Finance Revisions to Income Sprinkling Proposals Not Likely to Limit the Risk of Increased Tax Disputes
As has been well reported, on July 18, 2017 the Government of Canada released proposed tax changes impacting the taxation of private corporations. Included in the proposals were proposed changes to address “income splitting”. The proposals sought to expand rules that already apply a tax on split income (commonly referred to as the “kiddie tax”) to certain income earned by minor children that is attributable to private corporations run by family members. The government retreated on certain aspects of the proposals in October.
One of the many objections to the proposals concerned the introduction of a “reasonableness” test, which seeks to ensure that certain amounts now paid even to adult children from a related business are reasonable, in the sense of an "arm’s length" amount, having regard to the individual family member’s contribution of services or capital, the assumption of risks, and past contributions in regard to previous services, capital or risks.
On December 11, 2017 the Financial Post reported comments from the Chief Justice of the Tax Court of Canada as well as comments from a former Chief Justice of the Court that this reasonableness test is very subjective and open to litigation. Their fear was that the test would lead to substantially more Tax Court appeals and thereby add more stress to an already over-burdened court system.
The New Revised Proposals
On December 13, 2017 the Department of Finance published revised proposals relating to the income splitting portions of the July 18 tax proposals. The new proposals were introduced to simplify and better target the proposed income splitting rules and to reduce potential compliance burdens on small private companies. These proposals are to apply to the 2018 and subsequent taxation years.
In introducing the revisions the Department of Finance highlighted the fact that they now include “bright-line” tests to automatically exclude individual family members of a business owner who fall into certain categories. However, it is questionable as to whether they will prevent an increase in the number tax disputes predicted.
In terms of some of the “carve outs” referenced by the Department of Finance the tax on split income will not apply to “specified individuals” who are 18 years or older who receive split income from an “excluded business”. The definition of an excluded business of a specified individual for a taxation year would generally mean a business in which the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business in the year or in any of the five prior taxation years. Such engagement in the business will generally be a question of fact. However, adults who work in the business for an average of 20 weeks during the portion of the year in which the business operates, or who do so in any of the previous five years, will be deemed to be actively engaged in the business on regular, continuous basis.
The most recent draft legislation would also extend the meaning of an “excluded amount” in respect of which the tax on split income will not apply to property received pursuant to a settlement agreement on the break-down of a marriage, to capital property that is deemed to be disposed of on the death of a taxpayer and to gains received from the disposition of qualified small business corporation shares or from farm or fishing property.
For individuals aged 18 to 24 an excluded amount will also include:
- Amounts from property that were acquired by, or for the benefit of, the individual as a consequence of the death of a parent or, in some cases, other individuals;
- Amounts that are “safe harbour” returns of the individual, contributed in support of the business; and
- Amounts that are a “reasonable return in respect of the individual”, having regard only to contributions of arm’s length capital. Arm’s length capital will be defined generally as property of the individual that was not acquired from income or taxable capital gains or profits in respect of a related business, borrowed under a loan or transferred from a related person.
For individuals who have attained the age of 24 years before the taxation year in question who receive income (or taxable capital gains) from or in relation to “excluded shares” of a corporation, those amounts will also be excluded amounts. To be excluded shares the individual must: own shares in the corporation that represent at least 10 percent or more of the votes and value of the outstanding shares of the corporation; the corporation must derive less than 90% of its business income from the provision of services; cannot be a professional corporation; and all or substantially all of the income of the corporation cannot be derived from one or more related businesses.
For individuals in the “have attained the age of 24 years” category, excluded amounts will also include amounts that are a reasonable return in respect of the individual. This is defined similarly to the controversial reasonableness test that was part of the original income splitting proposals in July. It will also be determined having regard to work performed in the related business, property contributed in respect of the related business and risks assumed in respect of the related business.
There have also been some further refinements of the original income splitting proposals. For instance, previous proposals to include siblings, aunts, uncles, nieces, and nephews in the group of related persons that would be subject to the new income splitting rules, where they have influence over a corporation, have been removed. Additionally, it seems the Government has responded favourably to criticisms from the tax community, including our firm, that the original proposals attack the elderly. The revisions provide relief to the spouse of a business owner where the business owner is 65 years or older and has meaningfully contributed to the business.
Are There Likely to Be Less Tax Court Appeals if the Proposed Revisions Become Law?
If an individual clearly fits into one of the newly proposed “safe harbour” exceptions, the new proposals will not apply. However, we can conceive of many circumstances in which adult family shareholders will not fit into any of the safe harbour exclusions. In those cases there remains considerable uncertainty as to how CRA will assess and how courts will interpret the reasonableness standard. Furthermore, for individuals in the 18 to 24 year old category that do not meet the 20 week threshold for working in a business there is considerable question as to how to assess whether or not the individual is actively engaged enough, on a regular, continuous and substantial basis in a business to have it characterized as an excluded business.
One might have hoped that the Department of Finance would have had been persuaded by the recent conclusions of the Senate Committee on National Finance, withdrawn the legislation entirely and resolved to undertake a more considered review of tax legislation, to the extent that the government felt there were pressing fairness issues to be addressed.
It remains unclear what form the final legislation will take. There could potentially be one or more further iterations of draft amendments. As we await the ultimate passage of whatever version of tax legislation is enacted private company owners will still want to tread carefully in 2018 and seek advice before making payments to family members who own shares in their corporations.
Invitation for Discussion:
If you would like to discuss this article in greater detail, or any other business law matter, please do not hesitate to contact one of the lawyers in the Tax Law group at Nerland Lindsey LLP.
Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.