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The announcement in Budget 2017 that the Government was reviewing tax reduction strategies using private corporations created uncertainty and much speculation. On July 18, 2017, draft legislation (the « July Proposals« ) was released, which proposed to amend many sections of the Income Tax Act (Canada) (the « Act« ), including section 120.4, otherwise known as the « kiddie tax » or « tax on split income » (« TOSI« ). Shortly after a public consultation period, in which business owners, tax practitioners, and professional organizations had much to say, the Government made a series of announcements dialing back the July Proposals. One announcement was its intention to simplify the TOSI amendment to limit the ability of owners of private corporations to split income with their family members. On December 13, 2017, the Department of Finance released amended draft legislation with respect to the TOSI rules (the « December Revisions« ).
We wrote about the new TOSI rules in a previous article. Generally, income considered to be « split income » will be subject to the TOSI rules unless the amount is considered to be an « excluded amount ».
What is an « excluded amount »?
Income will be considered an « excluded amount » if the amount falls into one or more of several categories. In the first article of this series, we discussed some of the exceptions, including the retirement exception, the excluded business exception, the excluded share exception, and the qualified capital gains or qualified farm or fishing property exception. The following are the remaining categories where income is not subject to the TOSI rules:
(a) Inheritance exception (under 25 years old). For individuals under 25 years old, income from property that was acquired as a consequence of the death of the individual’s parent will not be subject to the TOSI rules. This exception also applies to income from property that was acquired as a consequence of the death of anyone, and is not limited to the death of a parent, if the individual is enrolled as a full-time student during the year at a post-secondary educational institution or the individual is eligible for a disability tax credit.
(b) Breakdown of relationship (divorce) exception. There are several anti-avoidance provisions in the Act that apply to spouses or common-law partners that are not applicable on the breakdown of their relationship. In keeping with this general scheme, property acquired by the individual under a transfer pursuant to a judgment or written separation agreement will not be caught by the TOSI rules if, at the time, the individual and the transferor were living separate and apart from each other because of a breakdown of their marriage or common-law partnership.
(c) Death exception. Canada does not have an estate tax. Instead, there is a provision in the Act that deems a disposition of each capital property of the taxpayer immediately before their death. Split income that is a taxable capital gain that arises from this deeming provision will not be subject to the TOSI rules.
(d) Safe harbour return exception. Income from a « safe harbour capital return » of the individual will not be subject to the TOSI rules. A « safe harbour capital return » is a new definition and is generally equal to 1% (the prescribed rate) of the fair market value of the property that the individual contributed to the related business, pro-rated based on the number of days the property was used in the business and not returned.
(e) Reasonable return exception (25+ years old). For taxpayers 25 years and older, income that is a « reasonable return » in respect of the individual will not be subject to the TOSI rules. Income that is in excess of a reasonable return will be subject to the TOSI rules unless the income fits within a different exception. When determining whether an amount of income is considered reasonable, the Government will look at an individual’s contribution to the business in relation to the following factors:
(i) work performed in support of the related business;
(ii) property contributed, directly or indirectly, in support of the related business;
(iii) the risks assumed in respect to the related business;
(iv) the total of all amounts that were paid or became payable, directly or indirectly, by any person or partnership in respect of the related business; and
(v) such other factors as may be relevant.
(f) Reasonable return exception (18 – 24 years old). For taxpayers between the age of 18 and 24, the reasonable return exception is substantially narrowed. It appears that only an « arm’s length capital » contribution of the individual is considered and nothing else. The new definition of arm’s length capital means any property except the following:
(i) property that was acquired as income from, or a taxable capital gain or profit from the disposition of, another property that was derived directly or indirectly from a related business;
(ii) property that was borrowed under a loan or other indebtedness; or
(iii) property that was transferred, directly or indirectly by any means whatever, from a related person (other than as a consequence of death of a person).
The possible exceptions from the proposed TOSI rules discussed in this article and our previous article are summarized in the following table:
|Under 18||18 – 24||25+||65+|
|Breakdown of relationship||X||X||X||X|
|Qualified capital gains or qualified farm or fishing property||X||X||X||X|
|Safe harbour return||X|
|Reasonable return – « arm’s length capital » only||X|
At first glance, the inheritance exception is nothing new and appears similar to the « old » definition of excluded amount. The original intention of the TOSI rules was to discourage income splitting with minor children (hence the term « kiddie tax »). However, income from property acquired on the death of a parent or income from property inherited by individuals with a disability or in full time attendance at a post-secondary institution was excluded. This provided some relief to those under 18 years old. Since kiddie tax only applied to minor children, there was no need for a relieving provision for those 18 years or older. Although the new TOSI rules apply regardless of age, this relieving provision is only available for those under 25 years old, potentially leaving individuals 25 years and older with a higher tax burden. There is a relieving provision in paragraph 120.4(1.1)(b) of the Act that allow individuals aged 18 years and older that inherit property to step into the deceased’s shoes when assessing whether income would be considered a « reasonable return » or from an « excluded business ». However, it may be difficult to produce evidence to show the labour contributions of a deceased shareholder, particularly since most business owners did not historically keep such records.
To fall within the divorce exception, the income must be from property acquired pursuant to a court order or written separation agreement. It will be important to wait for a judgment or written separation agreement before earning income from property received on a dissolution of a relationship. However, once no longer married or in a common-law relationship, income received from such property may no longer be subject to the TOSI rules.
If split income is not excluded by another exception, then there must be an assessment as to whether the amount is reasonable in the circumstances. If relying on this exception it will be prudent to keep records justifying the amount of income. This may include a log of work activities and outcomes, or information regarding the expected earnings of an arm’s length individual doing the same work with the same results. Until further guidance is provided by the CRA or the Tax Court of Canada, it is unclear how this exception will be interpreted or the evidence that a taxpayer will be expected to produce.
While interpretive guidance was released at the same time as the December Revisions, the rules are complex. The December Revisions are effective as of January 1, 2018, unless further changes are made prior to enactment, possibly in the upcoming Budget 2018.
If you or a family member receives income that could be characterized as split income, we suggest that you seek tax advice to determine the extent to which these new TOSI rules may apply to you.
Budget 2018 is being tabled on February 27, 2018. Please watch for our upcoming articles on the new TOSI rules after the Budget is released.