On July 18, 2017 the government proposed a number of significant income tax changes for small business operating through private corporations in Canada. Following significant backlash from the business community, the government postponed or eliminated most of these proposals, however, measures to curtail income splitting (“income sprinkling”) among family members remained largely intact. On December 13, 2017 the Canada Revenue Agency clarified their position on these proposals which are effective January 1, 2018.
We present a summary of proposed tax measures based on CRA’s view of the new rules:
What’s changed? Dividends, and interest, and certain capital gains paid by private corporations to related individuals are now subject to a very punitive Tax on Split Income (top rate tax) unless one of the exceptions listed below apply. In the past dividends were never subject to reasonably.
What hasn’t changed? Wages are not subject to the new tax rules because wages have always been subject to reasonably rules. While reasonably is not defined by the tax act and depend largely on the circumstances, paying wages to individuals that don’t work for the Company are certainly not permissible.
Exceptions: Tax on split income will not apply to amounts received from an “excluded business”, or on “excluded shares” or represent a “reasonable return”.
- Excluded business: Amounts derived from a Related Business where the individual was “Actively Engaged” in the activities of the business in the taxation year or in any five prior taxation years of the individual. An individual will be deemed to be “Actively Engaged” if the individual works in the business at least an average of 20 hours per week during the portion of the taxation year of the individual that the business operates, or meets that requirement for any five prior years. The five taxation years need not be consecutive. In any other case, whether an individual is Actively Engaged will depend on the facts and circumstances of that case.
This exception excludes part time or non-continuous work.
- Excluded shares: Shares of a corporation owned by an individual (aged 25 years or older) are excluded shares where:
- less than 90% of the corporation’s business income was from the provision of services and the corporation is not a professional corporation;
- the shares represent 10% or more of the votes and value of the corporation; and
- all or substantially all of the income of the corporation is not derived from another Related Business in respect of the individual,
This exception excludes family members holding non-voting shares, doctors, professionals, financial advisors, and consultants, and companies that derive income from related companies.
- Reasonable return: Payments that represent a reasonable return are permitted (for individuals aged 25 years or older) based on the following criteria:
- the work performed in support of the Related Business;
- the property contributed directly or indirectly in support of the Related Business;
- the risks assumed in respect of the Related Business;
- the total amounts paid or payable by any person or partnership to or for the benefit of the individual in respect of the Related Business; and
- other factors that may be relevant.
Individuals aged 18-24 have significantly stricter criteria, there are certain exceptions for individuals aged 65 and older, and taxable capital gains realized on death or from the disposition of qualified small business corporation shares are excluded as well.
So what now? The proposed changes have fundamentally changed tax planning for business owners and their families. If you have split income with your family by paying dividends to a low income spouse or children, you should expect a significant increase in your tax bill. Even if you qualify for one of the exclusions from Tax on Split Income, you must now keep very detailed documentation to defend your position to the CRA. These measure may not only increase your tax bill, they will also increase your compliance and paperwork burden, which small business try so hard to minimize.
An opportunity still remains: A significant income splitting opportunity remains (for now) with prescribed rate loans to family members and trusts. These loans are relatively low interest and depending on your portfolio value and return on your investment, can result in significant tax savings.
For more information on income splitting opportunities and how proposed tax changes impact your business, call the tax professional at Sloan Partners LLP
Disclaimer: This article is intended for educational and informational purposes only. It is not intended in any way whatsoever to provide tax advice. The reader should be aware that certain legislative changes and government announcements have been proposed and are subject to change. None of the persons involved in the preparation of this article accepts any responsibility for its contents or the consequences that arise from its use.