A major concern for Canadian small business owners has been the talk and proposals regarding revised tax rules that the government brought forward in the middle of 2017. While there was a lot of confusion, opposition and unanswered questions at the time, there have been some developments that will impact small business accounting and tax planning.
Background and Overview
Due to significant opposition from the Canadian Small Business community, tax accountants, accounting firms, and other stakeholders, the original proposals from July 18, 2017 that the Department of Finance issued with regards to small business tax changes were subsequently revised and released on December 13, 2017.
The revised proposed rules were better accepted by the business community, but still represent a large shift in the existing tax planning methods, strategies and abilities to split income for private corporations in Canada. Nonetheless, the new rules took effect on January 1, 2018 and are applicable to the 2018 and subsequent taxation years.
A common tax minimization strategy used by many incorporated small businesses and common among professionals with Professional Corporations, was to effectively reduce the overall tax burden by issuing shares and paying dividends to family members, who often had little involvement in business operations, and minimal investment in the business as well. The new TOSI (tax on split income) rules were intended to effectively remove the ability for many small business owners to split income and thereby remove their advantage over Canadian employees who are not able to use these types of tax planning strategies.
Revised TOSI and Income Sprinkling Proposals
The revisions that were released in December provided more insight into how the government planned to police these new rules, and also included a number of potential exclusions from the new rules as well.
Some of the tests to determine when TOSI will apply are subjective; however, the overall idea of TOSI, the new definitions and the new tests all add to the complexity of tax planning and the ability of small business owners to understand what may apply to them and their small business.
The bright side for some small business corporations is that the TOSI rules will not apply in situations where payments (i.e. dividends, interest and certain capital gains) are within the specified exclusions, also known as an “Excluded Amount”.
Excluded Amount Explained
- For all adults in Canada, any amount received from an “excluded business” will not be subject to the TOSI rules. Excluded Business is defined as:
Amounts are derived from an excluded business where the individual was actively engaged on a regular, continuous and substantial basis (“Actively Engaged”) in the activities of the business in a taxation year or in any five prior year taxation years of the individual.
In order to be considered “Actively Engaged” an individual would need to work in the business a minimum of 20 hours per week during the portion of the year when the business is operating (i.e. seasonal businesses may not operate for a full year) or has met that requirement of 20 hours per week in any of the five prior years; they do not need to be consecutive. If this test is met, the individual would be exempt from TOSI permanently on a go-forward basis under the new proposal.
If the individual does not make the 20 hours per week test, the individual may still meet this exclusion test. This would vary on a case by case basis upon further investigation by the CRA, if applicable.
- For individuals age 25 and over, TOSI will not apply on income from (or taxable capital gains from) the disposition of Excluded Shares” or a payment that qualifies as a “Reasonable Return”.
Excluded Shares would be defined as:
Shares of a corporation owned by an individual are and all the following conditions are met:
- Less than 90% of the corporation’s business income was from the provision of services;
- The corporation is not a Professional Corporation, i.e. physician, dentist, lawyer, chiropractor, etc.;
- The shares represent 10% or more of the votes and value of the corporation; and
- All or substantially all, of the income of the corporation is not derived from another Related Business in respect of the individual.
The specific requirement of the shares to be held by an individual means that any shares held through a Family Trust structure for the benefit of the individual would not qualify as an Excluded Share.
Reasonable Return would be defined as (for individuals age 25 and over):
- The work is performed in support of the Related Business;
- The property contributed directly or indirectly in support of the Related Business;
- The risks assumed, in respect of the Related Business;
- The total amounts paid or payable by any person or partnership to, or for, the benefit of the individual, in respect of the Related Business; and
- Any other such factors that may be relevant.
In assessing a Reasonable Return, the CRA has provided the following criteria to provide some clarity on how they will evaluate the payment:
- Labour Contribution – the work performed (tasks, hours, wage in comparison to industry, education, knowledge of individual, etc.) by the individual in support of the Related Business before the amounts became paid;
- Property Contribution – the property contributed (loans, capital, any collateral, opportunity costs, past contributions, etc..) by the individual in support of the Related Business;
- Risks Incurred – the risks (exposure to the liabilities of the business, personal reputation or goodwill at risk, extent contributions made at risk, etc.) assumed by the individual in respect of the Related Business;
- Historical Payments – the total amounts paid by any company or partnership to, or for, the benefit of the individual in respect of the Related Business; and
- Such other factors that may be relevant.
- For individuals between the ages 18 and 24, TOSI will not be applied to a return on property contributed in support of a Related Business that is a “Safe Harbour Capital Return” or, a Reasonable Return having regard only to contributions of “Arm’s Length Capital” to the business.
The Safe Harbour Capital Return is defined as a return that does not exceed a prescribed capital rate of return based on the highest prescribed rate under the Income Tax Act for the particular year. Currently this rate is at 2%, which would be applied to the Arm’s Length Capital invested by the individual to determine the maximum Safe Harbour Capital Return.
Arm’s Length Capital is property of an individual, other than property that is derived from property in respect of a Related Business, that is borrowed under a loan, or that is transferred from a related person (other than inherited property).
- For all individuals the taxable capital gain realized on death, from the disposition of qualified farm, fishing property, or qualified small business corporation shares, will be excluded from TOSI.
- For individuals age 65 or over, all amounts received by the individual spouse will not be subject to TOSI if the amount would have been an Excluded Amount had it been included in the individual’s income. This means that as long as the individual was active in the company in the past, once they reach the age of 65 they will be allowed to split income to their spouse and do not have to worry about the TOSI rules.
Although this draft legislation narrows the focus, and addresses many of the issues and concerns brought up by the various stakeholders, the revisions remain quite complex. The changes will certainly result in additional compliance costs for many small businesses and may result in a significantly larger tax burden for small business owners who have previously been income splitting with family members.