Just over a year ago, Budget 2017 announced that the Government was reviewing the taxation of private corporations. A consultation paper and draft legislation were released on July 18, 2017, which included amendments to section 120.4 of the Income Tax Act (Canada) (the “Act”), otherwise known as the “kiddie tax” or “tax on split income” (the “TOSI Rules”) (“TOSI v1”). After a summer of animated debate, the Government made several announcements in mid-October, including a commitment to simplify the TOSI Rules. On December 13, 2017, the Department of Finance released draft amendments to the TOSI Rules (“TOSI v2”). In February of this year Budget 2018 announced the Department’s intention to move forward with TOSI v2, as modified to take into account consultations and deliberations since its original release. A Notice of Ways and Means Motion was subsequently released with little fanfare, which made some further, relatively small, changes to the TOSI Rules (“TOSI v3”). Finally, TOSI v3 formed part of Bill C-74, Budget Implementation Act, 2018, No. 1, which is currently moving its way through Parliament.
We previously wrote about TOSI v2 here and here. Generally, income considered to be “split income” will be subject to the TOSI Rules, and taxed at the top personal marginal rate, unless the amount is considered to be an “excluded amount”.
Changes to the “Excluded Shares” Exception
In previous articles of this series, we discussed the types of income that can be considered “split income” and the different “excluded amount” categories. The way the TOSI Rules are drafted, “split income” will be subject to the TOSI Rules unless there is a specific exception that applies.
One of the exceptions is the “excluded shares” exception. Split income received by adults aged 25 or older will not be caught by the TOSI Rules if the income was derived from “excluded shares”. Excluded shares are shares of a corporation owned by a specified individual that meet certain conditions, including a “10% votes and value” test.
There was a concern in TOSI v2 that the 10% votes and value test was tested against the particular shares from which the income was earned. Assume, for example, that Spouse 1 holds non-voting preferred shares following a freeze transaction that represents 92% of the fair market value of the corporation. Spouse 1 and Spouse 2 each hold an equal number of voting common shares. Under TOSI v2, it was unclear whether a dividend resulting from the redemption of the non-voting preferred shares would be considered income from excluded shares, as the 10% votes test was not met. Further, a dividend declared on the common shares may not be considered income from excluded shares, as the 10% value test was not met. This would result in dividends derived from any share of the corporation to not be considered derived from excluded shares and not exempt from the TOSI Rules, unless another exception applied.
As a result of changes made in TOSI v3, the 10% votes and value test now considers all of the shares held by the shareholder. In the above example, dividends paid to Spouse 1 would be considered income derived from excluded shares since Spouse 1 collectively held shares that represented 10% of the votes and value of the corporation. This would result in any dividend income of Spouse 1 being treated as an excluded amount and not subject to the TOSI Rules, assuming all the other conditions to be an excluded share are met. However, Spouse 2 will still need to wait until their common shares increase in value, unless another exception applies.
As we previously noted, businesses have until the end of 2018 to plan and complete a corporate reorganization to meet the 10% votes and value test in the excluded shares exception for the 2018 taxation year.
What Should We Do About Family Trusts?
Another condition that must be met for the excluded shares exception to apply is that the holder of the shares must be a “specified individual”, which does not include a trust. This may raise the question that if the excluded shares exception does not apply because the shares are held by a trust, should the shares be distributed to the beneficiaries of the trust(s) and the applicable family trust wound up?
There are some situations where distributing shares to beneficiaries may be the preferred plan. For example, a distribution of assets may be appropriate if the shares would be considered “excluded shares” in the hands of the beneficiaries and the corporation intends to declare dividends on those shares. While distributing assets out of a trust may seem straight forward, there are many tax and legal implications to consider. It is recommended that you seek advice from someone that has experience with trusts prior to any such distribution.
In other situations a family trust may still accomplish the goals of the business owner. Generally, an exempt amount includes capital gains realized by the trust from the disposition of property that is qualified farm or fishing property or shares of a qualified small business corporation, as those terms are defined in the capital gains deduction rules in section 110.6 of the Act. This exception applies whether or not the capital gains deduction is claimed. There is no need to roll the shares to the beneficiaries prior to a sale provided that the taxable capital gain is made payable to the beneficiaries. A family trust can also be used to transfer the growth of a corporation to the next generation. As well, if the family members are active in the business or have contributed property to the business, then the excluded business or reasonable return exceptions may still apply. Finally, planning using prescribed rate loans (now 2% effective April 1, 2018) appears to still be available.
There are also non-tax reasons to keep assets in a trust, such as to protect the asset from creditors or a spouse of a beneficiary, to maintain control of assets if the beneficiary is a spendthrift or is still learning to manage their finances, secrecy, and to assist with disabled family members.
Please watch out for further articles about working with the TOSI Rules. We will also monitor any developments as TOSI v3 makes its way through Parliament.