Is the Future of Income Splitting in Jeopardy?

June 27, 2017


In its 2017 budget, the federal government announced that it would be reviewing certain tax planning strategies that it believes result in wealthy individuals gaining unfair tax advantages over other Canadians. In particular, the government intends to review three tax-saving strategies that involve the use of private corporations and is expected to release a paper shortly to summarize its findings and propose policy alternatives to address these issues. One of these issues is the use of private corporations to split income between family members.

“Income splitting is essentially the redistribution of income among members of the same family, where income-earning assets are transferred out of the hands of the high-income earning family members into the hands of the lower-income family members, making the related income from those assets taxable to the lower-income family members,” explains Eric Wipf, a tax partner in BDO’s Calgary office. “Doing so allows a family to retain the most amount of income by taking advantage of the tax brackets, deductions and credits available to each family member. It’s a fairly common and acceptable practice and is something we, as tax advisors, frequently recommend to our owner-manager clients.”

While income splitting can be achieved in a number of ways, the government is focusing its current review on a form of income splitting commonly known as “income sprinkling.” Where a family business is carried on through a corporation, multiple classes of shares can be issued to family members, either directly or through the use of a family trust, allowing the corporation to distribute (or “sprinkle”) dividends or other income (such as capital gains) to some, but not all, shareholders. In this way, the family’s overall tax burden can be minimized, since income can be paid to the family member shareholders in lower tax brackets.

Often, a tax plan to sprinkle income using a private corporation is carried out as part of an estate freeze. In the basic scenario, the owner-manager would exchange their shares for fixed-value preferred shares, which cannot increase in value, thereby “freezing” the current value of the business. Common shares, which represent the future growth in value of the company, are then held either directly by the owner-manager’s family members, or indirectly by them using a family trust. With such a plan, dividends could be paid on one class of shares to the exclusion of others, which can achieve the income splitting goal. Using a fully discretionary family trust for this purpose can further facilitate income splitting since the trustees can determine the optimal type and amount of income to be distributed to each family member beneficiary of the trust.

“What’s interesting is that the federal government has already put rules in place to prevent certain abuses when it comes to dividend sprinkling,” says Wipf. For instance, the “kiddie tax” rules prevent the transfer of income from high-income individuals to their children under the age of 18. Where dividends or certain other types of business income are paid to a minor child, these rules apply to tax the offending income in the child’s hands at the top federal personal tax rate. Other rules, known as the attribution rules, can also result in adverse tax results in certain situations. Generally, these rules apply where an individual makes a gift or a low-interest or interest-free loan to a spouse or child either directly or indirectly through a corporation.

In light of the existing constraints on income splitting with family members, tax advisors are concerned about what the government might be targeting now. They generally cast a large net that catches more than the issue they are primarily seeking to address “Certainly, we already know that many forms of income splitting with your minor children is a no-no, but income splitting with your spouse or adult children was definitely something that you could do. We will just have to wait and see what happens,” says Wipf. “In the meantime, if your family business operates through a corporation, it isn’t a bad idea to talk with your tax advisor about what you can do now before any changes are proposed.”

As announced by Minister Morneau at a recent Board of Trade speech in Toronto, we expect the government to release a consultation paper in the coming days or weeks proposing changes to the way private corporations are taxed as a way of dealing with these three tax savings strategies. Following the release of this paper, we will be hosting a webinar with Dave Walsh, Tax Service Line Leader for Canada along with a number of our Partners in order to review and discuss the impact on private corporation owners. Our BDO Canada Tax advisors will remain dedicated to providing you with updates and information as it is released.

Update - July 18, 2017

Finance Minister Bill Morneau released the much anticipated consultation paper on July 18 proposing changes to how private corporations are used to gain tax advantages. The Canadian Department of Finance promised a consultation paper, however, Canadian taxpayers received proposals with effective dates and draft legislation on income splitting and conversion of capital gains. The federal government is asking for further consultation around holding passive investments inside a private corporation.  See our detailed review and watch our on demand webinar to learn more about the proposed reforms and how they might impact you.

For more information or assistance, please feel free to contact us.

The information in this publication is current as of June 26, 2017. 

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.

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