The federal government provided revised income sprinkling measures Wednesday, offering clarity about how its controversial changes to the Income Tax Act will be implemented.
The feds “have significantly narrowed the scope, and they’ve provided clarity,” says Dave Walsh, partner and tax service line leader at BDO Canada.
Specifically, the feds provided bright-line tests for determining whether family members are significantly involved in a family business, and thus are excluded from potentially being taxed at the highest marginal tax rate (known as the tax on split income, or TOSI).
A key requirement is “regular, continuous and substantial” contribution to the business, says Finance.
Family members who fall into these categories won’t be subject to TOSI:
- The business owner’s spouse, provided the owner meaningfully contributed to the business and is aged 65 or over. This aligns with current pension income splitting rules.
- Adults aged 18 or over who have made a regular, substantial labour contribution—generally an average of at least 20 hours per week—to the business during the year, or during any five previous years. The measure recognizes that post-secondary students may step back from the business during the school year. Hours will be prorated for seasonal businesses.
- Adults aged 25 or over who own 10% or more of a corporation that earns less than 90% of its income from services, and isn’t a professional corporation. This is consistent with current tax rules concerning capital, and recognizes that some service-based or professional-based businesses often don’t require significant capital to do business. (Service- or professional-based businesses must pass the labour test, above.) Business owners have until Dec. 31, 2018, to adjust to this exclusion.
- People who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they wouldn’t be subject to the highest marginal tax rate on the gains under existing rules. This is consistent with the feds’ withdrawal in October of the lifetime capital gains exemption measures.
Family members aged 25 or older who don’t meet any of these exclusions would be subject to a reasonableness test to determine how much income, if any, would be subject to the highest marginal tax rate.
In certain cases, adults aged 18 to 24 who have contributed to a family business with their own capital will be able to use the reasonableness test on the related income.
The government claims most private corporations won’t be impacted by the measures, adding that the number of businesses potentially affected is fewer than 45,000, or roughly 3% of all corporations.
In a conference call, a spokesperson for Finance Minister Bill Morneau said CRA will take businesses “at their word” when it comes to claiming an exemption for a family member. Audits would require proof.
What advisors should know
Advisors can tell their business-owner clients to take full advantage of income sprinkling for the remainder of 2017, says Walsh. And, for 2018, “there’s no reason to panic,” he says.
That’s because the rules kick in on Jan. 1, 2018, but clients have a year to get compliant. That means non-service businesses, for example, have a full year to get onside with the 10% ownership test, he says. And service businesses can take that time to get family members on the payroll.
Senate calls for further delay
The details come as Parliament prepares to rise for its winter break and after business groups were pressuring the government to release details so they could prepare before the changes come into effect on Jan. 1. Earlier this week, the Canadian Federation of Independent Business called for a one-year delay to give businesses time to adjust.
The changes to income sprinkling are part of the tax proposal the Liberal government introduced in the summer, which sparked wide resistance from business groups. In October, Morneau scrapped many of the proposals but maintained the changes to income sprinkling, promising details this fall.
Earlier Wednesday, the Senate finance committee released a report saying the government should scrap or postpone its proposed tax changes, including those to income sprinkling.
The committee began reviewing the proposals this fall, hosting 30 meetings across the country. Its response after hearing from 138 witnesses and receiving 32 written submissions was that “many problematic elements remain.”
“The income sprinkling proposal will be complicated to apply, require significant paperwork, and rely on the subjective determination of tax auditors, inevitably leading to inconsistency and litigation,” the report said. “It also would not recognize legitimate income splitting based on implied joint ownership of family property.”
While CRA officials told the committee they could work with a reasonableness test for income sprinkling and are developing a guidance document, most witnesses told the committee that such a test would be complicated and increase compliance costs for small businesses. The report lists the following reasons:
- small businesses receive substantial formal and informal support from family members;
- farm families live where they work and rarely keep track of who does what when;
- considerable paperwork will be needed to justify dividends;
- many people have been using dividends rather than salaries due to the effort that it would take to determine a reasonable salary;
- holding a share is not an employment contract and the rules cannot be the same; and
- no other jurisdiction applies a reasonableness test to dividends.
The report said witnesses worried the rules would lead to uncertainty, tax appeals and litigation.
Witnesses also criticized the government’s passive income proposal as well. The committee said the proposal “is based on a one-size-fits-all approach, which would constrain the growth of small businesses and the regular operations of medium and large businesses. It would encourage businesses to take funds out of their corporation and create an uneven playing field with public corporations and non-Canadian controlled corporations.”
The Senate report says the government should undertake a full review of the Income Tax Act.