Canada: Tax Proposals Affecting Private Companies And Their Shareholders: Income Splitting

This is the third in a series of posts arising out of the Liberal Government's paper "Tax Planning Using Private Corporations."

In the first post of this series, we presented an overview of the proposals the Liberal government outlined in its paper "Tax Planning Using Private Corporations" (the "Paper"). Proposals in respect of the capital gains exemption were dealt with in the second of this series of posts. The purpose of this post is to outline the proposals dealing with income splitting.

Income Splitting

The term "income splitting" describes strategies designed to shift income from one taxpayer who pays tax at a high rate of tax to another taxpayer who pays tax at a lower rate. For decades shareholders of Canadian private companies have included the business owner who is actively engaged in the business and members of his or her family. The family members may hold their shares either directly or indirectly as beneficiaries of family trusts. Until now there have been few restrictions on the dividends that could be paid out to the family members. According to the Paper, the government now views the ability of business owners to split income and therefore take advantage of lower marginal rates to be "fundamentally unfair".

Tax on Split Income or TOSI

There are currently provisions of the Income Tax Act that deal with income splitting. The attribution rules apply to attribute income earned by spouses and minor children and capital gains realized by spouses to the person who transferred or loaned property to them. The attribution rules ensure that the income is taxed in the hands of the transferor or lender.

Dividends and certain partnership and trust income received by minor children may be subject to the Tax On Split Income or TOSI (commonly referred to as the "kiddie tax"). TOSI also applies to capital gains realized on the sale of shares of private companies to a non-arm's length person provided dividends on those shares would have been subject to TOSI. In this case, the amount received is subject to tax as a taxable dividend and not as a capital gain. Income from inherited property is generally exempt from the TOSI.

Where TOSI applies, the income is effectively subject to tax at the highest marginal rate. The parent and minor child are jointly liable for the TOSI.

TOSI does not apply to amounts received as employment income. In that case the private company's ability to deduct the employment income is subject to a reasonableness test. TOSI also currently does not apply to interest on debt issued by private companies or to income earned on investments acquired with the after-tax income that was subject to TOSI – referred to in the Paper as compound income.

Constrain Income Splitting vs. Recognizing Contribution

Consistent with the overriding theme of fairness, the Paper sets out measures which the government believes will constrain income splitting while at the same time recognizing the contributions of family members to the business. To this end, the Paper proposes extending TOSI to Canadian resident adults who receive "split income". The scope of TOSI will be expanded to include interest on private company debt and compound income received by someone under 25. The Paper also proposes to disallow the capital gains exemption on capital gains realized on shares that were subject to TOSI. TOSI will continue to not apply to split income from certain inherited property. The draft legislation is broad, complex and subjective. If enacted, the rules are proposed to be effective after 2017.

In determining whether there is split income it must be determined if there is a "connected individual"— a person who is related to a person who receives the income and has a presumed degree of influence over the circumstances in which the amount is paid.

  • Currently, a related person could be a grandparent, parent, spouse, common law partner, child or sibling. The draft legislation proposes to extend the definition of related persons to include aunts and uncles and nieces and nephews as well as trusts and those persons with whom the trust is deemed to deal not at arm's length. There can be more than one connected individual in respect of a corporation.
  • To be split income, the related person must have influence. In this regard, the draft legislation sets out the following factors: (i) strategic influence (factual control over the corporation alone or as part of a related group), (ii) equity influence (owns property representing 10% or more of the equity value of the corporation), or (iii) investment influence (10% or more of property is derived from property acquired from the individual or another corporation in which the person is a connected individual). Where the corporation carries on a service business, there will also be an earnings influence test where the individual's services are the primary contributor to the activities or revenues of the corporation's business.
  • TOSI will only apply to split income where the amount is "unreasonable". Reasonableness will be determined having regard to such factors as involvement in the business, capital contributions, previous returns and remuneration. The factors depend on the age of the individual at the time of the receipt of income. Generally speaking, those between 18 and 24 are subject to a more stringent test than those who are over the age of 24.
    • For those between the age of 18 and 24 years, the factors will be (i) the extent to which the individual is actively engaged in the business on a regular, continuous and substantial basis; (ii) the return on the assets contributed to the business exceeding a prescribed return (currently 1%); and (iii) amounts previously paid to the person.
    • For those who are 25 or over, the factors that will be considered will be (i) the extent to which the individual contributed labour that would have been remunerated by salary, (ii) assets contributed or risks assumed in the business and (iii) amounts previously paid to the person.

There is no doubt that the Paper's income splitting proposals will change both the ownership of private companies and how the profits of that business are distributed. It will have an effect on multi-generational businesses and family-owned companies where there are both active and non-active shareholders in the business. It should still be possible for related persons who are actively involved in the business not to be subject to TOSI. However, because the factors are subjective, there is bound to be uncertainty until such time as the Canada Revenue Agency gives some indication of how the factors will be interpreted.

The next posting will deal the Paper's alternative proposals for the taxation of a private company's passive income.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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