Unless you've been hiding under a rock, you probably know that thousands of business owners and professionals across the country have been up in arms about proposed tax changes introduced in July – and for good reasons that I won't repeat here today. On Wednesday, Finance Minister Bill Morneau announced revisions to the part of the proposals dealing with "income sprinkling" (the practice of paying income to family members in a lower tax bracket). Some background will be helpful here.
Since 1999, our tax law has levied a special tax – called the "Tax on Split Income" (TOSI) – on certain types of income paid to minor children. I'm talking about income from certain business arrangements such as dividends on private company shares, or trust or partnership distributions derived from income from a private business or rental activity of a related person. Where the TOSI applies, the income is taxed in the hands of the minor at the top personal tax rate going. These rules for minors are not changing. So, what's new?
The proposals made in July were designed, among other things, to extend the TOSI to those over age 18 as well. It's clear that the government has kept the basic structure of the changes announced in July, but has created some exceptions so that the TOSI won't apply in every case that an adult receives income from a private business of a related person.
Now, if you or an adult family member fail to qualify for one of the exceptions, the TOSI will apply to the income received, but only to the extent it exceeds a reasonable amount. So, a "reasonableness test" will be applied to figure out how much of the income should be subject to the high tax rate – the TOSI. Clear as mud?
What are the exceptions to the TOSI for adults? Here they are:
1. You work in the business. If you contribute labour to the business (generally 20 hours a week) in the current year, or during any five previous years (they don't have to be consecutive years), then the TOSI won't apply. If you don't meet the 20-hour threshold, then it will be a question of fact as to whether you were actively engaged in the business on a "regular, continuous, and substantial basis."
2. You're 25 or over and own shares. If you're 25 or older and own at least 10 per cent of the voting shares and value of the corporation, then the TOSI won't apply, provided the corporation meets the following three tests: It earns less than 90 per cent of its income from the provision of services, it's not a professional corporation, and it does not derive all or substantially all of its income from another related business. If you want this exception to apply in your case, you'll have until the end of 2018 to meet the 10-per-cent ownership condition.
3. You're the spouse of a contributor. Regardless of your age, if you're the spouse of someone age 65 or over who has made significant contributions to the business, then the TOSI won't apply. This is designed to provide income-splitting opportunities in retirement that mirror the pension-income-splitting rules in place today for employees with pensions. The original proposals didn't include this opportunity, which I criticized the government for in my article dated Oct. 19, so this is a welcome change.
4. You inherit shares. If you're 18 or over and inherit shares upon the death of an individual who was able to receive income free of the TOSI rules, then you too will be free from the TOSI rules.
5. You realize capital gains on the shares. If you're an adult who disposes of property that qualifies for the lifetime capital gains exemption (this typically includes qualified small-business corporation shares, and qualified farm or fishing property), the TOSI will not apply to those capital gains. This is true whether or not you claim the lifetime capital gains exemption to shelter the capital gain from tax.
6. You're age 18 to 24 and contribute capital. If you're age 18 to 24 inclusive, you'll probably face the TOSI unless you work in the business (see exception No. 1 above). Having said this, if you've contributed capital to the business, a reasonableness test will apply to determine how much income you can receive annually and avoid the TOSI.
There's much more than can be said about these proposals. The intention today was to simply make you aware of the key provisions. More on this topic later.
Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at email@example.com.