On December 13, Finance Minister Bill Morneau released the federal Department of Finance’s revised proposed legislation to restrict income sprinkling. At the same time, the Canada Revenue Agency (CRA) released new guidance on these proposed measures. The intended purpose of this revised legislation is to simplify the application of the proposed income-sprinkling legislation introduced in the July 2017 consultation paper Tax Planning Using Private Corporations.
It’s important to remember that the proposed legislative changes contained in the documents are not law yet. Therefore, they could be subject to further changes. Regardless, the federal government has indicated that the proposed changes will be effective as of January 1, 2018. Furthermore, the government has indicated that final legislation will be included in the 2018 budget process.
A high-level summary of the proposed income-sprinkling legislation and our preliminary analysis follows:
Current tax legislation allows all adult shareholders (18 and older) to receive dividends from private corporations regardless of the nature of their involvement in the operations of the private corporation. This has allowed incorporated physicians to use dividends to sprinkle or split corporate income with adult family members who are shareholders. Provided the adult family members are in lower tax brackets than the physician, significant tax savings can result.
Current tax legislation provides that if minor children (under the age of 18) receive dividends from a family-owned corporation, the minor child will pay tax at the highest marginal tax rate and will be denied access to personal tax credits in respect of the income. This punitive tax is commonly referred to as “kiddie tax” but is technically called tax on split income or “TOSI.”
December 13’s proposed legislation confirms that, starting January 1, 2018, TOSI rules will extend to dividends received by adult family members, subject to a new “reasonableness” test.
To simplify the number of circumstances where the reasonableness test would have to be considered, the December 13 proposed legislation introduces several new exclusions from the TOSI rules.
Exclusions from TOSI rules:
- The proposed TOSI legislation will not apply to amounts received in the year from an “excluded business.”
An adult individual (18 and older) will be considered to have received a dividend from an excluded business if the individual was actively engaged in the business on a regular, continuous and substantial basis during the taxation year in which the dividend is received or in any five previous taxation years. The proposed legislation considers an individual to have actively engaged in the business if that individual has contributed at least 20 hours of work per week throughout the portion of the year when the business operates. The question of what constitutes a regular, continuous and substantial basis is a question of fact; however, the 20-hour-per-week test is meant to help simplify the application.
- The proposed TOSI legislation will not apply to adult individuals over the age of 24 with respect to dividend income received from “excluded shares.”
Income will be considered to have been received from excluded shares to the extent the following conditions are met:
- The individual is at least 25 years of age in the year the dividend is received;
- The individual owns at least 10% of the outstanding shares of the corporation in terms of both votes and value; and
- The corporation meets the following conditions:
- It earns less than 90% of its income from the provision of services;
- It is not a professional corporation (i.e., it is not a corporation carrying on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor); and
- At least 90% of its income is not derived from a related business.
- The proposed TOSI legislation will not apply to income received by an individual from a related business if the individual’s spouse made the contributions to the business and the individual’s spouse has attained the age of 65 in or before the year in which the amounts were received.
What do these proposed exclusions from the TOSI rules mean for incorporated physicians and their families?
There may be circumstances where dividends received by a family member (spouse, adult child, parent, etc.) could be considered to have been earned from an excluded business if the family member is actively engaged in the business, had previously been actively engaged for a period of five years or has met the 20-hour-per-week test. In these circumstances, it is expected that income splitting with family members could still be available because of the proposed exemption from the TOSI rules.
Given the proposed definition of excluded shares, it is not expected that physicians operating a medical professional corporation will be able to rely on the excluded shares definition for an exemption from the TOSI rules.
Once an incorporated physician reaches the age of 65, the proposed changes provide that physicians will be able to split income with their spouses without the TOSI rules applying. This means it could remain advantageous to continue to include spouses as shareholders of a corporation.
What if an incorporated physician’s family members do not meet any of the proposed exclusions from the TOSI rules?
Dividends paid to adult family members who do not meet an exemption from the TOSI rules will be subject to a proposed “reasonableness test.”
As proposed in the July consultation paper, the reasonable test for individuals ages 25 and over will consider the extent to which the family member contributed labour or capital to the corporation, as well as the risks that were assumed in respect of the related business and the historical amounts paid to the family member. No significant changes were introduced for this test in the December 13 proposed legislation.
The reasonableness requirements are more strict for adult family members who are 18–24 years old than for those who are 25 or older. Family members between the ages of 18 and 24 will only be allowed to receive dividends that do not exceed a prescribed rate of return on capital contributed to the business.
Dividend payments to adult family members who do not meet the reasonableness tests would be subject to the highest marginal tax rates and the loss of personal tax credits, similar to the current TOSI regime.
Timing and administration
The revised income-sprinkling rules are proposed to be effective for the 2018 and subsequent taxation years. The changes will become law as part of the 2018 budget process. Although the proposed rules are not law yet, the CRA has confirmed that taxpayers should proceed as if they are law, effective January 1, 2018. This is consistent with how other draft legislation is administered.
If a taxpayer is relying on the 20-hour-per-week test to determine that the business is an excluded business and is asked to provide support for the hours worked by the CRA upon an audit by the CRA, then the individual receiving the dividends from the corporation will have to demonstrate that an average of 20 hours per week was worked during the part of the year that the business operated. Records such as timesheets or schedules should be maintained by either the individual or the business. If the individual is paid a salary, payroll records will be considered as support.
As an incorporated physician, what should you do now?
Given that these proposed changes will not affect the payment of dividends to family members in 2017, a small window of opportunity remains to pay dividends subject to existing rules.
If you are the primary contributor to your corporation and over age 65, your retirement and tax plans likely are not impacted by these proposed changes.
We expect that many incorporated physicians, under age 65, who pay dividends to their spouse and/or adult children shareholders will be affected by these proposed changes. As these proposed changes have been summarized at a high level, we would encourage you to discuss your specific facts and circumstances with your tax advisor to assess whether or not you meet any of the proposed TOSI exclusions or the proposed reasonableness tests, before paying any dividends in 2018.
Where you are impacted, you should obtain at least a preliminary compensation recommendation from your tax advisor and meet with your MD Advisor to discuss ramifications for your savings, retirement, and other financial plans.