With the new "income splitting" rules (known as the "tax on split income" or "TOSI") now law effective January 1, 2018, I am constantly asked if income splitting is dead for business owners and their families. Whenever I'm asked this question – especially recently given that we just celebrated Halloween – I think of many of the 1980's slasher movies. Just when you think the villain is dead, he or she magically arise from the dead and starts slashing people to death again. The Department of Finance can probably relate. Just when they think they've effectively killed off income splitting (or using their phrase, "income sprinkling"...a phrase that annoys me), business owners, individuals, and their advisors rise from the dead to create new income splitting plans. We'll see if the Department of Finance will continue on with the 80's slasher movie standard plot where they will fight the villain until the villain is eventually dead.
However, like the 80's slasher movies, there's usually version 2 or 3 or 4 or 5, etc. of the movie. And somehow, the villain always seems to be resurrected magically. In my opinion, income splitting is kind of like that. No matter what the Department of Finance dreams up to stop perceived mischief, income splitting plans will survive, especially if the affected parties feel targeted, attacked and their overall tax situation is not fair. Believe me, after the embarrassing July 18, 2017, private corporation tax rollout by the Department of Finance, there is no shortage of parties who feel that way. I'm sure the Department of Finance would like to forget some of the experiences, but I think it's fair to say that generally the tax community and their clients who are private business owners have not forgotten and are still bitter. Accordingly, such affected parties and their advisors are aggressively looking for legitimate ways to continue to income split.
There is no shortage of aggressive income splitting plans. Although these will not be discussed here, in my opinion some of the "plans" are just simply wrong. Some involve sophisticated planning taking advantage of various provisions of the Income Tax Act (Act), while others are more vanilla income splitting plans include the following:
Examine the Exits from the TOSI "Escape Room" – one of our firm's friends describes the TOSI legislation as an escape room. It's your job to find the exits. And the exits are not clearly marked. That's an excellent analogy. There are certainly exists from the TOSI rules. If you're lucky enough to navigate your way through and find one of the exits, then income splitting is still fair game. The simple fact, however, is that the TOSI legislation is so horribly complex that the average business owner and non-tax specialist advisor will not be able to navigate the escape room and will likely be permanently trapped. Such people will, unfortunately, need to hire tax specialists to help them navigate and find the exits (or even just to know that they are caught). In my opinion, that is simply not right. The average business owner and their accountants (or other advisors) should not need to seek the assistance of tax specialists (like our firm) for such a common issue – family remuneration from their business – that applies to a very broad audience. When this is necessary, the tax system risks a complete breakdown. My colleague – Kenneth Keung – will soon be releasing a more detailed blog about the TOSI rules and the exits. (Our firm has developed a TOSI flowchart that can assist the navigate to exits and can be accessed here). In the meantime, business owners and their advisors should very carefully seek the exits from the TOSI rules to see if there are opportunities.
Prescribed Rate Loans – these plans have been very common over the years to split income with family members and avoid the attribution rules. For example, a common plan would be to have Mom loan money to a newly formed trust for the benefit of the Family (including Mom, Dad, and children). As long as the loan bears interest at the "prescribed rate" at the time the loan was made and the interest is timely paid on an annual basis, then the trust can realize the underlying income with no attribution to Mom. In addition, as long as the trust's income was comprised of passive income derived from publicly traded securities, then the "kiddie tax"would not apply if such income was paid – or made payable – to any minor beneficiaries of the trust.
With the new TOSI rules, prescribed rate loan planning like the above can still work. However, there is now a caution that needs to be added. Overly simplified, if the investment activities of the recipient of the loaned funds (in the above example, the trust) can be considered to rise to the level of a "business," then the trust would be considered to have a "related business" and the TOSI rules could then apply. The common law and the Canada Revenue Agency's ("CRA") administrative views have consistently shown that the activity level to constitute a business is low. Accordingly, prescribed rate loan planning should keep this risk in mind by ensuring that the investment activity level of the recipient is as passive as possible to maintain the position that the activity levels of the recipient of the loaned funds do not rise to the level of a business.
Salaries to Family Members – Salaries (or director fees or other types of remuneration) are not subject to the TOSI rules. Instead, they are subject to the normal provisions of the Act that have long applied to such remuneration. The two most common provisions that are used to attack unreasonable salaries paid to family members are:
- Paragraph 18(1)(a) of the Act which – for the purpose of computing income from a business or property – will deny the deduction of an outlay or expense except to the extent that it was made or incurred by the taxpayer for the purpose of gaining or producing income from the business or property. In plain English, was the salary paid to gain or produce income from the business? If not, then no deduction.
- Section 67 of the Act which states that when computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible, except to the extent that the outlay or expense was reasonable in the circumstances. In plain English, if the amount expended is not reasonable in the circumstances then no deduction.
The application of the above provisions does not affect the taxability of the amounts received for the recipient of the amounts.
So let's consider a simple fact pattern involving Mr. and Mrs. Apple who collectively own all of the shares of AppleCo. Mr. Apple is active in the business while Mrs. Apple is not and will never be. AppleCo is in the business of providing repair services to Windows-based computer users. Mr. Apple is frustrated with the new TOSI rules and decides that he wants to pay a $75K salary to Mrs. Apple instead of paying a $75K dividend to her. Is that legitimate income splitting? Likely not. Paragraph 18(1)(a) and / or section 67 of the Act will deny the deduction of the $75K salary to AppleCo. However, if AppleCo is eligible for the small business deduction, then AppleCo's corporate tax rate on the first $500K of profits will approximate 10%. Accordingly, in our example, the denied deduction will cost AppleCo $7,500 in corporate tax. In addition, Mrs. Apple will pay tax on the $75K she has received. Accordingly, this type of planning becomes a simple math game. What will the personal tax be on the amounts received by Mrs. Apple? Add that to the additional corporate tax as a result of the denied deduction for AppleCo and compare the total to what the tax would be had a dividend been paid to Mrs. Apple with the application of TOSI. If the resulting math is positive, then consideration should be given to this. However, the CRA might not be amused by this type of planning. They might argue that the payment of the unreasonable salary to Mrs. Apple was a shareholder appropriation and, if so, they would seek to apply TOSI to the $75K received by her (since a subsection 15(1) shareholder benefit is caught by TOSI), or in the worst case they may argue the that the payment is a benefit to Mr. Apple thus resulting in double taxation. While arguments can be made against shareholder benefit applications, this risk should be considered before attempting to do this kind of income splitting, especially if the salary payment is significant.
So, like the 1980s slasher movies, it's bloody out there. The Department of Finance will likely continue to keep an eye on the resurrection(s) of the villain and bring out new weapons. The weapons may be effective in the short-term, but we're confident that the villain will always rise from the dead to ensure the movies keep coming.
On December 5, Moodys Gartner Tax Law will host the Tax on Split Income ("TOSI") – Last Minute Review and Planning Webinar. We'll review the legislation along with numerous examples of application, and discuss basic planning that should be considered before December 31, 2018.
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