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With the kiddie tax rule, it is difficult to achieve business income splitting through a corporation with minor children |
Income splitting is the process of redirecting income within a family group to take advantage of the lower tax brackets, deductions and credits available to each family member. Income is split by transferring income-earning assets from high-income to lower-income family members. Of course, there are rules in place to minimize income splitting among family members and one of those rules is the tax on split income or, as often referred to, the kiddie tax. The kiddie tax was introduced in 2000 to prevent the use of certain income splitting arrangements being undertaken at that time. Under the rule, minor children are subject to tax at the highest marginal rate on income they receive under an income splitting arrangement. This income is referred to as “split income” and includes the following sources of income:
- Taxable dividends and shareholder benefits received directly by a minor, or indirectly through a trust or partnership. Dividends and benefits in respect of publicly traded shares are excluded.
- Business income from a partnership or trust, where the income is from property (prior to 2003, this reference was to goods) or services provided to, or in support of, a business carried on by:
- a person related to the minor, including a relative who is a partner of the partnership earning business income,
- a corporation where a relative of the minor owns 10% or more of the corporation’s shares, or
- a professional corporation where a relative of the minor is a shareholder.
Generally effective for 2003 and subsequent years, the government proposed to extend the income splitting tax to catch rental or interest income earned by a trust or partnership from a family business and received by minor children.
Personal tax credits cannot be claimed to reduce the kiddie tax. However, the minor will be allowed to claim the dividend tax credits and foreign tax credits, where applicable, to reduce the tax.
Although limited, there are some exceptions to the kiddie tax:
- The tax will not apply where both of the minor’s parents are non-residents of Canada,
- The tax will not apply on income from property inherited from a parent, and
- If the child is going to college or university, or is disabled, income from property inherited from others won’t be subject to the tax.
In the 2011 federal budget, a proposal was announced to further extend the kiddie tax to apply to capital gains, as tax plans have been developed using capital gains to avoid the kiddie tax on split income. Under this proposal, split income will be expanded to include capital gains realized by, or included in the income of, a minor from the disposition of shares of a corporation to a person who does not deal at arm’s length with the minor, if taxable dividends on the shares (if paid) would have been subject to the tax on split income. Where capital gains are caught under this rule, they will be treated like dividends for tax purposes. This means that beneficial capital gains inclusion rates will not apply and the income will not be eligible to be offset by the capital gains exemption. For reasons that are not clear, this deemed dividend cannot be designated as an eligible dividend and the corporation will not be able to treat the amount as a dividend paid. This will deny proper tax integration and a dividend refund for the corporation if it has refundable tax. The capital gains exemption denial is very punitive as it will mean that an exemption will not be available on a related party buyout even if there are commercial terms.
As announced in the budget, this measure is set to apply to capital gains realized on or after March 22, 2011. Although the government was defeated shortly after the budget was announced, it is expected that this measure will be reintroduced by the new government and possibly with the same effective date. It is also expected that the government will continue to monitor the effectiveness of the kiddie tax rule as a method to minimize income splitting and will propose rules as necessary where avoidance of the kiddie tax is found.
With the kiddie tax rule, it is difficult to achieve business income splitting through a corporation with minor children and the latest proposal to capture capital gains further limits such tax planning techniques with minors. We believe that the changes are far too broad, and it would have been possible to deal with the issues the government finds contentious with more detailed and directed changes that would not unfairly deny capital gains exemption claims for commercial transactions.
Note that income splitting with your spouse and children who are 18 years of age and older is still possible. If you have questions about the application of the kiddie tax or income splitting strategies in general, contact your BDO advisor.
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