Tax Changes for Small Business

On December 13, 2017, the Department of Finance released a number of updates relating to the proposed changes to private corporation taxation, in particular, the income sprinkling proposals, which were originally announced on July 18, 2017. Below is an update of the changes to the proposals.

Individuals that receive certain types of income derived from a “related business” will be subject to Tax on Split Income (TOSI) unless an exclusion applies. TOSI is subject to the highest personal tax rate with no benefit of personal credits.

Commencing on January 1, 2018 TOSI will potentially apply in respect of amounts that are received by adults, not just those under 18 years. The application of TOSI to individuals under age 18 (commonly known as the “kiddie tax”) would not generally change.

Income Streams at Risk

Private corporation dividends, partnership allocations, trust allocations, capital gains, and income from debt may all be subject to TOSI.

Tax on Split Income (TOSI) Revised

The proposals continue to rely on an extension of the TOSI to combat income sprinkling perceived as abusive by applying the highest personal tax rate, with no personal credits, to such income. The application of TOSI to individuals under age 18, introduced in 1999 (commonly known as the “kiddie tax”), is not proposed to change. Commencing in 2018, however, the TOSI will also potentially apply in respect of amounts that are received by specified adult individuals, either directly or indirectly, from a related business.

Related Business and Source Individuals

A related business  in respect of a taxpayer includes any business where another individual related to the taxpayer:

  • personally carries on the business (this means income from a sole proprietorship to a related person can be subject to TOSI);
  • is actively engaged in the business carried on by a partnership, corporation or trust;
  • owns shares of the corporation carrying on the business;
  • owns property the value of which is derived from shares of the corporation having a fair market value not less than 10% of the fair market value of all of the shares of the corporation; or
  • is a member of a partnership which carries on the business.

Exceptions and Exclusions

Responding to many of the criticisms of the proposals, several exclusions from the TOSI rules for specified adult individuals were introduced. Where any of the exclusions apply, an individual will not be subject to TOSI on income received from that related business.

  1. Excluded Business: A taxpayer over age 17 will not be subject to the TOSI on amounts received in the year from an “excluded business”.  An excluded business a business in which the taxpayer is actively engaged on a regular, continuous and substantial basis in either the year in which the income is received or in any five previous years. The five taxation years need not be consecutive.An individual will be deemed to be actively engaged in any year in which the individual works in the business at least an average of 20 hours/week during the portion of the taxation year that the business operates. If a taxpayer does not meet the 20-hour per week bright line test, then it is a question of fact as to whether the taxpayer was actively engaged in the business on a regular, continuous and substantial basis.
  2. Excluded Shares: A taxpayer over age 24 will be exempt from TOSI in respect of income received from “excluded shares”, including capital gains realized on such shares.The definition of excluded shares requires all of the following criteria be met:
    • The shares must be owned directly by the individual taxpayer.
    • The corporation cannot be a professional corporation (i.e. a corporation carrying on the business of an accountant, chiropractor, lawyer, dentist, medical doctor or veterinarian).
    • The corporation must derive less than 90% of its business income from the provision of services.
    • All or substantially all of the income of the corporation must be derived from sources other than one or more other related businesses.
    • The taxpayer must own shares accounting for no less than 10% of the votes which could be cast at an annual meeting of the shareholders and no less than 10% of the value of all issued and outstanding shares.
    • Taxpayers will have until the end of 2018 to meet the condition of owning at least 10% of the outstanding shares of a corporation in terms of votes and value to meet this requirement for the 2018 taxation year. After 2018, they must meet this requirement at the time the income is received.
  3. Reasonable Return: The TOSI will not apply to amounts which reflect a “reasonable return”, defined as follows:
    • For taxpayers over age 17, but not over age 24, the rules are more restrictive. Only a reasonable return in respect of contributions of capital will be eligible. This can be a “safe harbour capital return”, basically the highest prescribed rate of interest in the taxation year applied to the fair market value of property contributed, prorated where it is used by the business for only part of the year. Alternatively, it can be a reasonable return in respect only of “arm’s length capital” contributions, which cannot be property the individual obtained from a related business, a loan or other indebtedness, or a transfer from a related person (other than as a consequence of a person’s death).
    • For taxpayers over age 24, an amount which is reasonable based on work performed for the business, property contributed in support of the business, risks assumed in respect of the business, amounts paid or payable from the business, and any other factors which may be relevant.
  4. Capital Gains: Although the TOSI will be expanded to apply to capital gains of interests in entities through which a related business is carried on, some gains will be excluded. The TOSI will not apply to capital gains arising due to a deemed disposition on death. Capital gains on qualified farm or fishing property or qualified small business corporation shares will also be excluded from TOSI. This exception will not apply where the gain is deemed to be a non-eligible dividend. This deeming provision presently applies only where the purchaser does not act at arm’s length with the taxpayer. The draft legislation further restricts this deeming provision to apply only to taxpayers under age 18.
  5. Retirement Income Splitting: The TOSI rules will not apply to income received by an individual from a related business if the amount would have been excluded from TOSI had it been received by the taxpayer’s spouse and the spouse was age 65 in or before the year in which the amounts are received.
  6. Inherited Property: Where property is inherited from a deceased spouse, any amounts which would have been excluded amounts to the deceased spouse in the year he/she died will be exempt from TOSI to the surviving spouse.Taxpayers under age 25 will be exempt from TOSI in respect of income from property inherited from a parent. Where the taxpayer is either enrolled as a full-time student in post-secondary education, or is eligible for the Disability Tax Credit, the TOSI will not apply to income from property inherited from any person.

    Taxpayers over age 17 who are not exempt from TOSI on income from inherited property under another exception will generally be exempt from TOSI where an exception would have applied had the deceased taxpayer received the income. This provision does not require the deceased individual have been related to the recipient of the property.

  7. Relationship Breakdown: Income derived from property acquired as a result of the breakdown of a marriage or common-law partnership will be exempted from the application of the TOSI rules.

Other Changes

There are a number of other changes to the proposals from those proposed in the Consultation Paper. These include:

  • The Government will not proceed with the proposed measures to apply the TOSI to compound income.
  • The scope of related individuals for the purposes of the TOSI rules will not be extended to aunts, uncles, nieces and nephews.
  • The July proposals restricting access to the capital gains exemption have been abandoned, as has the proposed transitional election to realise capital gains.

Summary

This new draft legislation is a substantial change from the July 18, 2017 proposals. The provisions are lengthy, complex and nuanced, and it is likely that further concerns and challenges will be identified in the coming months. As well, it is uncertain whether there will be further changes, given the concerns which have already been identified, as well as the recommendations of the Senate released on the same date as these proposals.
With the TOSI still proposed to be effective in 2018, existing compensation structures should be reviewed, considering issues including the following:

  • Are existing income streams exposed to TOSI?
  • Are any of the exceptions applicable and, if so, what documentation or other support exists, or should be maintained going forward?
  • Should a permanent file holding any existing documentation be created and maintained?
  • Can planning be undertaken to access exemptions (e.g. increasing hours worked by family members; restructuring to access exceptions, or to more clearly direct income from excluded businesses)?

While there may be further changes to the rules, identifying the planning that may be desired assuming the rules proceed as drafted will minimize delays in implementation once the rules are known with greater certainty, even if these plans must be fine-tuned for any further changes before being implemented.

Administration of Income Splitting Proposals

On December 13, 2017, CRA released both a Frequently Asked Questions document and a series of examples on the application of the proposed amendments.

Reasonableness Test

CRA provided considerable details on the factors they would consider in evaluating the reasonableness test, relevant for taxpayers over age 24 who do not qualify for other exceptions, as follows:

  1. Labour Contribution – the work performed by the individual in support of the related business before the amounts became paid. Factors which may be considered can include the following:
    • the nature of and hours required for the tasks performed;
    • a competitive salary/wage for the tasks in relation to businesses of similar size and industry;
    • education, training and experience;
    • particular knowledge, skills or know-how that the individual possessed;
    • business acumen;
    • records such as timesheets, schedules or logbooks may be provided to establish the number of hours worked in a year.
  2. Property Contribution – the property contributed by the individual in support of the related business. Factors which may be considered can include the following:
    • the amount of capital contributed to the business;
    • the amount of loans to the business;
    • the fair market value of property transferred to the business, including technical knowledge, experience, skill, or know-how;
    • whether the individual has provided property as collateral for loans or other undertakings;
    • opportunity costs; and
    • past property contributions.
  3. Risk Incurred – the risks assumed by the individual in respect of the related business. Factors which may be considered can include the following:
    • whether the individual is exposed to the financial liabilities of the business;
    • whether the individual is exposed to statutory liabilities related to the business;
    • extent of the risk that contributions made by the individual to the business may be lost;
    • whether the individual’s reputation or personal goodwill is at risk;
    • past or ongoing risk assumption.
  4. Historical Payments – the total amounts paid by any person or partnership to or for the benefit of the individual in respect of the Related Business. These should generally include any payment of any kind, benefits, and deemed payments.
  5. Other factors that may be relevant in any particular circumstance. CRA noted that the above list is not to be considered exhaustive.

CRA’s commentary clearly envisions a review of all contributions and payments since the inception of the business. They also indicated that similar considerations will be relevant to determine whether the individual is actively engaged in the activities of the business. For individuals under age 18, there is no reasonableness exception. The reasonable return for an individual age 18 to 24 is restricted to consideration of contributions of capital, either under the safe harbor formula or a reasonable return on arm’s length capital.

Please contact your accountant if you have any questions and to get started on any changes you need to make.