New income splitting laws that took effect Jan. 1, 2018 have high-income small business shareholders scurrying to find ways to avoid paying higher taxes on funds paid to tax-exempt and low-bracket children and spouses. This practice, also known as income sprinkling, involves distributing income from capital gains in the form of wages, shares, and dividends in the names of minor children and older relatives who pay no taxes or who are in much lower tax brackets. For example, a business may list a minor child or retired spouse as an employee receiving a salary, or issue dividend checks in their name. This income that should normally be taxed at a high rate will therefore be subject to a significantly lesser amount of tax or go completely untaxed, costing the government millions.
The Canadian government previously attempted to curb this income splitting vehicle by enacting the Tax on Split Income (TOSI), or “kiddie tax” laws, which make this income subject to the maximum federal tax rate of 33% plus the applicable provincial rate. New rules that were proposed to go into effect in January 2018 should crack down even further by creating extensions, exceptions, and exemptions for family members in some situations.
Not all income splitting is affected. Income splitting is an essential part of many small businesses’ tax planning strategies. This Department of Finance publication goes into detail about what is and what is not permitted and what the TOSI law changes intend to address.
Relatives who are at least 18 years old do not have their income considered TOSI income if it comes from an excluded business – one in which they are “actively engaged on a regular, continuous and substantial basis in the activities of the business” for the reporting year or for any five previous reporting years. They can satisfy this condition by working 20 or more hours per week.
The new rules also allow an exemption for holders of excluded shares that give them 10% of both the votes and the value of a private corporation.
Relatives Between 25 and 64
Unless they are otherwise exempt, relatives over the age of 25 are allowed no more than a reasonable rate of return on investments. The government determines this rate after considering the extent of their participation in the business, the value of their contribution, and their degree of risk. Between the ages of 18 and 25, the only factors the government takes into account in determining a reasonable rate of return are contributions made with arm’s-length capital, or money they have acquired and invested on their own that is at arm’s length from, or not connected to, the family or business. Otherwise, they are allowed a safe harbor capital return – a return on their investment that is less than or equal to the prescribed rate – which is 1%, as of 2017.
Dividends Paid to a Partner or Spouse Over 65
Under the old TOSI rules, any payments made to a partner or spouse who doesn’t contribute to the business are subject to the top marginal rate. Under the new rules, dividends paid to a spouse or partner over 65 are exempt from the tax if the spouse contributed in any meaningful way to the business.
Lifetime Capital Gains Exemption
As announced in October 2017, the feds will not enact any changes to the current Lifetime Capital Gains Exemption (LCGE), which would have severely restricted those exemptions, nor will it move forward on changing the rules regarding the conversion of income to capital gains.
As for the timing of these new rules, even though they took effect January 1, 2018, small business owners have up to December 31, 2018 to get compliant. And this means that non-professional corps have time to pass the 10% ownerships test and/or ensure that family members meet the new reasonableness tests.
With the effective date of these rule changes approaching, it remains to be seen how much revenue the government stands to gain or how small business owners, tax planners, and professional accountants respond to them.