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Yesterday, we took a look at how the draft legislation recently released by the Department of Finance would affect taxation of passive investments. Today, in Part 2 of our 4-Part series, we’ll be focusing on the second area of concern: Income splitting (also referred to as income sprinkling).
Second Area of Concern: Income Splitting
Currently, when a high-income earner wants to shift some of his/her income to his/her lower income spouse or minor children, the Canadian income tax system deals with any perceived abuses by:
- Devising income attribution rules that shifts the income earned by the spouse or minor children back to the high income earner spouse/parent. In the case of a spouse, the attribution rules apply to investment income and capital gains. In the case of minor children, this applies to investment income, but not to capital gains.
- Devising the Tax on Split Income (“TOSI”) rules (commonly referred to as the kiddie tax). In this case, split income earned by a minor child (not subject to the income attribution rules above) is subject to tax at the highest rate of marginal tax. This achieves the same effective result as if the income were attributed back to the child’s high income parent. The most common form of split income is dividend income from a private corporation.
When a business owner introduces a family member as a shareholder of his/her private corporation, the income tax savings can be considerable. For example, an individual resident in Ontario in 2017 can receive up to $33,300 of ineligible dividend income or $56,500 of eligible dividend income, without having to pay federal or provincial income tax on the amount (other than the Ontario health premium and perhaps some alternative minimum tax). Keep in mind as well that the tax savings are magnified if the business owner introduces multiple family members as shareholders of the corporation, and paying dividends to them annually.
On the other hand, had the business owner received the same level of dividend income, he/she would have potentially paid tax at a top marginal tax rate of 39.34% on the eligible dividend income, and 45.3% on the ineligible dividend income for 2017.
The Department of Finance believes that the current legislation is unfair, as this form of income splitting is not available to business owners earning income directly, or to other classes of taxpayers (such as employees).
The proposed legislation will attack this form of tax planning and other perceived abuses by expanding the TOSI rules to cover situations which are not dealt with under the current legislation. They will accomplish this by:
- Expanding the TOSI rules to apply not only to minor children, but also to spouses, adult children, parents, siblings, aunts, uncles, nephews and nieces (referred to as “specified individuals”); and
- Expanding the types of split income subject to the TOSI rules, including:
- Interest on loans to corporations, partnerships or trusts;
- Taxable capital gains on shares, if the income on such shares would be split income; and
- Second generation income, if it is earned on income that was split income.
Where a specified individual receives split income, the TOSI rules will apply where the amount received by the individual is unreasonable in relation to what would have been paid or payable by an operating entity to an arm’s length person, having regard to:
- The functions performed by the individual to the business;
- The assets contributed, directly or indirectly, by the individual in support of the business;
- The risks assumed by the individual in support of the business; and
- The compensation received by the individual for services already completed.
This “reasonability test” is highly subjective. It is our opinion that this legislation will inevitably result in a significant increase in tax audits and CRA disputes, while also impacting existing corporate ownership structures.
Join us next week, in Part 3 of our 4-Part series, when we’ll take a look at how the proposed legislation will impact the Enhanced Capital Gains Deduction (“ECGD”).
For more information on this topic, contact your Zeifmans advisor or reach out to us at 416.256.4000 or info@zeifmans.ca.
Related news:
Part 1: Passive Investments
Part 3: The enhanced capital gains deduction (“ECGD”)
Part 4: The conversion of income into capital gains
Federal Government tax changes announced Oct 16
Oct 18 and 19 updates on the taxation of owner-managed businesses
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