INCOME SPLITTING – UPDATE
In July 2017 the Federal Liberal Government introduced proposals to end income splitting. Since then there have been a number of changes in response to criticism and a final set of rules were released effective January 1, 2018.
The objective of these rules is to eliminate the tax benefit generated from payments to a family member who has not contributed to the family business. This has been done by the introduction of Tax on Split Income (“TOSI”) which applies the highest personal tax rate to the income a family member has received from the family business.
The hard truth is that if you ordinarily income split with your spouse, adult children or other family members your personal income tax bill due in April 2019 will be much higher than it has been in prior years.
There are a number of exclusions from TOSI which we will briefly outline below:
1. Business owners aged 65 and over
The TOSI rules have an exception that is intended to allow a business owner to income split in retirement so the rules are consistent with the pension income splitting rules. The exception allows a business owner who is over 65 years of age to income split with a spouse without the application of TOSI.
2. Inherited property
Exceptions to the TOSI rules have been provided where an individual inherits property. If the conditions are met by the deceased person, the recipient of the inheritance is deemed to meet those conditions as well.
Therefore, if shares of a company are inherited directly from the primary business owner, the recipient of the inheritance could be paid dividends from that company without the application of TOSI. However, if the spouse of a business owner who does not meet any of the TOSI exceptions leaves shares to an adult child, the adult child would not be exempt of the TOSI rules.
3. Relationship breakdown
On the breakdown of a relationship, property transferred to a spouse while they are living separate and apart and pursuant to a decree, court order, or written separation agreement will also be exempt from the TOSI rules. However, the shares must be transferred directly from one spouse to the other for this exception to apply. Additionally, a former spouse would not be considered a related person and therefore TOSI would not apply.
4. Excluded business
The TOSI rules contain provisions which exempt adult family members who have attained the age of 25 if the family member has actively engaged on a regular, continuous, and substantial basis in the business. One way to meet this test is for the family member to work an average of 20 hours per week or more for the current year or any 5 preceding years. For seasonal businesses, this condition needs to be met only for the period of the year the business operates. If this condition is met, the family member will need to be paid directly from the business they are doing the work for. The exclusion will not apply if the family member is paid from a related company or a holding company. There are other ways of meeting this criteria but they are beyond the scope of this short discussion.
5. Excluded shares
The excluded share exception allows businesses that earn less than 90% of their business income from services to be exempt from the TOSI rules in some circumstances. Professional corporations will not qualify for this exception, so it is not available to accountants, dentists, doctors, lawyers, etc. The recipient of the income must directly own at least 10% of the votes and value of the business. As a result, family trusts can not be used to pay these individuals and a restructuring may be necessary for the conditions of this exception to be met.
6. Reasonable Return – under age 25
The TOSI legislation allows for a reasonable return to be paid to family members however the conditions to determine a reasonable return are much more onerous for those under the age of 25. Family members under the age of 25 will be limited to receiving a reasonable return on the value of contributions they have made to the business. A reasonable return is not defined so its presumably the amount of return one would expect if they invested in a similar business of an unrelated person. However, we know that the guideline for the maximum amount that may be paid is equal to CRA’s prescribed rate which is currently 2%.
7. Reasonable Return – age 25 and over
The exceptions for those aged 25 and over are much more broad. A reasonable return considers various factors to determine the contribution made by the family member. These factors include the work performed, investment contributions, and risks assumed. This will increase the administrative burden and risk of paying family members as a business will have to track/log all contributions and attempt to determine a reasonable return for the contribution made.
The TOSI rules do not impact salary payments made to family members. Salary payments have always been subject to a reasonability and business purpose test. This prevents a business from deducting salary payments that are unreasonable or that are not incurred for a business purpose.
Ultimately, these new laws along with existing laws make it much more difficult for a business to pay family members. If the TOSI rules apply, they not only eliminate any benefit, they can be punitive in some situations. There are still opportunities to income split in some circumstances so its more important than ever to get tax advice before making salary, dividend, or any other payments to family members.
Please contact us as soon as possible to discuss tax planning options available for the year. In some cases, it may be necessary to implement these plans before Dec 31 to maximize any benefits and minimize costs of the new rules.
