Tax Alert - Government Simplifies Measures to Rein in Income Sprinkling

On December 13, the federal government released legislation to simplify restrictions on income sprinkling, proposed to go into effect January 1, 2018. These revisions indicate they have listened to feedback during the consultation period, by providing more certainty to taxpayers through the introduction of “bright-line” tests to automatically exclude some family members, and allow income sprinkling for those members who make sufficient contributions to the business.

We invite you to join our webinar Reining in Income Sprinkling II: Reviewing Revised Legislation on Friday, December 15 at 12:00 pm ET to learn more about the revised tax on split income proposals and how they might impact you.

Register

Following is a summary of what the revised legislation contains.

Tax on Split Income Rules

Beginning in 2018, the tax on split income (TOSI) will be expanded to apply in respect of certain amounts received by adult individuals. Generally, these amounts will include dividends or interest paid by a private corporation directly or indirectly to an individual from a related business, certain split income from partnerships and trusts, and capital gains or profit from the disposition of certain properties, subject to specific exclusions.

Exclusions from TOSI

Exclusions from the TOSI rules will generally apply to income or gains derived from businesses where an individual has significantly contributed time or capital to the success of the business. As discussed below, there is a significant new exception for taxpayers and their spouses who are age 65 and older. In addition, the capital contribution exception is modified for taxpayers who are between 18 and 24 years of age.

Taxpayers over age 24

Taxpayers who are over age 24 can avoid the TOSI rules on income received from a company if they own shares (excluded shares) that represent at least 10% of the votes and value of the company at the time the income is received. This is a capital contribution test that only applies to shareholders over age 24. Using the example of a dividend, if the shareholder owns excluded shares, then a dividend on these shares is not split income. In addition, to qualify as an excluded share the business of the corporation is restricted to businesses where less than 90% of the income of the corporation is from services. There are also specific restrictions in that professional corporation shares cannot be excluded shares.

A special transitional rule applies for purposes of applying the 10% test noted above to allow this test to be applied at the end of the year in respect of 2018 only. That is, if an amount is received in 2018, and at the time of receipt, the taxpayer does not own 10%, the amount received could be excluded from TOSI in 2018 if they increase their ownership to 10% by the end of 2018.

If the taxpayer does not meet the capital contribution test, then they can still avoid TOSI if they meet the labour contribution test. Under this test, the taxpayer must be actively engaged in the business on a regular, continuous and substantial basis in either the taxation year, or in any of five prior taxation years. For these purposes, the Canada Revenue Agency has established a “bright-line” test, whereby an individual is considered to be actively engaged in the business if they work an average of 20 hours per week in the business during the year, or in any five previous taxation years. In the situation of a seasonal business where that business operates for only part of the year, this 1,000-hour annual requirement will be prorated for the portion of the taxation year of the individual that the business operates. Note that any combination of five previous taxation years would satisfy this test. The five previous years need not be consecutive or be after 2017.

Finally, the TOSI rules can further be avoided where the income receipt represents a “reasonable return”. This concept is further explained below.

Taxpayers between ages 18-24

For taxpayers in this age range, the labour test or a modified capital contributions test applies. Where the labour test is not met, then the amount received must instead fit into one of two specific return of capital tests.

Adults over the age of 65

The TOSI rules will not apply to income or capital gains received by an individual from a related business where that individual's spouse (or common-law partner) made contributions to the business and has reached the age of 65 years in or before the year that amounts are received. This also applies where the individual's spouse died in the year and the amounts would be excluded from TOSI had they been received by the individual's spouse in the year in which they died.

Other Changes

In addition, TOSI will not apply to compound income (income earned from the investment of income that was subject to TOSI or other attribution rules) as was proposed in July. Another change from the July proposals is that aunts, uncles, nieces and nephews will not be considered to be related individuals for purposes of these revised TOSI rules. Income from property that is acquired by an individual as a result of a marriage breakdown, pursuant to a court order or separation agreement, will also be excluded from TOSI.

Capital Gains

Beginning in 2018, the definition of split income is expanded to include taxable capital gains and income from the disposition after 2017 of certain property. Rules will apply to exclude specific taxable capital gains from an individual's split income. These include taxable capital gains that arise from the disposition of property that can qualify for the lifetime capital gains exemption (i.e. qualified small business corporation shares and qualified farm or fishing property, as well as those that arise as a result of an individual's death). Note that the current rule that re-characterizes certain capital gains realized by minors on non-arm's length transfers into taxable dividends continues to apply to minors, but will not be extended to individuals over 17 years of age.

Reasonable Return

For individuals aged 25 or over who cannot rely on the exclusions outlined above, an amount can still be an excluded amount if it is a “reasonable return” based on one or more of the following “reasonableness criteria”:

• Labour Contribution - work performed by the individual in support of the related business before the amounts became paid;
• Property Contribution - property contributed by the individual in support of the related business;
• Risk Incurred - risks assumed by the individual in respect of the related business;
• Historical Payments - total amounts paid by any person or partnership to or for the benefit of the individual in respect of the related business; and
• Such other factors that may be relevant.

The Canada Revenue Agency has stated that the determination of a “reasonable return will be based on the facts and circumstances of each case”, and has provided factors that will be considered in making that determination. For example, what constitutes a reasonable return is also determined with regard to previous amounts received from the business.

For individuals aged 18 to 24 who have contributed “arm's length capital” in support of a business, their reasonable return from the business would be based only on that property contribution of the individual.

Please contact one of our trusted BDO advisors to discuss your plan to split income with family members to ensure that you maximize income sprinkling opportunities under the new rules.

Dave Walsh
Canadian Tax Service Line Leader

Rachel Gervais
GTA Tax Service Line Leader

Peter Routly
Central Canada Tax Service Line Leader

Daryl Maduke
Western Canada Tax Service Line Leader

Shelley Smith
Eastern Canada Tax Service Line Leader

Learn more about BDO's Canadian Tax Services