“Should ol’ Legislation be forgot, and never brought to mind”
-The Department of Finance
It seems like the government has a ‘knack’ for introducing exceedingly complex and fundamental tax legislation, just as Canadians were getting ready to take a well-deserved break. In our last email sent about the government’s proposed tax legislation (see our July 26th, 2017 email entitled Kraft Berger LLP Summary of Recent Proposed Tax Changes Released on July 18, 2017), the government introduced these tax changes right in the heart of the summer. After receiving over 21,000 submissions, and receiving some large amounts of pushback and media attention, the government has amended its July 18th, 2017 proposals. The following is a detailed summary of the rules. Please ensure to speak to speak to us should you have any further questions.
Proposed Legislation 2.0
On December 13th, 2017, the Department of Finance released its revised proposed legislation (“Proposed Legislation 2.0”) targeting, what it perceives, as legislatively unintended abuses involving “Income Sprinkling” using Private Corporations. This revised legislation supercedes and replaces the July 18th 2017 proposed legislation (“Proposed Legislation 1.0”). One of the main areas of complexity contained within the Proposed 1.0 Legislation was the curtailing of “Income Sprinkling” amongst “inactive” shareholders, or shareholders that did not earn a “reasonable” return on their investment in the private corporation. Dividends (and other types of income) paid to such shareholders would be subject to a Tax on Split Income (“TOSI”), which taxes such income at the highest marginal tax rate.
The changes made in Proposed Legislation 2.0, although still extremely complex and broad in their application, do contain significant improvements to Proposed Legislation 1.0, namely:
- a) “Brightline” tests have been introduced to clarify when a particular shareholder has been “actively engaged” in a particular business;
- b) The proposals concerning restricting the use of the Life-time Capital Gains Exemption (“LCGE”) and the prevention of “surplus stripping” have been abandoned (something the government announced it would be doing in October of 2017);
- c) Many types of income and capital gains will not be subject to the TOSI rules;
- d) The extremely complex “Split Portion” and “Connected Individual” definitions have been abandoned;
- e) Aunts, Uncles, Nieces and Nephews, are not considered to be “related persons” for purposes of the TOSI rules;
- f) The types of shareholders with whom income can be split have been greatly expanded, compared to Proposed Legislation 1.0; and
- g) Certain non-arm’s-length transfers of shares will no longer be re-characterized as dividends.
Only persons who are considered to be “specified individuals” are subject to the potential application of the punitive TOSI rules. Whereas Proposed Legislation 1.0 contained a nearly two-page definition as to whom was a specified individual, Proposed Legislation 2.0 contains a much more concise definition, defining a specified individual as being:
- a) Any person resident in Canada, if that person is over the age of 17 years, (or if the individual died during the year, was a Canadian resident immediately prior to their death); and
- b) Any person under the age of 18 years, if that person has a Canadian-resident parent at any time in the year.
As such, almost all persons resident in Canada will be considered a “specified individual”, and must consider the application of the TOSI rules on income/taxable capital gains received/earned from private corporations.
As alluded to above, only items which are considered to be “split income” (and which are not considered to be “excluded amounts”, as described below), are subject to the TOSI rules. Proposed Legislation 1.0 initially proposed four new types of “split income”. These were:
- a) Interest earned in respect of certain debt obligations from non-publicly-traded entities;
- b) Taxable capital gains realized on the disposition of non-publicly-traded shares, partnerships or capital interest in most trusts;
- c) Certain conferral of benefit provisions; and
- d) Income earned from the re-investment of income previously subject to TOSI.
Proposed Legislation 2.0 has removed the conferral of benefit income, and income earned from the re-investment of income previously subject to TOSI, from the “split income” definition. As such, these types of income are no longer potentially subject to TOSI.
This is the major focus of Proposed Legislation 2.0. If a specified individual earns an amount of income or taxable capital gain that would otherwise be considered “split income”, such income/taxable capital gain will be subject to TOSI, unless the amount constitutes an “excluded amount”. Proposed Legislation 2.0, thankfully, increases the types of income/taxable capital gains which are considered to be an “excluded amount”.
The following income/taxable capital gains are considered to be excluded amounts and are not subject to TOSI:
- If the individual is over 17 years of age:
The amount is not derived from a “related business” (described below) of the individual, or is derived from an “excluded business” (described below) of the individual. For individuals over 17 years of age, where the income is not derived from a “related business”, or is considered to be derived from an “excluded business”, the income earned will not be subject to TOSI. Essentially, if a person related to the individual is not actively engaged on a regular basis in the business and does not have a certain ownership interest in the business, income earned by the individual from that business will not be subject to TOSI. Similarly, where the individual is actively involved in the business for the year, or in any five previous years, the income will not be subject to TOSI.
- a) A related business in respect of a specified individual, is essentially a business carried on at any time in year, by a person related to the specified individual, or carried on by a corporation, partnership, or trust, if the related person is “actively engaged on a regular basis”, in the activities of the corporation, partnership or trust.
- b) Similarly, a related business will also exist, where a person related to the specified individual owns shares in the corporation carrying on the business, or owns property that derives its value from the corporation, if those shares or property represent at least 10% of the fair market value of that corporation.
Contrary to Proposed Legislation 1.0, Aunts, Uncles, Nieces and Nephews are not considered to be “related persons” for purposes of the “related business” definition (a welcome improvement).
An Excluded Business is one where the specified individual is “actively engaged” on a regular and continuous basis, in the year, or in any five previous taxation years. This is a welcome improvement to Proposed Legislation 1.0, as it provides relief for persons who were once active in the business, and are longer active in the business (such as a retiring founder of the business). The five previous years do not need to be consecutive, and years prior to 2018 can be included.
Proposed Legislation 2.0 clarifies to some degree, what “actively engaged on a regular and continuous basis” means. A specific rule deems a person to be engaged on this basis where that person works in the business at least an average of 20 hours in the business per week (during the portion of the year in which that business operates). It should be noted, that for a taxable capital gain to be considered to be derived from an “excluded business”, the five previous taxation criteria must be met.
2) If the individual is between the ages of 18 to 24 inclusive:
The amount constitutes a “safe harbour return of capital”, or a “reasonable return” in respect of “arm’s-length capital” (described below).
If the individual is between the ages of 18 to 24 inclusive and is not actively engaged in the business, the individual can still earn an amount of income from the business without that income being subject to TOSI. However, the amount of such exempt income is limited based on amounts contributed to the business by the individual. Where the amount contributed by the individual was neither borrowed, received from a related person, nor acquired from proceeds received from a “related business”, the individual will not be subject to TOSI on income earned up to a reasonable return (i.e., a return that an arm’s-length investor would realize in similar circumstances). If the amount contributed was received from sources other than those previously mentioned, income earned by the individual on the amount contributed, times a prescribed rate, will not be subject to the TOSI rules (this is referred to as a “safe harbour return of capital”).
Safe Harbour Return of Capital
This relieving provision essentially enables a specified individual between the ages of 18 to 24, to earn income that is exempt from the TOSI rules, to the extent of the property contributed by the individual to the business, multiplied by the prescribed rate in effect during the year. Suffice it to say that in most cases, given the low interest-rate environment, this exception will generally not amount to much of a safe harbour.
Reasonable Return on Arm’s-Length Capital
This rule enables a specified individual between the ages of 18 to 24, to be exempt from the TOSI rules, to the extent that he or she earns a “reasonable return” on property that the individual contributes. Such property must not be: a) borrowed, b) received from a related person (other than as a consequence of death), c) nor acquired from proceeds received from a “related business”.
Essentially, this must be property that the individual contributes from their own sources to the business (such as, for example, from salary earned, or inherited property). Again, this appears to be an exception that will be of little relief in the vast majority of cases, given that it is quite restrictive in its nature. Similarly, it would appear seemingly unlikely, that a person under the age of 25 would have a substantial amount of non-borrowed capital to invest in a business.
3) If the individual is over the age of 24:
The amount is earned on “excluded shares” of the individual, or constitutes a “reasonable return” earned by the individual.
One such relieving measure introduced in Proposed Legislation 2.0, is where an individual earns income from “excluded shares”. Income earned by an individual from “excluded shares” will not be subject to the TOSI rules, notwithstanding that the individual has not made any contribution (labour, capital or otherwise) to the business. Income earned by an individual from a corporation will be considered to be earned from “excluded shares” where:
- The individual is over 24 years of age;
- The individual owns at least 10% of the value of the corporation (and can cast at least 10% of the votes in corporation);
- At least 90% of the business income of the corporation is not earned from the provision of services, or from a related business of the individual; and
- The corporation is not a professional corporation.
An additional relieving measure for individuals over the age of 24, is where that individual earns a “reasonable return” in respect of the business. A “reasonable return” generally means income earned by the individual that is “reasonable” having regard to factors such as, the work performed y the individual in the business, the property contributed by the individual to the business, the risks assumed by the individual in respect of the business, the amounts paid to the individual in respect of the business, and “any other such factors” as may be relevant. Therefore, Proposed Legislation 2.0 is essentially allowing income earned by an individual to escape the TOSI rules, to the extent that the income is commensurate with the contribution(s) made to the business by the individual. This test is extremely subjective in nature, and although the CRA has provided some examples/guidelines as to how it may apply the rules, the CRA admits that such application is a work in progress.
One major relieving provision to Proposed Legislation 2.0, is an exception added for persons owning shares of certain corporations. Essentially, if the person is over 24 years of age, and owns at least 10% of the votes and value of a corporation that earns less than 90% of its revenue from services, and is not a professional corporation, income earned on such shares, or taxable capital gains realized on the sale of such shares, will not be subject to the TOSI rules. Similarly, less than 90% of the corporation’s income cannot be derived from a “related business” of the specified individual.
This carve out will be helpful to non-service-related businesses for shareholders who are over the age of 24 and are not active in the business of the corporation from which the income is earned. Keep in mind, however, that the shares must be owned by the individual receiving the split income. As such, if shares are held via a trust, and the income is earned by the trust and allocated to the individual, the “excluded shares” exception will not be met.
As a relieving transitional measure, the government is allowing persons, until the end of 2018, to meet the 10% votes and value test. Therefore, for 2018 only, a share will be an excluded share if the 10% test is met at the end of 2018 (as opposed to having to meet the 10% test immediately before earning the dividend or realizing the taxable capital gain).
Similar to the test contained in Proposed Legislation 1.0, if the amount earned constitutes a “reasonable return” earned by the individual, the amount will be an excluded amount. In order for this exception to be met, the person must be over the age of 24.
In determining what constitutes a “reasonable return” in respect of a particular amount, the following factors are to be considered:
- The work performed by the individual;
- The property contributed directly or indirectly by the individual (persons 18 to 24, can avail themselves of this criterion only):
- The risks assumed by the individual in respect of the business;
- The total amounts already paid to, or for the benefit of, the individual in respect of the business; and
- Any other factors that may be relevant.
Therefore, for individuals who are over the age of 24, the above factors can be taken into consideration when determining if a particular amount is subject to TOSI. The difficulty will be ascertaining precisely what weight is to be given to a specific factor with respect to an amount of income earned, in determining if the “return” earned by the individual is “reasonable” in the circumstances. Therefore, it will be imperative that precise records be kept as to the various types of contributions made by the individual.
4) If the individual is under the age of 25:
Income/Taxable Capital Gains earned from property inherited from a parent, or, if inherited by a non-parent, the person is a full-time student, or is eligible for the disability tax credit is exempt from the TOSI Rules.
Other Types of Excluded Amounts
In addition to the age-dependent “excluded amounts” identified above, Proposed Legislation 2.0 identifies three additional types of income which are considered to be “excluded amounts”.
- Taxable capital gains arising on the death of an individual;
- Income or Taxable Capital Gains earned from Property transferred between spouses, as a consequence of the breakdown of marriage; and
- Taxable Capital Gains arising from the disposition of Qualified Farming or Fishing Property, or Qualified Small Business Corporation Shares. Such a gain will be an excluded amount whether or not the individual claims the Life-time Capital Gains Exemption in respect of the taxable capital gain.
Income Splitting with Spouses 65 +
One unique addition to the Proposed Legislation 2.0 rules is that if an amount of income would have been an “excluded amount” in respect of an individual’s spouse or common-law partner, and that spouse or common-law partner is at least 65 years of age, then the amount earned by the individual (irrespective of the individual’s age) will be deemed to be an excluded amount, not subject to the TOSI rules. This appears to be an attempt to align these new rules with the pension splitting rules.
Similarly, if the individual’s spouse has died and the amount of income earned by the individual would have been an excluded amount to the spouse in the year of death (had they not died), the amount of income earned by the individual will be an excluded amount, and will not be subject to the TOSI rules. This is true even if the deceased spouse had not yet attained the age of 65.
Other Notable Items
1) As with Proposed Legislation 1.0, Proposed Legislation 2.0 has continuity provisions, which essentially state that if an individual inherits property from a person, the individual is generally deemed to “inherit” the deceased person’s various attributes (i.e., reasonable return factors, age, etc) for purposes of the above rules.
2) A welcome departure from Proposed Legislation 1.0, is that taxable capital gains realized on non-arm’s-length transfers will continue to be re-characterized as dividends, only in cases where the vendor is under the age of 18. Proposed Legislation 1.0 was going to extend this punitive re-characterization to adults who were inactive in the business, which would have resulted in a myriad of technical and practical issues. This is certainly a noteworthy improvement by the government.
Proposed Legislation 2.0 is a significant improvement over Proposed Legislation 1.0 in that the complexity has been reduced, more “brightline” tests have been added, and there are many more exclusions from the TOSI rules; however, the legislation remains exceedingly complex. The rules could have been significantly simplified, while maintaining the government’s objectives, by simply increasing the existing “kiddie tax” age from “under 18”, to “under 25”.
Nevertheless, what this Christmas/New Year’s legislation reminds us of, is that income earned from private corporations can no longer be taken for granted.
The intent of this Newsletter is to provide a general overview of the December 13th, 2017 Proposed Legislation, and is not to be relied upon for tax planning pertaining to your specific situation. Please contact your Kraft Berger advisor to address your tax position, as each situation is unique.”
Written by Justin Abrams
Justin Abrams, Partner, Tax