Revised Draft Income Sprinkling Rules Released

On December 13, 2017 the Department of Finance released revised draft legislation concerning the income sprinkling rules.  These rules were originally announced on July 18, 2017 and were the subject […]

On December 13, 2017 the Department of Finance released revised draft legislation concerning the income sprinkling rules.  These rules were originally announced on July 18, 2017 and were the subject of much criticism.

The new rules are to take effect January 1, 2018.  The new rules are an improvement over the rules released on July 18 but still leave much to be desired.

As a recap, the rules subject “split income” received by a “specified individual” to the highest marginal tax rate, regardless of the marginal tax rate that would otherwise apply to the individual.  This tax is referred to as “tax on split income” or “TOSI”. 

Very generally, in the context of most family situations, “split income” is a reference to taxable dividends received from private corporations, taxable capital gains realized from the disposition of shares, and income allocations from family trusts.  The specified individual is in most cases usually a spouse or common-law partner, but can also be a child.

In a family situation where income sprinkling is occurring, the income received will in most cases be split income.  Is it then subject to TOSI?

Excluded Amount

Under the new rules, if the income can be regarded as an “excluded amount”, it is not subject to TOSI, and the income sprinkling is permitted.  There is a laundry list of excluded amounts – some are easier to obtain but involve significant family events; others are harder to obtain because of the criteria that need to be met.

An excluded amount is generally one of the following:  To the extent that the income amount…

1. Is received by an individual who has not attained the age of 24 before the current year on property that is inherited from a parent. If the property is inherited from other than a parent, the income may still be an excluded amount if the individual is enrolled as a full-time student at a post-secondary institution, or is claiming the disability tax credit. [1]

2. Is from a property acquired by the individual as a result of a qualifying matrimonial property division (i.e.: divorce).

3. Is a taxable capital gain that arises because of a deemed disposition immediately before death.

4. Is a taxable capital gain from the disposition of property that is qualified farm or fishing property of the individual or qualified small business corporation shares of the individual.

These are the easier ones.  The harder ones are as follows:  Again, to the extent that the income amount…

5. Is derived from an “excluded business”.

If the specified individual is actively engaged on a regular, continuous and substantial basis in the activities of the business in either the taxation year or in five of the previous taxation years, then it is an excluded business.

The rules deem an individual to be actively engaged on a regular, continuous and substantial basis in the activities of a business in a taxation year if the individual works in the business on average at least 20 hours per week during the portion of the year in which the business operates.

The five-year test is intended to ensure that individuals who have made significant labour contribution to a business over a number of years will continue to be exempt from TOSI in respect of income derived from the business after the individual has retired from, or reduced their involvement in, the business.  In order to qualify, it is not necessary that the five preceding years be continuous.  These years can be before the effective date of these new rules.  This then means that once a person has “worked” for a least five years in the business, TOSI will not apply on a go-forward basis, and full income splitting is permitted.

6. If the individual has attained the age of 24 years before the current year, is income from, or a taxable capital gain from the disposition of, “excluded shares” of the individual.

If you’re not a professional corporation or a business providing services (ie: consulting), then this is the excluded amount exception for you. 

If the shareholder receives a dividend from a corporation, the shareholder owns greater than 10% of the votes and value of the corporation, and:

  • The corporation is not a professional corporation, and
  • Less than 90% of the corporation’s income for the last taxation year of the corporation that ends at or before that time was from the provision of services the shares are excluded shares.

To summarize, if a specified individual receives split income on excluded shares, the income is an excluded amount and TOSI does not apply.

Based on early application examples provided by the Canada Revenue Agency, dividends received from an investment holding corporation may be exempt from these rules due to the excluded share exception.

7. If the individual has attained the age of 24 years before the current year, a “reasonable return” in respect of the individual.

The reasonable return exception is similar to the reasonability requirements previously referenced in the July 18 rules.  Here, an amount is not subject to TOSI on income derived from a related business if the amount is reasonable having regard to the relative contributions of the individual and other family members who contribute to the related business.  This is no longer an arm’s length test but rather a comparison to other individuals that are involved in the business.

The factors to be considered are as follows:

a. The work they performed in support of the related business,
b. The property they contributed in support of the related business,
c. The risks they assumed in respect of the related business,
d. The total of all amounts paid or payable to them in respect of the related business, and
e. Such other factors as may be relevant.

The reasonable return exception does not apply if the specified individual is under the age of 25.

Other Excluded Amounts

Not necessarily a harder exception to achieve, but which can only be explained once the concept of excluded amount is understood, TOSI will not apply to income received by an individual from a related business if the individual’s spouse made the contributions to the business and has attained the age of 65 years in or before the year the amounts are received.  The above provision aligns the ability to income split on retirement income similar to the pension income splitting rules.

There are other excluded amounts that are not discussed above such as when an individual under the age of 24 makes a contribution of property (i.e.:  loan or share subscription) in support of a related business.

Also, the July 18 rules included aunts, uncles, nieces and nephews as a potential specified individual.  The new rules do not reference these individuals.

Final Comments

The government has consistently taken a tone that professionals are abusing the tax system.  This tone is evident in the excluded share carve-out where professional corporations are specifically excluded.  However, in drafting these rules, the government has also targeted those businesses that provide services, not just professional services.  It seems that if the business builds something, creates something, sells a product, etc. then income sprinkling is permitted (as long as the requisite number of shares are owned).  While there are various ways to fit into an excluded amount, if the excluded share exception is the only way, it would be necessary, for example, for a hair salon to start tracking its income sources based on income from haircuts versus income from product sales.  In the same vein, is a car repair facility selling a repair service or selling a product when oil is changed and new brakes are installed?

Also, the government has now had two attempts to clarify whether the rules apply to dividends received from investment holding corporations.  The rules as presented on first blush do not appear to apply to dividends received from investment holding companies.  However, application examples provided by the Canada Revenue Agency do reference investment holding company situations, implying that a “business” includes the earning of investment income.  This issue will need to be further studied.

Next Steps

It will be important to get educated on these new rules and continue the dialogue with your professional advisor.  If there is a family member receiving income from a business (or investment holding corporation), it’s time to chat.

[1] There are also other inheritance rules not summarized here.