: labour contributions, capital contributions, risks assumed, and amounts paid to the individual. We caution that the rules are complex and are based on subjective criteria – there will be a myriad of scenarios where it will be uncertain as to whether or not the TOSI regime applies.
The CRA has issued guidance outlining how it intends to administer these proposed rules, including a number of examples. CRA also outlines factors that it may consider in evaluating an individual’s labour contribution, capital contribution, risk assumption, and total amounts paid, for purposes of determining a “reasonable return” where other exceptions to the TOSI rules are not applicable. In the context of determining if a payment is reasonable, the CRA states that it “does not intend to generally substitute its judgment of what would be considered a reasonable amount unless there has not been a good faith attempt to determine a reasonable amount.” This will create an important bias for taxpayers to properly document the rationale or information that substantiates that an amount is reasonable. The CRA examples are a good resource to review the application of the new rules in a number of common scenarios.
Finance has confirmed that the government will not pursue the contemplated measures that would have limited access to the Lifetime Capital Gains Exemption (LCGE). This means that private company tax planning may continue to use structures that seek to access the LCGE of family members to reduce the tax incurred on the sale of a private business. However, a capital gain that does not qualify for the LCGE will be subject to the TOSI regime – the essential rule is that if a dividend received on the relevant share would be subject to TOSI, then a gain from the sale of the share would be considered to be TOSI. Further, the application of the TOSI regime will depend on the age of the individual with the punitive effect that a minor will be subject to tax on 100% of a capital gain realized, whereas a non-minor would still only be subject to tax at a 50% inclusion rate. The preceding will accentuate the benefits of realizing a capital gain that qualifies for the LCGE.
Finance also confirmed its intention to proceed with measures that address tax deferral opportunities related to investments held in a private corporation and reiterated that these measures would apply on a prospective basis. We do not have draft legislation for these measures or a contemplated implementation date.
While the Finance update provides some clarity on the new tax measures, we are still left with significant new constraints on tax planning for private company groups. The tax regime will also embody more complexity given the requirement for a taxpayer to determine whether or not amounts received are subject to TOSI. We expect that this will lead to some ongoing uncertainty and disagreements between the CRA and taxpayers with respect to whether or not TOSI applies. Further, private company groups continue to have undue uncertainty about eventual implications of the passive investment regime and how such measures will affect accumulated wealth and related planning. It will be important for private company groups to revisit their corporate structures and planning implemented in the past to determine if changes are required.
We remain disappointed with the exercise and continue to question the policy merits of the new measures, especially in light of the contemplated changes to the US tax regime which will be positive for business. The new measures are discouraging to entrepreneurs and are an important disincentive to this key driver of the Canadian economy – we will feel the repercussions for years to come.
