Morneau reform on income-sprinkling: Understanding it once and for all
As the last year for income sprinkling was coming to an end, many of us awaited clarifications on the related measures released by Canada’s Finance Minister, Bill Morneau, on July 18, 2017. The federal government had announced its intention to put an end to tax strategies that allowed families to use a private corporation to reduce their overall tax burden, even if some family members who benefited from the strategy did not contribute to the business.It should be noted that certain reform measures, announced in the middle of summer almost a year ago, no longer apply since late October 2017, when the government backtracked in response to some 29,000 comments received during the consultation on tax planning. The income sprinkling measures were clarified in a December 13, 2017 announcement and have been in effect since January 1, 2018.
To ensure that managers and owners of private businesses pay their fair share of income tax, the federal government extended the application of the tax on split income (TOSI) rules. Previously, TOSI applied when a dividend from a private corporation, or income from a partnership or trust derived from a private corporation, was paid or allocated to a minor. When TOSI applies, income is subject to the highest marginal personal tax rate, currently 53.31%, instead of the progressive tax rates.
Since January 1, 2018, TOSI also applies to adult individuals when the amount they receive from a corporation, of which a family member is a manager or shareholder, meets the income sprinkling definition and is not reasonable under the circumstances. Only the portion considered as unreasonable is subject to TOSI.
According to the December 13, 2017 announcement, TOSI will not apply in the following situations:
Excluded shares for taxpayers aged 25 and older
Dividends paid on shares owned by an individual may be exempt from the application of TOSI if the following conditions are met:
- The individual is over the age of 24.
- Less than 90% of the corporation’s income comes from the provision of services.
- The corporation is not a professional corporation within the meaning of subsection 248(1) of the Income Tax Act.
- The individual owns at least 10% of the corporation's outstanding shares in terms of votes and value.
- The corporation’s income is not derived directly or indirectly from a related business.
Excluded business of an adult individual
An adult individual is not subject to TOSI for an amount received if, during the year or the five previous taxation years, he or she was actively engaged on a regular, continuous and substantial basis in the business. An individual who works an average of 20 hours per week during the part of the year that a business operates will be deemed to be actively engaged on a regular, continuous and substantial basis for the year.
Shareholder whose spouse is 65 and older
The TOSI rules will not apply to related business dividends received by a taxpayer if the taxpayer’s spouse is 65 and over and is considered to have meaningfully contributed to the business during the year or previous years. The exemption continues to apply after the spouse’s death.
Therefore, the question is whether any of the tax relief applies to the amount paid. If this is not the case, it will have to be determined whether the amount paid is a “safe harbour” capital return or a reasonable return. If so, TOSI will not apply.
For this purpose, the definition of “safe harbour” capital return, which only affects individuals aged 18 to 24, is introduced. For a given taxation year, an individual’s safe harbour capital return is the return on the fair market value of his or her contribution to the capital in support of a related business, up to but not exceeding a prescribed rate (the highest rate for the year in question).
The second concept, “reasonable return,” applies to individuals whose situation does not qualify them for any other exclusion. The amounts paid are therefore subject to TOSI for amounts received from a related business that do not meet the definition of reasonable return. For individuals aged 25 and older, the question is whether it is possible that an arm’s length person has agreed to pay the individual the agreed amount, taking into consideration the work performed, capital contributed, risks assumed, previous returns and payments, and any other relevant factors. If so, the amount will be considered a reasonable return.
In the case of individuals aged 18 to 24, the reasonable return criterion will be stricter than for adults aged 25 and older, as the erosion of tax revenues is apparently higher for income attributed to these young adults, who often have no income and are still students. Only contributions of arm’s length capital, not labour contributions, will be considered for these individuals. That means TOSI will not apply if the amount paid to individuals aged 18 to 24 constitutes a reasonable return on contributions of arm’s length capital.
Other changes to TOSI have also been proposed. Among other things, the rules will now include income from certain debts and capital gains from dispositions of certain property prior to 2017.
Admittedly, the subjective nature of the reasonable return criterion will surely result in some uncertainty in practice for professionals who will deal with these new measures in 2018.
Réjeanne Lepage, M.Fisc, CPA, CGA
Taxation Expert, MALLETTE LLP
Quebec CPA Order Technical working group on taxation and commodity taxes