On December 13, 2017, the Government published details of its proposals to (in their view) simplify and improve the treatment of income sprinkling, which are proposed to be in effect for the 2018 tax year and beyond.
The Canada Revenue Agency (CRA) has also released guidance with respect to these measures.
The revised measures, in the government’s view, are designed to ensure that they do not affect family members who make meaningful contributions to a family business. The measures include several automatic, bright-line tests.
Background of Proposed Changes to Small Business Taxes
In July 2017, the Government released a consultation paper with proposals to address unfair tax planning strategies using private corporations.
As part of their consultation paper the Government targeted the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business.
Any income they considered to be income sprinkling would be subject to tax in the recipient’s hands at the highest federal tax rate.
The Government continues to state that family members who make a meaningful contribution to the business will not be affected by the new measures.
Determining Whether a Family Member is Significantly Involved in the Business
Specifically, these tax changes will clarify the process for determining whether a family member is significantly involved in a business, and thus excluded from potentially being taxed at the highest marginal tax rate (known as the tax on split income or TOSI).
The changes include clear, “bright-line” tests – to automatically exclude individual members of a business owner’s family who fall into any of the following categories:
- The business owner’s spouse, provided that the owner meaningfully contributed to the business and is aged 65 or over.
In recognition of the special challenges associated with planning for retirement and managing retirement income, the 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.
- Adults aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hours per week) to the business during the year, or during any 5 previous years.
For businesses with seasonal operations, such as may be the case with farms and fisheries, the labour contribution requirement will be applied for the part of the year in which the business operates.
- Adults aged 25 or over who own 10% or more of a corporation that earns less than 90% of its income from the provision of services and is not a professional corporation.
- Individuals who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they would not be subject to the highest marginal tax rate on the gains under existing rules.
Individuals aged 25 or over who do not meet any of the exclusions described above 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.
While not addressed in this announcement, the Department of Finance had this to say on the reasonableness test in past announcements:
Finance confirms that it will introduce “reasonableness” tests for adult family members aged 18-24, as well as those 25 and older. The tests will consider whether these individuals made contributions to the business through any combination of the following:
- Labour contributions
- Capital or equity contributions
- Financial risks, such as co-signing a loan or other debt
- Past contributions in respect to previous labour, capital or risks
Tax Planning Strategies
Every situation is unique and you should have a discussion with your tax specialist about income sprinkling and what steps you need to take to reduce the taxes you pay.
Some basics steps are to ensure you have proper documentation and paperwork to support involvement in the business.
- Prepare timesheets to justify involvement
- Consider a separate voting class of shares for young adults. (This would only be applicable for non-professional corporations.)
Income Sprinkling Measures Effective 2018
The revised income sprinkling measures are proposed to be effective for the 2018 and subsequent taxation years. The measures will be legislated as part of the 2018 Budget process.
The Government will also move forward with measures to limit tax deferral opportunities related to passive investments, and details of that plan will be included in Budget 2018. When introduced, the passive investment measures will apply only on a go-forward basis.
We will continue to provide updates on the proposed changes to small business taxes for private corporations as they become available.