On July 18, 2017, the Department of Finance introduced a set of tax rules designed to address what they described as “unfair tax planning strategies” using Canadian Controlled Private Corporations (CCPCs). The Government had since then announced they will no longer move forward with measures that would limit access to the Lifetime Capital Gains Exemption or with measures relating to the conversion of income into capital gains. This, as discussed further in our previous Tax Updates released on the 16th, 18th, and 19th of October 2017.
Until recently, the Government had been silent regarding their initial proposal surrounding income splitting measures. This created significant confusion due to the subjective nature of quantifying one’s “reasonable” compensation based on labour and capital contributions.
On December 13, 2017, the Federal Government made an announcement which purports to clarify the details surrounding their income splitting measures, intended to be effective as of the year 2018 and those years subsequent. Specifically, the announcement was supposed to clarify the process for determining whether a family member is significantly involved in a business and thus potentially excluded from the expanded tax on split income or “TOSI” rules, which would tax split income at the highest marginal tax rate.
The changes include various “bright-line” tests that outline specific criteria that, if met, would exclude income that would otherwise be subject to TOSI rules. If met, income otherwise subject to tax at the top marginal rate would be considered an “excluded amount” from TOSI rules.
Excluded Business Exemption
Adults aged 18 or over who receive income from an “excluded business” will not be subject to the TOSI rules. To qualify as an excluded business, the individual must have made a substantial labour contribution (generally contributing an average of at least 20 hours per week) to the business during the year, or during any five previous years. The excluded business exemption is one of the bright line tests that would result in the income received being an excluded amount.
Essentially, if a family member has made a substantial labour contribution in any five previous years, that individual can receive any amount of dividend thereafter even if they are no longer actively involved in the business at the time the dividend is received. It is not necessary that the five previous years be consecutive, or after 2017. Any combination of five previous years of contribution will satisfy the test. If the bright-line test of 20 hours per week is not met, it is a question of fact whether the individual was actively engaged in the business on a regular, continuous and substantial basis. It is also important to note that past contributions will flow through to any beneficiaries upon death of the individual deeming them to have been actively involved in the business in question in a way that meets the Excluded Business Exemption.
TOSI rules will not apply to specified individuals over the age of 24 years with respect to income received from “excluded shares” owned by the individual. This exclusion from TOSI will apply to income received from a share if all of the following conditions are met:
- The individual has attained the age of 25 years in or before the year income is received
- The individual owns at least 10 percent of the outstanding shares of a corporation in terms of votes and values of the company
- The corporation earns less than 90 percent of its income from the provision of services
- The corporation is not a professional corporation
- All or substantially all of its income is not derived from a related business; for example, a professional corporation pays rent for the building in which the professional business is carried on to a corporation which is owned by the adult children of the professional
While “provision of services” is not a defined term, we understand that the Government is attempting to restrict the income splitting for incorporated professionals, consultants, or those who derive income from providing the services of the individual. While it does not provide any relief for the professionals, this measure does provide relieving measures for other businesses as they will be allowed to utilize income splitting with family members aged 25 or older if the individuals own more than 10% of the company in terms of voting shares and fair market value of shares. The individuals will have until the end of 2018 to meet the conditions of owning 10% or more for their holdings to qualify as excluded shares.
Retirement and Inherited Property
Recognizing the special challenges of planning for retirement and managing retirement income, the revised income splitting proposals will be better aligned with existing pension income splitting rules. TOSI rules will not apply to income received by the business owner and the spouse, provided that the owner has meaningfully contributed to the business and is aged 65 and over.
Furthermore, surviving spouses and individuals who have attained the age of 18 and who inherit the property from a deceased individual will continue to benefit from the contributions made by the deceased and will not be subject to TOSI.
Lifetime Capital Gains Exemption (“LCGE”)
The initial proposals also suggested the application of TOSI rules with respect to Lifetime Capital Gains Exemption. Generally, TOSI will apply on the disposition of shares where the individual has not made a contribution of labour or capital. However, these changes provide for the exemption of TOSI rules where shares can qualify for the LCGE, regardless of an individual’s contributions to the business. As a result, purification of CCPCs in order to meet the conditions of claiming LCGE will be required to ensure TOSI rules do not apply on a sale of shares.
Exemptions for Capital Contributions
Individuals aged 25 or over who do not meet any of the exceptions noted above will be subject to a reasonableness test to determine how much income is taxable at their top marginal rate. The reasonableness tests will consider the individual’s labour and property contributions, as well as the risks assumed.
Furthermore, individuals aged 18 to 24 who do not meet any of the exemptions can also reduce TOSI by relying on a “Safe Harbour Returns Exemption” or an “Arm’s Length Return Exemption”. The Safe Harbour Exemption considers the capital contributed to the business (whether from arm’s length sources or not) multiplied by the highest CRA prescribed rate for that year to determine the TOSI reduction. The Arm’s Length Exemption considers arm’s length capital contributed multiplied by a reasonable return. Arm’s length capital is essentially the individual’s own funds. The capital cannot be received or borrowed from a related person, unless received from the death of a related person. It also cannot be borrowed from a related business or from any source. It should be noted that the reasonable rate of return one could expect is not defined and creates significant uncertainty when relying on this exemption. These capital contribution exemptions do not consider labour contributions or risks assumed.
It should be noted that, for the purposes of TOSI, related individuals will no longer include aunts, uncles, nieces and nephews as initially proposed.
Despite a plea from the Senate Committee to abolish or delay the tax proposals, it appears the Federal Government will proceed to implement the proposed TOSI rules. It is anticipated that the measures will be legislated as part of the 2018 Budget process. Finance also confirmed its intentions to proceed with measures regarding passive investments held in CCPCs, which will be effective after Budget Day.
Corporate structures and estate and succession plans need to be revisited, especially where it is anticipated that adult children will be a part of the business going forward. In these cases, corporate structures should also be reviewed to ensure that the business qualifies as a small business corporation for purposes of the LCGE, at which point the necessary purification strategies should be put into place.
For more details on the proposal, refer to the Department of Finance website.
If you have any questions or wish to receive additional information, please do not hesitate to contact us at firstname.lastname@example.org
The information in this article is of a general nature and is in summary form and may not include all the details noted in the consultation paper. Contact one of our tax professionals to discuss these matters in the context of your situation before acting upon such information.