For decades, Canadian corporate business owners have been able to distribute a portion of corporate income by way of dividends to family members in lower marginal tax brackets, realizing substantial tax savings.
The Canada Revenue Agency tried to challenge these sorts of dividend sprinkling arrangements in the 1990s using existing provisions of the Income Tax Act, but were ultimately unsuccessful at the Supreme Court.
In 2000, the Liberal government enacted the tax on split income (TOSI), also known as the “kiddie tax”. This tax essentially ended the practice of income splitting with minor children because dividends they received from family-owned companies would be taxed at the highest marginal rate, regardless of the child’s income level. Over the years, the TOSI regime was broadened to include other types of income allocated to minors through a trust or partnership if derived from a family source business. The following will focus on income from dividends.
On July 18, 2017, the current Liberal government proposed the elimination of tax advantages that can be gained through income splitting. In response to public comments, Prime Minister Justin Trudeau has reiterated his party’s position on the matter, contending they would straighten out perceived unfair tax advantages which are inherent in the system.
Proposed Changes to Income Splitting
The proposed changes seek to expand the TOSI regime to include amounts paid to adults in numerous circumstances where a dividend paid from a family company exceeds an amount determined by applying a subjective “reasonableness” test.
Generally, the criteria for evaluating whether a dividend paid to a family member is “reasonable”, include the family member’s contribution to the business of their:
- Labour – What would be paid to an employee in a similar business performing similar functions?
- Capital – What funds has the individual invested in the business?
- Assumed risk – Has the individual guaranteed debts of the corporation, and what would be reasonable compensation for providing the security?
- Historical payments made – What is the pattern of compensation over time?
In short, reasonableness is to be predicated on compensation that would be paid to an unrelated party in similar circumstances.
The test will be even stricter in the case of adults under age 25. In order for dividends to escape TOSI, the recipients will have to be considered as actively engaged in the business “on a regular, continuous and substantial basis”, and all capital contributions will be subject to a prescribed maximum allowable return on assets at the rates set under the Income Tax Act Regulations (currently 1%).
Further adding to complexity, if an individual under age 25 earns income on property that was acquired using income that was subject to TOSI, the income earned on that property would also be subject to TOSI. For example, if a 22-year-old individual received a dividend that was subject to TOSI, and the funds from the dividend were invested in a term deposit, the interest earned on that term deposit would be subject to TOSI.
The Impact of the Proposed Changes
As explained below, the proposed “reasonableness” test is anything but reasonable.
- Contribution in the form of labour to a particular business can only be considered in the context of a business that earns primarily (generally >50%) “active” income. There are rules in the Income Tax Act that deem income from property to be income from an inactive business, unless a corporation employs more than five full-time employees. A corporation that does not employ more than 5 individuals, and that earns most of its income from holding a portfolio of rental properties or securities, is an example of a business that generally is deemed to earn income that is not active business income. Dividends paid to shareholders could be subject to TOSI if the individual shareholder did not make a financial contribution, or assume risk.
- It is not uncommon for founders of businesses to retire and allow their children to succeed them as operator. Dividends paid on shares owned by the parents could be subject to TOSI if not justified by the founders’ current risks assumed or capital invested. As drafted, the proposed provisions imply that past performance would not be counted in the determination of reasonableness.
- Capital gains realized by individuals on disposals of their shares of a private corporation could be subject to TOSI to the extent that notional dividends received on those shares in the year in an amount equal to the gain would have been subject to TOSI. This in turn can affect eligibility for the capital gains exemption.
- For example, assume
- An individual owns shares of a private corporation;
- The shares have appreciated in value over time;
- The shares are sold to an unrelated party in a fair market value transaction;
- The individual was not actively involved in the operation of the corporation’s business, has never made a financial investment in the business, and has never assumed any risk in connection with the business.
- Had the individual received notional dividends on his shares in an amount equal to the gain, the dividends would have been considered as split income in the year and subject to TOSI.
- The individual’s taxable capital gain arising on the sale of shares would be split income and therefore subject to TOSI.
- The amount of capital gains exemption the individual could claim would be reduced to the extent that the capital gain on the shares was split income.
- In addition, if a capital gain arises from a transfer to a non-arm’s length person such as a family member, it would be converted to a taxable dividend either under the TOSI rules or through another proposed income tax provision. This may discourage intergenerational transfers and is not sound economic policy.
- For example, assume
The proposed rules are unduly complex and leave taxpayers with uncertainty and onerous compliance obligations; the onus will be on corporate owners to substantiate reasonableness for dividends paid to adult family members. The implications of these changes may not be immediately obvious, and could ultimately require significant interpretation by the courts.
Although the government consultation period on these changes ended October 2, 2017, the draft rules are intended to apply effective 2018.
Hopefully, the Ministry of Finance will consider simplifying the provisions in response to consultations and public outcry. The rules could be easily simplified by permitting spousal dividend sprinkling and applying the existing TOSI rules to family members up to age 24 or even higher.
The Ministry of Finance should consider levelling the playing field in the taxation of the family unit for all taxpayers in all circumstances.