According to Government of Canada statistics, Canada is home to almost 1.2 million employer businesses, with about three-quarters of them operating in the service sector and the remaining one-quarter in the goods-producing sector.1 The large majority of these Canadian enterprises are small businesses (defined as 1 to 99 paid employees), with particularly strong representation in the construction and retail industries, along with professional and technical services industries.2 Yet while the industries, products or services, and structures may vastly differ from one company to the next, there’s one commonality many business owners currently share — the need to grasp the new proposed tax changes for private corporations and the impact they may have.
In the summer of 2017, the Federal Government (“Government”) released proposed tax changes that would have impacted almost all private corporations in Canada. One of these changes targeted income splitting with family members through a private corporation. Many business owners raised concerns, and after a consultation period and a review of submissions received during that period, the government released revised draft legislative proposals in December, which outlined the narrower scope of the proposed income splitting rules and offered more clarity in regards to what the changes entail. These proposed changes to the income splitting rules may impact a number of business owners to a varying degree, and there may be additional challenges for some professionals with professional corporations. The Government confirmed its intention to move forward with these proposals in the 2018 Federal budget on February 27, 2018.
Regardless of the industry or size of the business, if you are an owner of a private corporation in Canada, the following provides a description of what may apply to you.
Note: The following information provides an overview of the proposed tax changes for private corporations. To specifically determine the impact of the proposed legislation on you and your business, as well as to gain additional details as they relate to your situation, it is crucial to consult with qualified tax and legal advisors.
What is changing?
A primary focus of these proposed changes is income splitting, or income sprinkling, which is a fairly common strategy some business owners or incorporated professionals use to redirect income to other family members who are in a lower income tax bracket.
Before the proposed changes, there were rules that specifically pertained to income splitting with minor children. Known as “tax on split income” (TOSI) or “kiddie tax” rules, they limited splitting certain types of income — such as dividends from private corporations — with those under 18.
With the new proposed changes, however, these TOSI rules will be expanded to certain family members who are age 18 and over, and will potentially apply to certain amounts received, either directly or indirectly from a related business. (In this context, related business is generally defined as one where an individual is related to another individual who is actively engaged in the business or owns a significant portion of the equity in the corporation that carries on the business.)
In general, the amounts subject to TOSI could include interest or dividends received from a private corporation, or certain income received from partnerships and trusts, but it does not apply to salaries received from the related business. There are, however, certain age categories and criteria that will exclude certain family members from these new TOSI rules. To better determine whether the TOSI exclusions apply, the government has developed “bright-line” tests for these exclusions.
The following chart outlines some basic criteria for the TOSI exclusions:
|Those aged 18 or over||To qualify for an exclusion from TOSI, the individual must be “actively engaged” in the business on a regular, continued, and substantial basis in the current year or in any five previous tax years, which need not be consecutive years. Being “actively engaged” means that the individual works in the business at least 20 hours per week during regular business operation periods.|
|Those aged 18 to 24||If the individual doesn’t meet the “actively engaged” criteria, above, he or she will be entitled to receive a return on capital based upon a prescribed formula. However, if the return exceeds this prescribed formula, it needs to be determined whether this is a “reasonable return” considering only contributions of “arm’s length capital” (which is any capital contributed to the business, with the exception of property income from a related business, borrowed funds or funds received from a related person, other than inherited property).|
|Those aged 25 or over||
If the individual doesn’t meet the “actively engaged” criteria, he or she can be exempt if he or she has “excluded shares.” The main criteria that constitutes excluded shares is owning at least 10 percent of the shares in a private corporation in terms of votes and value. This exemption is not available for professional corporations or service businesses.
For those who don’t meet the “actively engaged” or “excluded shares” criteria, a reasonable test can be used to determine how much income, if any, would be subject to TOSI. There is specific “reasonableness” criteria that will be considered, including labour contribution, property contribution, risk incurred, historical payments and other relevant factors. The Canada Revenue Agency has also stated that determining a reasonable return will be based on the circumstances of each case.
|Any individual (including minors)||Taxable capital gains realized from the disposition of qualified farm or fishing property and qualified small business corporation shares will not be subject to TOSI.|
Note: To ensure that your particular circumstances are properly accounted for and to determine if and how any of the new changes and exclusions may apply to your business, it is important to consult with qualified tax and legal advisors.
Are there any specific changes for spouses or partners?
There is a significant age-related exception for business owners and their spouses. If the business owner is aged 65 or older in the year, and if an amount paid to them would not be subject to TOSI under one of the exceptions, then any amount paid to their spouse would also not be subject to TOSI. This exception attempts to account for challenges associated with planning for retirement and better aligns the TOSI rules with existing pension income splitting rules.
At a glance: Other exclusions from TOSI
- Capital gains arising from an individual’s death
- Income or capital gains from property received as a result of marriage or common-law relationship breakdown
- Inherited property by an individual aged 18 or over (i.e. the inheritor continues to benefit from the contributions made by the deceased individual)
Tax impact for professional corporations
Depending on circumstances, the tax effects of these new changes may be felt most among some incorporated professionals, such as physicians, lawyers and dentists, for example. For many in this situation, while incorporation may have provided a wide range of benefits, for some, a main factor in their original decision to incorporate their practices may have been the tax advantages of being able to split income with family members. With the proposed new measures, however, these benefits may have disappeared for some.
While family members of professional corporations do have the opportunity to qualify for some of the exclusions, given the specialized nature of work carried out by many incorporated professionals and the requirements imposed by the governing professional body for regulated professionals, it may be difficult for family members to meet the exclusion requirements.
Based on the new limitations, some incorporated professionals may be in a position where they are no longer able to distribute income to family members who are in a lower tax bracket. As a result, those who have relied on this type of income splitting in the past may now face a higher tax rate on all of their income, which may ultimately impact their household after-tax income.