Potentially the Income Tax Grab of the Century
Our current Minster of Finance along with the Liberal Government have proposed to make changes to the Canadian Income Tax Act that are going to significantly raise the income taxes that middle class Canadians will end up having to pay. The proposed measures will result in a number of changes that will also have a negative impact on entrepreneurs, independent contractors and general small business owners. Not left out, will be the negative effect on women, in general (more and more women are entering the professions).
Historically individuals planned their business endeavors, with the aspects of taxation, creditor proofing and ease of use. A significant number of individuals chose the corporate route as the most logical route to follow.
The proposed changes can be lumped into a number of categories, namely:
Major Changes to Income Splitting
One of the most significant methods of income tax planning has been the use of various forms of income splitting. This method takes into consideration that most successful business rely on the family unit as an economic unit. It should be pointed out that a large number of cultures plan around the family and the family becomes the basic economic unit.
The proposed legislative changes are going to make it more difficult for corporations to pay wages and dividends to family members other than those who are actively involved in the economic activities. The proposed changes will result in individuals that are not active in the business operations, paying income taxes at a significant higher rate. This rate increase will apply to family employees and family shareholders.
Major Changes to Saving For the Future
One of the most basic investment-rules is to save for the future and then invest the excess funds into income generating investments.
The proposed rules will result in these savings and the related return on investments being taxed at significantly higher rates, such that it may not make economic sense to use a corporation for saving and investment purposes.
This prospect seems to run afoul of general good business practices, which would result in the corporate entity saving and investing excess funds, when times are good and potentially using that excess when times are not quite as good.
The philosophy of penalizing good fiscal practices will lead to insolvency and potentially more bankruptcies of corporate entities.
Limiting the Use of the Small Business Deduction
Our current government seems to think that small business are getting to many income tax benefits and are proposing to limited the eligibility of the small business deduction.
They are proposing that each business or economic entity, be allowed one small business deduction, if they met the general criteria.
They are proposing the sharing of one small business-deduction.
They will be looking at share ownership and blood relationships to determine whether corporations are entitled to a small business deduction or are required to share of one.
Historically speaking under the Liberal Government of Lester b. Pearson, in the mid-1960’s the Carter Royal Commission on Taxation conducted a review of the Canadian Income Tax Act and subsequently issued its Tax Reform Report.
Under the Liberal Government of Pierre Trudeau, a major overhaul of the income tax system was undertaken. And in 1972 the Canadian Income Tax Act over went a major overhaul. One of the major points of this overhaul was the recognition of the value of small business. The new act emphasized this aspect and provided certain incentives for small business.
Major changes, that are going to cut to the core of our Income Tax Regime, are being proposed and railroaded through our political system (90 days from proposal to implementation) without a chance of real discussion, debate, and reflection on their impact.
At the present-time, there is a lot of uncertainty with respect to:
What the actual rules will be?
When they will become effective?
We strongly suggest that you contact your member of parliament and give them your feedback with respect to the above changes. Now is the time to for action.
The specific proposals with respect to income splitting are…
Extension of the tax on split income (TOSI) rules
Measures are proposed to extend the TOSI to apply to certain adult individuals who have amounts included in split income, but generally only to cases where the amount is unreasonable under the circumstances. In addition, the measures would expand the circumstances in which the TOSI applies, including the types of income that are considered to be split income. The TOSI would continue to not apply to income received by an individual as salary or wages (i.e., employment income).
Generally, these measures would apply the TOSI to a Canadian resident adult individual who receives split income (i.e., income from the business of a related individual, including a corporation over which a related individual has influence), when the amount in question is unreasonable under the circumstances. An adult individual in receipt of split income would be liable for the TOSI on the unreasonable portion of the income. Proposed measures will:
- Expand the meaning of ‘specified individual.’ As described above, only specified individuals are liable under the TOSI. The measures would extend the meaning of ‘specified individual’ to include Canadian resident individuals, whether minor or adult, who receive split income. Adult individuals who do not receive split income would not be affected by the measures.
- Introduce a reasonableness test. A reasonableness test would be introduced for the purpose of determining whether TOSI applies to a specified individual who is an adult. If a split income amount received by an adult specified individual is reasonable within the meaning of this test, then the amount that would otherwise be split income of the individual would be excluded from split income and thus not be subject to the TOSI. As described in detail below, the test is proposed to apply differently based on the age of the adult specified individual (i.e., whether the individual is between 18 and 24 or is 25 or older), recognizing the opportunities for income sprinkling with younger adult family members.
All adult specified individuals would be subject to the reasonableness test in respect of split income (i.e., income from the business of a related individual, including a corporation over which a related individual has influence). An amount would not be considered reasonable in the context of the business to the extent that it exceeds what an arm’s-length party would have agreed to pay to the adult specified individual, considering the following factors:
- Labour contributions, the extent to which:
– for an adult specified individual age 18-24, the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business; and
– for an adult specified individual age 25 or older, the individual is involved in the activities of the business (e.g., contributed labour that could have otherwise been remunerated by way of salary or wages).
- Capital contributions, the extent to which:
– for an adult specified individual age 18-24, the amount exceeds a legislatively-prescribed maximum (using the same rate used for purposes of the tax attribution rules) allowable return on the assets contributed by the individual in support of the business; and
– for an adult specified individual age 25 or older, the individual has contributed assets, or assumed risk, in support of the business.
- Previous returns/remuneration:
All previous amounts paid or payable to the individual in respect of the business. For example, this would include amounts paid by a corporation to the individual as dividends on shares held by the individual, as well as salary or wages paid by the corporation to the individual for services rendered by the individual in respect of the corporation.
Morgan carries on a freight forwarding business through a corporation. Morgan owns all of the voting shares of the corporation. Morgan’s 26-year-old child, Jesse, is an accountant and, except as described below, does not participate in the freight forwarding business. Jesse owns dividend-eligible shares of the corporation, which Jesse purchased for $1. Jesse’s shares do not participate in the growth of the corporation. Both Morgan and Jesse are resident in Canada.
During a fiscal year, the corporation paid Jesse for accounting services he performed on behalf of the corporation. The amount paid by the corporation was equivalent to what the corporation would have paid an arm’s-length party to perform the services. The corporation also declared, and paid, for the fiscal year a $100,000 dividend on the shares held by Jesse.
Jesse received the dividend income from a related business source.
The dividend income received by Jesse will not meet the reasonableness test and will therefore be subject to the TOSI. Although Jesse is involved in the activities of the business, Jesse’s contributions were limited to providing accounting services. Jesse purchased the shares for $1, and therefore did not contribute assets or assume risks in respect of the business in any material way. Finally, although Jesse provided accounting services to the business, the business already paid Jesse for the fair market value of these services.
If, on the other hand, Jesse had contributed significant assets to the corporation, for example by purchasing shares from the corporation for a cash payment of $100,000, then Jesse would be permitted under the reasonableness test to a reasonable return on this investment without the return being subject to the TOSI. Further, if Jesse had been 24 instead of 26 years old, the reasonableness of Jesse’s dividend would be determined using a higher standard of labour contribution and imposing a prescribed maximum return on the $100,000 contributed to the corporation.
The measures also propose that in two cases, the TOSI would apply to the split income of adult specified individuals regardless of the reasonableness test:
- The first case involves ‘compound income,’ meaning income derived from the investment of split income and certain other amounts, of an individual under age 25. This is intended to discourage income sprinkling capital ‘seeding’ arrangements used by high-income individuals. These arrangements involve income being sprinkled to lower-income family members and the after-tax (e.g., after the TOSI applies) proceeds of that sprinkled income being invested by the family members or a family trust. The resulting investment income is available to be sprinkled with the lower-income family members, instead of at the high-income individual’s higher tax rate, as it would have been in the absence of the arrangement.
- The second case involves amounts brought into split income under a proposed anti-avoidance rule that applies in respect of certain property held or acquired to circumvent the TOSI rules. In the case of the anti-avoidance rule, the reasonableness test would be inapplicable given that the purpose of holding or acquiring the property is to circumvent the TOSI rules
- Introduce the definition ‘connected individual.’ A connected individual test would be introduced to determine whether an adult specified individual’s income from a corporation would be treated as being split income. A Canadian resident individual with a certain measure of influence over a corporation would be treated as connected with the corporation. For example, adult family members of the ‘connected individual’ who receive dividends on an unlisted share issued by the corporation would be required to determine whether a portion of the amount received is unreasonable.
The proposed measures would introduce the definition ‘connected individual’. This definition applies in the case of split income from a corporation. The definition establishes a link for the purposes of the TOSI rules between the specified individual who receives an amount, the corporation from which the amount is derived and an individual (the ‘connected individual’) who is related to the specified individual and has a presumed degree of influence over the circumstances in which the amount is paid.
A ‘connected individual’ in respect of a corporation would mean an individual (other than a trust) who is resident in Canada where any of the following conditions are met:
- Strategic influence: the individual has factual control of the corporation alone or as part of a related group of persons.
- Equity influence: the individual owns property representing 10 per cent or more of the equity value of the corporation.
- Earnings influence: in the case of a corporation that carries on a service business, the individual or a related person owns shares in the corporation and either the individual’s services are the primary contributor to the activities or revenues of the corporation’s business, or the individual performs all or part of the services and, for the corporation to carry on the service business, the performance by individuals of those services is regulated under the laws of Canada or a province or territory.
- Investment influence: 10 per cent or more of the value of the corporation’s property is derived from property acquired from the individual or from another corporation in respect of which the individual is a ‘connected individual’.
There may be more than one connected individual in respect of a corporation, and an individual may be both a connected individual and a specified individual in respect of the same corporation.
The ‘connected individual’ concept would also apply in determining whether certain income of a specified individual from a partnership or trust is, in determining whether it is split income, derived from a business of a related person. In addition, for income received through a partnership or trust, certain tests that currently apply in determining whether income of a minor specified individual is derived from a business of a related person would be extended to apply to adult specified individuals. In the case of adult specified individuals, amounts included in split income under these tests would also be subject to the reasonableness test in determining whether the TOSI applies.
- The current joint and several tax liability rule with respect to the TOSI rules would be extended to apply in the case of adult specified individuals aged 18-24. A related individual who has sprinkled income with an adult specified individual aged 18-24 may be assessed joint liability with the adult specified individual for the adult specified individual’s unpaid TOSI that arises in respect of that sprinkled (i.e., that part of the split) income.