Earlier this week Finance released the new laws for income sprinkling for businesses across Canada, to take effect January 1, 2018. Plenty of time, right? Finance Minister Bill Morneau sure thinks so.
Because the changes take effect so soon, it is imperative that business owners understand the changes and adjust their business and tax planning accordingly, hopefully prior to enactment. If your business does not have an advisor or a tax planner, please reach out to us at KBH so we can be your knights in shining armor during this stressful time.
Our summary of the proposed changes are as follows.
Originally, three changes were proposed:
- Increasing the tax on passive income earned inside a corporation;
- Curtailing transactions which converted ordinary dividends to capital gains; and
- Splitting income among family member using dividends.
The government originally proposed to curtail income splitting so business owners are no longer able to “sprinkle” income to family members to alleviate tax owed. The government proposed to evaluate the contribution of each family member to a businesses results.
Dividends and capital gains? These would be taxed at the top marginal rate if they were in excess of a “reasonable” return — so determined by the federal government. AKA “Tax on Split Income”, or TOSI.
The Revised Proposal
1. Where a business owner is age 65 or older and splits income with a spouse (aligning the rules with the existing pension income splitting rules);
2. If a capital gain qualifies for the Capital Gains Deduction (Qualified Small Business Corporation Shares or Qualified Farm Property); and
3. In the case of shares inherited from a deceased by will, if income or gain on the shares would not be TOSI to the decedent.
Who/What is Excluded
There will be two exemptions as Finance has introduced “bright line” tests that exclude certain specified individuals from the rules. Individuals are now excluded from the income sprinkling rules if they:
1. Worked more than 20 hours per week in the current year (pro-rated in case the business operates for only a portion of a year), or
2. Have previously met the above test for at least five years. This can be any five years; they need not be continuous or recent. If this test is met, then income can be split for a lifetime.
Excluded shares
The individual will be exempt from TOSI if they are:
1. At least 25 years old by the end of the year.
2. Own 10 percent of the business (by votes and value), and the corporation earns less than 90 percent of its income from the provision of services, and it is not a professional corporation.
3. A business owners’ spouse so long as that owner contributed to the business, and is 65 and over.
4. Adults 18 years and older who were regularly engaged in business activities, generally over 20 hours a week.
5. Individuals who realize taxable capital gains, so long as they would not be subject to the highest marginal tax rate on the gains under the existing rule.
Contributing Factors
In order to determine whether the amount received exceeds the reasonable amount, the business needs to consider the following factors:
Labor Contribution:
1. Nature of the tasks performed
2. Hours required to complete the tasks
3. Competitive salary or wage for the tasks in relation to similar business in the industry
4. Education, training, experience, etc.
5. Degree and nature of activities comparable to similar business in the industry
6. Time spent on said activities in comparison to time spent on other undertakings
7. Knowledge and skills that the individual posses
8. Business acumen
9. Past performance on functions
Property Contributions:
1. The amount of capital contributed to the business
2. The amount of loans to the business
3. The fair market value of property (both tangible and intangible property) transferred
to the business, including technical knowledge, experience, skill or know-how
4. Whether the individual has provided property as collateral for loans or other
undertakings
5. Whether other sources of capital or loans are readily available
6. Whether comparable property are readily available
7. Whether property are unique or personal to the individual
8. Opportunity costs
9. Past property contributions
Risk Assumption:
1. Whether the individual is exposed to the financial liabilities of the business, whether
through guarantees of mortgages, loans or lines of credit or otherwise
2. Whether the individual is exposed to statutory liabilities related to the business
3. Extent of the risk that contributions made by the individual to the business may be
lost, whether in whole or part
4. Whether any risk is indemnified or otherwise limited in the circumstances, whether
by agreement or otherwise
5. Whether the individual’s reputation or personal goodwill is at risk
6. Past or ongoing risk assumption
Total Amounts Paid:
1. Other amounts previously paid to the individual, (including salary or other
remuneration or compensation, dividends, interest, proceeds, and fees)
2. Benefits
3. Deemed payments (as may be reasonably required in the circumstances)
Other Changes to Note
In order to simplify the application of the new rules and to address potential consequences as a result of the original proposals, the following changes have been proposed:
• TOSI will not apply to compound income, or income derived from property acquired as a result of a marital breakdown.
• Aunts, uncles, nieces and nephews will not be considered “related individuals” for purposes of the TOSI rules.
• Confirmation that the broad rules countering conversion of regular income to capital gains have been abandoned.
• Under the original proposal, individuals aged 18-24 were permitted to only earn the prescribed rate of return on capital contributions before TOSI applied. They will now be entitled to earn a reasonable return.