Income Sprinkling – Is This Possible Anymore?
The draft rules announced by the Department of Finance on December 13, 2017, now extend the TOSI rules to certain family members over the age of 17. The new rules took effect on January 1, 2018. Also, the definition of “split income” has been expanded to include interest income earned on indebtedness, and capital gains (or profits). It is no longer practical for business owners and professionals to split income with family members, as doing so would cause the spouse or child to be taxed at their highest marginal tax rate unless they fall within an exclusion below. Generally, the shareholder (i.e., spouse or child) must show specific labour or capital contributions to the business operations in order to qualify for the exclusions, which are also age-dependent.
Age 18 or Over – income received will not be considered TOSI if it comes from an “excluded business”. An excluded business is one where you are “actively engaged in the corporation’s business on a “regular, continuous and substantial basis”. To satisfy this test, you must have worked an average of 20 hours per week in the business during the year, or in any of the five prior years, which do not need to be consecutive years. CRA has indicated that logbooks, timesheets or schedules should be maintained to support the 20-hours worked. However, it may be problematic to qualify under the five-year rule, due to the records not being kept prior to the 2018 implementation of this new law. (CRA has not provided any guidance for this situation.) Note that if the income is derived from a “related business” TOSI will apply on this income. (An example would be where a business owner (father) pays a dividend to eighteen-year-old son – because of the relationship between father and son, this income would be considered from a “related business” and taxed under the TOSI rules.) Note that TOSI will still apply to direct or indirect capital gains realized on property connected with the business.
If none of the above applies to you, you are allowed to earn a “reasonable return” on your shares based upon the work you did, the property you contributed and the risks you took on.
Unfortunately, if you are between ages 18 to 24, the only factor in determining a reasonable return is the amount of your capital contributions that are made with “arm’s length capital”.
Age 25+ – Individual can generate income regardless of their age if the corporation considered being “excluded shares”. Excluded shares are defined as shares in a private corporation that give you at least 10% of the votes and fair market value of the company. The company must earn less than 90% of its income from services and cannot be a professional corporation. In addition, all or substantially all of the corporation’s income for the last taxation year cannot be derived directly or indirectly from another related business. As mentioned above, the reasonable return test is less stringent for this age group, as it considers if you have made a “meaningful contribution” to the business, such as the work performed by you, the property you contributed directly or indirectly, any financial risk assumed by you in respect of the business (e.g., co-signing a business loan), other payments already received from the business, and other factors deemed relevant. Compared to the age 18-24 group, there is no arm’s length capital requirement for this age group.
If you are relying on the excluded share provision, you will have until the end of 2018 to meet the condition of owning at least 10% of the voting shares and fair market value of the corporation.
Age 65 or Older – if you are age 65 and have “meaningfully contributed to the business”, TOSI will not apply to any private company dividends or capital gains transferred to your spouse. A “meaningful contribution” involves a labour or capital contribution, as well as the financial risk taken on. This rule change will align your situation with the existing pension income-splitting rules.
In addition, TOSI does not apply to amounts received by individual family members if:
- The gain is realized by an individual on his or her death
- The amount is received by an individual from property received as a settlement due to a marriage breakdown
Tax Planning Strategies
Consider lending money to your spouse, child or trust using a prescribed rate interest loan instead of paying dividends to them. You would have to charge an interest rate equal to or less than the current prescribed rate, which is 1%. That way, the passive income earned on the loan would be taxable in the hands of your spouse or child at their marginal tax rate, but you would avoid the TOSI altogether.
Consider paying salaries to family members for work performed, which would be deductible by the payer and reportable by the recipient. The reasonableness test must always be applied to the amount of the salary, however, for it to be deductible. The TOSI rules do not affect salaries.
If you are a beneficiary of a family trust which owns company shares or own shares of an operating company through a holding company, it is advisable for you to hold the shares directly, as under the exemption for “excluded shares”, the shares must be directly held by the individual receiving the income in order for it not to be subject to TOSI. The trust may have to reorganize its shareholdings by rolling the shares over to the beneficiaries. Careful review to ensure the shares meet the 10% value test is needed. In the case of a holding company owning the operating company (“opco”) shares, the income cannot be derived directly or indirectly from a related company (the opco in our example). By holding the opco shares directly, the amount would not attract TOSI.
You can still claim the lifetime capital gains exemption (LCGE), as there is an exclusion from TOSI for taxable capital gains from the sale of qualified farm or fishing property or qualified small business corporation shares. While it is still necessary for the property to qualify for the LCGE in order for the exclusion to apply, you don’t have to actually claim the LCGE.
Business owners may consider buying the shares of family members, or have the corporation re-purchase these shares, so that the shareholders can report a capital gain (taxed at 50%), instead of receiving fully-taxed dividends.
Another tax-planning option is to have the corporation set up an Individual Pension Plan (IPP). The contributions made by the corporation are tax-deductible and the income is allowed to grow in the plan tax-free as well. The business owner can take advantage of pension income-splitting when he retires at age 65. A further incentive for an IPP is that contribution limits are usually much higher than what could be contributed to an RRSP.