Backgrounder on Simplified Measures to Address Income Sprinkling
As the Government of Canada reduces taxes on small businesses, it is ensuring that the benefits of these lower tax rates are shared fairly, and support owners who invest in their business, create jobs, strengthen the middle class and grow the economy.
In July 2017, the Government released a consultation paper with proposals to address unfair tax planning strategies using private corporations. The proposals addressing income sprinkling included draft legislation released for comment. In October, the Government made several announcements with respect to the proposals, including that the Government will not move forward with measures that would limit access to the Lifetime Capital Gains Exemption or with measures relating to the conversion of income into capital gains.
Based on feedback from Canadians during the consultation period, the Government is simplifying and better targeting its proposal to limit the ability of owners of private corporations to lower their personal income taxes by sprinkling their income to family members who do not contribute to the business.
Family members who make a meaningful contribution to the business will not be affected by the new measures.
Summary of Income Sprinkling Rule Changes
Specifically, these tax changes (which are proposed to be effective for the 2018 and subsequent taxation years) will clarify the process for determining whether a family member is significantly involved in a business, and thus is excluded from potentially being taxed at the highest marginal tax rate (known as the tax on split income or TOSI).
The changes include clear, "bright-line" tests – or off ramps – to automatically exclude individual members of a business owner's family who fall into any of the following categories:
- The business owner's spouse, provided that the owner meaningfully contributed to the business and is aged 65 or over. In recognition of the special challenges associated with planning for retirement and managing retirement income, the new approach to income sprinkling will be better aligned with the existing pension income splitting rules. This also reflects the fact that a business can play an important part in supporting its owner in retirement.
- Adults aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hours per week) to the business during the year, or during any five previous years. For businesses with seasonal operations, such as may be the case with farms and fisheries, the labour contribution requirement will be applied for the part of the year in which the business operates.
- Adults aged 25 or over who own 10 per cent or more of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation.
- Individuals who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they would not be subject to the highest marginal tax rate on the gains under existing rules.
Individuals aged 25 or over who do not meet any of the exclusions described above would be subject to a reasonableness test to determine how much income, if any, would be subject to the highest marginal tax rate. In certain cases, adults aged 18 to 24 who have contributed to a family business with their own capital will be able to use the reasonableness test on the related income.
For additional clarity, the Canada Revenue Agency (CRA) has released guidance with respect to these measures. The CRA's guidance will seek to help businesses and family members understand the operation of the measures and, in doing so, effectively reduce their compliance burden in relation to these new rules. Taxpayers with questions regarding its guidance can contact the CRA.
Impact of New Changes
The vast majority of private corporations will not be impacted by these proposals. In fact, the simplified measures have further reduced the number of businesses potentially affected from 50,000 corporations – about 3 per cent of Canadian-controlled private corporations – to fewer than 45,000. More significantly, the proposals provide greater certainty that the revised rules will not apply to individuals who make a meaningful contribution to a business.
Owners of private corporations will have until the end of 2018 to adjust to the new exclusion for non-service businesses.
The revised income sprinkling measures are proposed to be effective for the 2018 and subsequent taxation years. The measures will be legislated as part of the Budget process.
The Government will also move forward with measures to limit tax deferral opportunities related to passive investments, and details of that plan will be included in Budget 2018. When introduced, the passive investment measures will apply only on a go-forward basis.
Other Actions to Ensure Fairness and Support Small Business
As the economy grows, the Government will ensure the middle class shares in the benefits of this growth, by keeping taxes low on middle class Canadians, including small businesses and family-run businesses.
In addition to these changes to the income sprinkling measures, the Government is taking a range of actions to ensure fairness and support small business, including:
- Lowering the federal small business tax rate from 11 per cent in 2015 (to 10 per cent effective January 1, 2018, and to nine per cent effective January 1, 2019), knowing that a continued tax advantage for Canadian businesses – including the lowest small business tax rate in the G7 – will help them to create more jobs and grow the economy.
- Moving forward with measures to limit the tax deferral opportunities related to passive investments, while providing business owners with more flexibility to build a cushion of savings for business purposes – for example, to deal with a possible downturn or finance a future expansion – as well as to deal with personal circumstances, such as parental leave, sick days or retirement.
- Intergenerational transfers. During the consultation period, the Government heard from business owners, including many farmers and fishers, about the challenges with intergenerational transfers of businesses. The Government will work with family businesses, including farming and fishing businesses, to make it more efficient, or less difficult, to hand down their businesses to the next generation.
Gender considerations previously communicated with respect to the proposed income sprinkling measures are not affected by these revised draft legislative proposals. Data show that men represent over 70 per cent of higher-income earners initiating income sprinkling strategies, and women represent about 68 per cent of recipients of sprinkled dividends (and 58 per cent of recipients of income derived from trusts and partnerships). While this income is of benefit for recipients, it also creates incentives that reduce female participation in the workforce. Increased participation of women in the workforce is a source of economic opportunity for individuals and is a major driver of overall economic growth.
Frances worked for her parents' manufacturing business on a full-time basis throughout the year in which she turned 22 to the year in which she turned 28. Frances then stepped back from being involved in the business for three years. Frances received dividend income from her parents' manufacturing business during the years she worked for the business, as well as the three years when she did not participate in the business.
The highest marginal tax rate would not apply in respect of any of the dividends Frances receives. With respect to the dividends received by Frances in the years she was working full-time, the highest marginal tax rate would not apply, on the basis that she was actively engaged in the business on a regular, continuous and substantial basis in the year that the dividend was received (she would also satisfy the "bright-line" test of working an average of 20 hours per week). With respect to the dividends received by Frances in the years after she stepped back from the business, the highest marginal tax rate would not apply as the business would be an "excluded business" on the basis that she was actively engaged in the business on a regular, continuous and substantial basis for at least five prior years.
Jeff and Charles are spouses. Jeff is a doctor practicing family medicine through a professional corporation on a full-time basis. Charles is not a doctor. He runs Jeff's medical clinic and he works four days a week for eight hours a day, taking six weeks of vacation per year (including all of July). The rest of the time, Charles runs a part-time consulting business. Both Jeff and Charles own shares in the professional corporation. Each year, the professional corporation pays Jeff and Charles salaries. The retained earnings in the professional corporation are then paid out as dividends to Jeff and Charles on a 50/50 basis.
Both Jeff and Charles would be considered to be actively engaged on a regular, continuous and substantial basis in the business carried on by the professional corporation. Jeff and Charles would have certainty that they satisfy this condition because they both satisfy the 20-hour deeming rule. Therefore, the highest marginal tax rate would not apply to Jeff or Charles' dividend income.