Whether you know it as income sprinkling or income splitting, as of January 1, 2018, the rules have changed. There is still lots of uncertainty that exists surrounding the interpretation of the proposed federal legislation but here is what you need to know as a business owner.
By Shauna Forret, Tax Partner, KPMG in Canada
Over the past year, a number of changes have been introduced by the federal government that could impact small businesses and their owners. As a tax partner at KPMG, we are working with our clients to determine the impact of these new rules so that they as business owners can make informed decisions moving forward.
WHAT IS INCOME SPRINKLING?
Income sprinkling is a way for individuals to allocate income to lower income earning family members, generally by way of dividends. I often get questions about whether income sprinkling is still possible. The answer, fortunately, is yes in certain circumstances.
To help business owners better understand the impact of these new rules, I’ve laid out the essential highlights of the rules to help guide you going forward or at least to allow you as business owners to reach out to your professional advisor if you have not done so already.
CHANGES TO INCOME SPRINKLING
Prior to these new rules, business owners could income split in certain circumstances with other family members, in order to take advantage of lower marginal tax rates. The new rules introduced, referred to as Tax on Split Income (TOSI), are designed to prevent income splitting in certain circumstances and thus eliminate the advantage of the use of marginal tax rates of multiple individuals. This advantage can result in tax savings of anywhere from $30,000 to $37,000 annually, depending on the province.
In order to determine if you are impacted, you must ask yourself these three questions:
1. Is there a “specified individual”?
Prior to 2018, the rules were focused on minors, preventing income splitting with those under the age of 18. Now, “specified individuals” includes any Canadian‐resident, regardless of age.
2. Does the “specified individual” earn any split income’?
Split income now includes any of the following types of income:
- Dividends from a private company, or a shareholder benefit;
- Partnership and trust income from a related business;
- Non‐arm’s length capital gains by minors;
- Interest on debt obligations from private corporations, partnerships or trusts;
- Taxable capital gains on all dispositions of the above.
3. Is the split income on “excluded amount”?
The answer to this question depends on the age of the individual. A few of the exclusions apply to all ages:
- Income from property acquired on the breakdown of a marriage or common-in-law partnership.
- Taxable capital gain arising on death.
- Income where the spouse is 65 or older, and the income would not be TOSI to the spouse.
- Income where the spouse is deceased, and the income would not be TOSI immediately before the death of the spouse.
Additional exclusions are available, depending on whether the individual’s age is over 25, between 18 and 24, or under 18. For example, an individual over 25 could meet the “reasonable return” exclusion as it relates to their contributions of labour, capital, and risk to the business. If the individual is over 18, the income could qualify as income from an “excluded business” if the individual is actively involved on a regular, continuous and substantial basis in the business (an average of 20 hours per week) during the current year or any 5 preceding years (even if they are not in succession).
HOW ARE FAMILY TRUSTS IMPACTED?
The new TOSI rules certainly limit the ability to use family trusts as a form of income splitting where an individual does not meet one of the exclusions.
For example, where an individual over 25 who receives income on “excluded shares” of a corporation, the income would not be TOSI. However, shares held through a family trust would not qualify because the shares must be held by an individual.
This doesn’t mean that family trusts are no longer beneficial. Under the new rules, it is still possible to use a family trust to access and/or multiply the capital gains exemption where a qualified sale of shares occurs. Family trusts will also continue to be useful in providing flexibility as part of succession or estate planning initiatives, as well as other non‐tax benefits, such as asset or creditor protection.
HOW ARE HOLDING COMPANIES IMPACTED?
With the new TOSI rules, there are a number of uncertainties that exist in interpreting the rules and how holding companies could be impacted. For example, for the “excluded share” definition, it is not entirely clear whether shares held indirectly in an operating company (via a holding company) would meet the exclusion. However, like family trusts, despite the possible limitations as it relates to TOSI, a holding company may still be beneficial for other reasons, such as asset or creditor protection.
WHAT CAN I DO?
If you’re still not sure about how your family trust or holding company holds up under these new rules, here are some alternatives you could consider and discuss with your professional advisor to determine if they may helpful with your own situation.
- Contribute arm’s length capital to the business in exchange for a reasonable return.
- Reorganize the share ownership of the company in 2018 in order to meet the “excluded share” definition perhaps by distributing the shares from the family trust directly to an individual.
- Amalgamate the holding company and operating company.
- Issue a prescribed rate loan to lower income earning spouse or family trust.
- Pay a reasonable salary instead, where able, or have the individual work a minimum of 20 hours per week.
In light of the complexity of these rules, having conversations now and taking steps early to address the impact of the TOSI rules is key. Reach out to your professional advisors today.