Canada: 2017 Year End Tax Planning For Employees

Last Updated: January 2 2018
Article by David Rotfleisch

Amendments to the Income Tax Act – Split Income Rules – Revised Legislation – A Canadian Tax Lawyer Analysis

There has been a whirlwind of activity with respect to tax legislation during the Honourable Bill Morneau's stint as Canada's Minister of Finance. The Department of Finance's consultation paper "Tax Planning Using Private Corporations" was released in mid July of this year and the consultation period closed the first week of October.

Morneau quickly back pedaled on a significant number of the changes following public comment. The changes that have survived since the close of the consultation period are set out in revised draft legislative proposals that were released on December 13, 2017. These rules are proposed to be applicable to the 2018 and subsequent taxation years.

Overview of the Changes

The majority of the remaining revisions are to section 120.4 of the Income Tax Act or the "Tax on split income [Kiddie tax]" provisions. The basic idea is that the "Kiddie tax" will be expanded to include adults of all ages to discourage Canadian business owners from income splitting to specific individuals, which includes family members and related individuals. For adults (ages 18+), a reasonableness test is applied in order to determine whether the tax on split income (TOSI) would apply to any amount of split income that the adult individual received. Any income to which TOSI applies will be taxed at the top marginal federal tax rate of 33%. The general scheme and rules for income splitting have not changed and the rules defining a specified individual are unchanged. Contact our experienced Canadian tax law firm and learn more about the new income splitting rules and the most recent amendments.

The key revisions to the new split income rules released by the Department of Finance on December 13, 2017 are the additional exclusions to this new tax on split income as well as clarification on the reasonableness test. These exclusions come in the form of clear bright-line tests or, as the Minister calls them, "off ramps". There are 4 main exclusions to the tax on split income for individuals it would otherwise apply to.

The first exclusion applies to both married and common law spouses of business owners where the business owner is over the age of 65. This exemption allows the spouse of the business owner to receive income from the business owner's business without having the new tax on split income apply. Furthermore, in the year when a business owner reaches the age of 65, the exemption applies to all income received by that business owner's spouse from the business for that year, not just income received after the business owner reaches the age of 65.

The second exclusion applies to inherited property. This exclusion applies for individuals 18 years of age and older and the result is that the income earned by an individual from inherited property will not be treated less favourably than if that income had been earned by the deceased. In other words, if the deceased would have been exempted from the TOSI, so will the beneficiary of the property, but if the deceased would have been subject to the TOSI, then so too will the beneficiary unless the beneficiary can independently meet one of the exemptions.

The third exclusion applies to adult individuals ages 25 and over who receive income from Excluded Shares. Excluded Shares in this context are defined as shares of a corporation owned by this 25+ adult who owns at least 10% of the shares of the where the corporation also meets certain requirements. Specifically, the corporation must earn less than 90% of its income from the provision of services, all or substantially all of its income is not derived from a related business in respect of the specified individual, and the corporation is not a professional corporation. Essentially, this exclusion does not apply to service businesses and professional corporations, and tries to prevent these restrictions from being circumvented by having a third entity in between the service business and the individual. So for service businesses and professional corporations the TOSI rules will apply to dividends paid.

The fourth exclusion applies to adult individuals ages 18 and over who receive income from an Excluded Business. An Excluded Business is one in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year in which the income is received or in five previous taxation years. That is to say, if income is received by an individual from an excluded business in 2017, the individual qualifies for this exclusion if he met the actively engaged test for 2017 or if he met the actively engaged test in 5 total previous years – the 5 years do not have to be consecutive.

Other than these four bright line exclusions, the reasonableness test from the original proposal remains substantially unchanged and also serves to limit the tax on split income. Essentially, for individuals 25 years of age or older, any amounts they receive within the limits of a reasonable return are not subject to the tax on split income, while any amounts that exceed the limits of a reasonable return are subject to the tax on split income. The reasonableness test considers 5 factors:

  • The work performed by the individual in support of the related business.
  • The property the individual contributed, directly or indirectly, in support of the related business.
  • The risks they assumed in respect of the related business.
  • The total of all amounts that were paid or that became payable, directly or indirectly, by any person or partnership to, or for the benefit of, them in respect of the related business.
  • Such other factors as may be relevant.

However, the backgrounder released by the Minister in regards to the recent amendments has clarified that part of the determination of a reasonable return is whether an amount is reasonable having regard to the contributions of the individual to the related business relative to other family members who have contributed to that business. This comparison with the contributions of other family members does not appear to be in the legislation, so may fall under the fifth factor which includes any other relevant factors or may be their administrative position on how they consider whether or not a return is reasonable.

For adult individuals 18 to 24 years of age, a different exclusion called a safe harbour capital return can apply. A safe harbour capital return is calculated by a formula and any amounts an 18-24 year old individual receives from a related business equal to or less than the safe harbour capital return value is excluded from TOSI. The safe harbour capital return amount is calculated as A x B where A is the rate equal to the highest CRA prescribed rate of interest in effect for a quarter in the year, and B is equal to C x D/E – C is the fair market value of property contributed by the specified individual in support of the business at the time it was contributed, D is the number of days in the year the property is used in support of the business, and E is the number of days in the year. Put more simply, this formula accounts for the value of the property the individual contributes and how often the property is used by the business, multiplied by a prescribed interest rate such that the more an individual contributes and the more often that property is used by the business, the higher the amount that can be returned to the individual without being affected by TOSI.

Tax Tips – Tax on Split Income

With the increased uncertainty of these new rules, it is more important than ever to speak to a tax lawyer to make sure that any current or future income splitting plans do not fall afoul of the new tax on split income rules. Even with the new tax on split income, income splitting remains a viable and beneficial consideration for Canadian business owners to reduce their tax burden. The additional exclusions from the recent amendments also provide greater opportunity for business owners to start or continue splitting income without being penalized by the tax on split income rules. Call one of our top Canadian tax lawyers and see if income splitting might be of benefit to you.

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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