A dash of income here, a sprinkle of income there: A new recipe for income splitting to please the CRA’s demanding palate
October 28, 2018
In January 2018, changes to Canada’s “Tax on Split Income” (TOSI) legislation came into effect, introducing more stringent rules for private corporations. Corporations have until the end of 2018 to ensure that they are compliant with the new regulations before answering to the CRA.
We’re sure that we don’t have to tell you that, in Canada, income is taxed on an individual basis, not on a household basis. While income tax can hurt, if you own a small business or private corporation, you’ve likely figured out that you can save on income tax by employing income sprinkling (also known as splitting).
Income sprinkling is when a private corporation pays dividends or other types of income to family members in an effort to reduce a business owner’s overall income tax. Smart. But the government is smart when it comes to meeting its needs too.
The not-so-great news:
The CRA has implemented changes to limit your ability to use the sprinkling option.
In the past, the CRA’s TOSI rules targeted income splitting with immediate family members who were minors under the age of 18. The new TOSI rules now apply a broader set of regulations to adults as well as minors. If your circumstance falls under the revised TOSI legislation, any split income will be taxed at a top personal tax rate and individual tax credits may be denied.
Split Income, as defined by the new TOSI rules includes: taxable dividends from private corporations; shareholder benefits; partnership income from related businesses; trust income; debt income; and more.
The government has introduced exclusions for certain circumstances—a few of which we cover below. If you fall under one of the excluded scenarios, TOSI will NOT apply. If you are aged 25 or over, and DON’T qualify for any exclusion, a reasonableness test will weigh any split income against your actual contribution to the business.
Notable exclusions from the new TOSI rules include:
- Retirement Exception: if a business owner is 65 years or older and is receiving split income from a business where they have made a meaningful contribution (see Excluded Business Exception), TOSI rules will not apply. TOSI will also not apply if the business owner’s spouse receives split income from the same business—regardless of their age.
- Excluded Business Exception: the TOSI rules should also not apply for income or dividends from a business or for capital gains from its sale, if a family member 18 or over is engaged in the business on a regular, continuous and substantial basis. A family member generally qualifies:
- If they have worked on average at least 20 hours per week in the business in the current year, during the part of the year in which the business operates; or,
- If they have worked on average 20 hours per week in the business (again during the part of the year in which the business operates), for ANY five years occurring at ANY TIME in the past; i.e., these five years do not need to be in succession. In this case, any dividends or capital gains they receive now or in the future from the family business should not be subject to TOSI.
- Excluded Share Exception: split income paid to individuals aged 25 or over will not be taxed by TOSI standards if it is derived from “excluded shares.” For shares to be considered as excluded shares, the following conditions must be met:
- Shares of the family member must represent at least 10% of the business both by votes and fair market value (these can be separate from the excluded shares).
- The corporation must earn less than 90% of its business income from the provision of services.
- The corporation must not earn more than 90% of its income from one or more other related businesses of the individual that are outside of the corporation.
- The corporation is NOT classified as a professional corporation (that is, it doesn’t belong in a field regulated by a professional governing body like a college).
One challenge is that the government has not explicitly defined every term referenced in the TOSI Act. For example, the Act does not define “services” under the Excluded Share Exception. Another challenge, for the Excluded Business Exception, is proving that a family member has worked 20 hours per week in the past. While the government intends to be flexible, they will need some evidence. Going forward, start tracking working hours.
While the above three exclusions represent notable exceptions, they are not the only ones set out by the government. Additional exemptions include inherited property, capital gain, marriage breakdown, and more.
No set formula:
Need guidance? PROLINK can offer perspectives on what others have done and can connect you to the right resources for your unique operations. Our goal is to build resilient organizations.
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