Since Wednesday, accountants, lawyers, small business owners and incorporated professionals have been burning the midnight oil — and not in celebration of Hanukkah. Rather they are trying to comprehend the implications of the new income sprinkling rules released that day and whether any steps need to be taken before Dec. 31 to ensure that business owners are properly prepared for the new rules, set to be effective on Jan. 1, 2018.
Here’s a primer on the proposed new rules and how they may affect your business in a couple of weeks.
What is income sprinkling?
Income sprinkling, which is sometimes known as “income splitting,” is a strategy sometimes used by higher-income small business owners or incorporated professionals to redirect their income to other, lower-taxed family members, generally through the payment of private company dividends. The payment of these dividends is often discretionary so that, with the proper legal structure, the owner can direct any amount of dividends in a particular tax year to specific family members. The amount and recipients can vary from year to year depending on their need for income and their tax brackets.
Isn’t there already a rule to prevent this?
Sort of. The current “Tax on Split Income” (“TOSI”), sometimes referred to affectionately as the “kiddie tax,” applies the highest marginal tax rate (currently 33 per cent federally plus provincial tax) to “split income” of certain family members under the age of 18. Split income includes private company dividends, capital gains and certain income from partnerships or trusts.
So, what changes are being made to the TOSI rules to further prevent income sprinkling?
The draft rules released on Dec. 13 will extend the TOSI rules to certain family members over the age of 17, with, as the government put it, some “clear, bright-line tests or off ramps” to exclude certain members of the related business owner’s family who fall into various categories.
What are these new exclusions?
It all depends on your age.
If you’re at least 18 years old in the year you receive so-called sprinkled or split income, it won’t be considered TOSI if it comes from an “excluded business.” An excluded business is one in which you were “actively engaged on a regular, continuous and substantial basis in the activities of the business” either in the tax year in question or in any five prior tax years, which need not be consecutive.
You’re considered to be actively engaged in the business if you work in the business at least an average of 20 hours per week. For businesses with seasonal operations, such as farms and fisheries, you only need to work 20 hours per week during the portion of the tax year that the business operates.
If you’re 25 or over, you can also be exempt from the TOSI rules if you hold “excluded shares.” These are shares in a private corporation which give you 10 per cent of both the votes and the value. Unfortunately, this exception will not be available for either professional corporations or services businesses.
And if none of these exceptions apply, you are permitted a “reasonable return” on your shares taking into account a variety of factors including the work you performed, the property you contributed and the risks you have assumed.
If you’re between 18 and 24, unfortunately the only factor taken into consideration in determining the reasonable return are capital contributions made with “arm’s-length capital.” Other than that, these individuals will only be permitted to earn a “safe harbour capital return,” defined as a return on his or her contributed capital that is either equal to or less than the prescribed rate — which is currently one per cent.
What about dividends paid to your spouse or partner?
There is one further exemption aimed at helping spouses and common-law partners in retirement. The new TOSI rules won’t apply to private company dividends or capital gains paid to you if your spouse or partner “meaningfully contributed to the business” and is aged 65 or over. This is a softening of the original rule which would have taxed all dividends paid to a spouse who wasn’t working in the business at the top rate. According to the government, this is “in recognition of the special challenges associated with planning for retirement and managing retirement income. (T)he new approach to income sprinkling will be better aligned with the existing pension income splitting rules. This also reflects the fact that a business can play an important part in supporting its owner in retirement.”
Do the proposed TOSI rules apply to salaries?
Nope. Salaries paid must always be considered “reasonable” to be deductible by the corporation.
How can you demonstrate to the CRA that you’ve worked an average of at least 20 hours per week during the part of the year that the business operates?
The Canada Revenue Agency issued some guidance saying that records such as timesheets, schedules or logbooks retained by either the employee or the business will be sufficient to establish the number of hours the individual worked in a given year. Where the individual also receives a salary or wages from the business, the CRA would consider information contained in payroll records that supports the number of hours the individual worked.
When are the new rules effective?
As stated above, the new rules are proposed to apply to the 2018 and subsequent taxation years. You have, however, until the end of 2018 to satisfy the 10 per cent ownership test under the definition of “excluded shares.”
But what if the rules aren’t passed until later in 2018? Will the CRA administer the new income sprinkling proposals before the law is actually enacted?
The CRA has stated that it expects taxpayers to file their returns on the basis of proposed legislation — a longstanding practice. To assist taxpayers in calculating their TOSI for the 2018 and later taxation years, Form T1206 “Tax on Split Income” will be updated by January 2019 to reflect the proposed legislation. In addition, the CRA will begin to assess taxpayers on the basis of the proposed legislation in 2019, for tax returns filed in respect of the 2018 and later taxation years.