Morneau’s new ‘simplified’ income sprinkling rules not so simple, tax changes still poised to negatively impact certain SMEs
Shortly after the release of the report by the Standing Senate Committee on National Finance, which is highly critical of the Department of Finance’s proposals on the taxation of private corporations, Finance Minister Bill Morneau released what he referred to as clarified rules around income sprinkling.
Unfortunately, the release came with the same rhetoric used to introduce the proposal last summer, which essentially implies that certain incorporated individuals are effectively not paying their fair share of taxes. The release also goes on to say that these changes were made after “extensive” consultations with small business owners and experts.
This assertion is problematic, because the rules were first introduced on July 18, 2017, with an initial consultation period that ended October 2, 2017, or a mere 76 days. Following that period, we received revised draft legislation on December 13, 2017. It’s not clear how that entails an ‘extensive’ period of consultation.
Notwithstanding the government’s assertions, the release of the rules does not appear to take into account the very recommendations made by the Senate when they called for the rules to be abandoned altogether, and that “the Government of Canada undertake an independent comprehensive review of Canada’s tax system with the goal of reducing complexity, ensuring economic competitiveness, and enhancing overall fairness.” Lastly, the Senators’ final recommendation stipulated that, should the Minister proceed with the proposals to amend the Income Tax Act, he should delay the implementation until at least January 1, 2019, so that draft legislation could be properly assessed and thorough consultations undertaken.
Alas, that final piece of advice has clearly been ignored as the income sprinkling rules are set to take effect on Jan. 1, 2018. Moreover, the latest release indicated that Finance will be moving forward with measures to limit the deferral opportunities related to passive investments, while indicating that these rules will apply prospectively from the budget date.
‘Clarified’ income sprinkling rules still opaque
Now, let’s take a closer look at yesterday’s clarifications to income sprinkling rules. Finance stated that the changes to the proposals, first introduced last summer, include “clear bright-line tests to automatically exclude specific individuals from falling into the new enhanced rules on the Tax On Split Income (TOSI).”
The reality is these so called ‘bright-line’ tests include some subjective terms such as “meaningful contribution to the business,” and “substantial labour contribution.” For those who do not fall under the four specific exclusions, there is still a reasonableness test on income allocated to those individuals. In my opinion, you can’t have ‘bright-line’ tests with such subjective terms included in your legislation. A more simplistic bright-line test would have been to follow a system similar to the one used in the U.S., whereby all individuals under the age of 25 are subject to the rules, with no exceptions. Finance could have simply left the current TOSI rules as they are and adjusted the applicable age from the current 18 years of age to 25 years of age. That, in my opinion, would have eliminated the alleged taxpayer mischief that concerns Finance.
Notwithstanding all of that, here are the exclusions the government is proposing in order to ease the impact of these changes:
- A business owner’s spouse, as long as the business owner has meaningfully contributed to the business and is aged 65 or older
- Adults over the age of 18 who have made substantial labour contributions to the business during the year, or during any preceding five years. A substantial contribution is considered to have been made if the individual worked an average of 20 hours per week during the business year, or during any five previous years. For seasonal operations, such as farms and fisheries, the labour contribution requirement is only applied to the period in which the business operates
- Adults aged 25 or older who own 10 per cent or more of a corporation that earns less than 90 per cent of its income from the provision of services and is not a professional corporation
- Individuals who receive capital gains from qualified small business corporation shares who would otherwise “not be subject to the highest marginal tax rate on the gains under existing rules”
Individuals who do not meet these exclusions would be subject to a Canada Revenue Agency “reasonableness test to determine how much income, if any, would be subject to the highest marginal tax rate,” according to Finance.
Based on these exclusions, if it wasn’t already clear that these measures are meant to target professionals, it should be now. As noted above, the Senate’s National Finance Committee immediately came out against the proposals on the taxation of private corporations, and, more specifically, to the changes to the income sprinkling rules. In their report, the committee argued:
“The income-sprinkling proposal will be complicated to apply, require significant paperwork, and rely on the subjective determination of tax auditors, inevitably leading to inconsistency and litigation. It also would not recognize the legitimate income sprinkling based on implied joint ownership of family property.”
But again, this sound advice has, at least up until now, been ignored.
There were some other changes to the original July 18, 2017 proposals on TOSI introduced yesterday, which are welcome. Specifically:
- The Government will not proceed with proposed measures to apply TOSI to compound income (i.e. income earned from the investment of an initial amount of income that is subject to the TOSI or attribution rules)
- The July 2017 proposals had included amendments to extend the application of subsections 120.4(4) and (5) of the Income Tax Act (which currently apply to minors and effectively deem twice the amount of a taxable capital gain to be a dividend in certain circumstances) to specified adult individuals. These amendments will not move forward. Furthermore, it is proposed that the existing provision be modified so that it will not apply to a minor in circumstances in which a capital gain arises as a consequence of that person’s death
- The class of related individuals for the purposes of the TOSI rules will not be extended to aunts, uncles, nieces and nephews
- Income derived from property acquired as a result of the breakdown of marriage or common-law partnership will be exempted from the application of the TOSI rules
- Generally, individuals aged 18 to 24 will be permitted a prescribed rate of return on capital contributed to a related business. In certain cases, however, such as where the individual earned the capital contributed from an unrelated business, the individual will be permitted a reasonable return on the contribution
Service businesses to be disproportionately affected
Based on these revised proposals, it would appear that the biggest impact will be to service businesses, as well as professional corporations. For all other types of businesses, it seems that income sprinkling will be allowed for individuals over the age of 24 that own more than 10 per cent of the shares of the corporation, which represent 10 per cent of the votes and value of the corporation. In all other cases, where an individual is providing substantial labour contributions to the business, (i.e. an average of 20 hours per week), those individuals should also be able to continue to receive income. For spouses who are shareholders of a service business, but are not actively involved in that business, it would appear that they may only be able to receive income once the owner of that business attains the age of 65, and, of course, has provided a meaningful contribution to that business.
Moving forward, for service businesses with passive shareholders, it looks like 2017 will be the last year that dividends can be paid to those shareholders without consequence. As such, it may make sense to maximize the payment of those dividends prior to the end of 2017. In all cases, however, one should consult their tax professional before making any decisions.
Tax changes poised to negatively impact entrepreneurs
Again, as I noted above, and also in a previous webinar, the easiest way to manage perceived inequalities related to income sprinkling would be to leave the so-called Kiddie Tax rules unchanged, and increase the eligibility age to 24 years old.
Unfortunately, alternative policy options such as these have gone largely ignored. Despite bending on several tax changes, the federal government seems intent on pushing ahead despite the pleas of entrepreneurs who argue that corporation-targeting tax reforms will disproportionately impact everything from their competitiveness to their ability to save for retirement.
Let’s be clear: there are a host of issues that even the revisions to these proposed reforms still fail to address.
Take the assertion that the changes are intended to improve the ‘neutrality and fairness of the Canadian tax system.’ In my opinion, the government has missed the mark when it comes to achieving this otherwise laudable goal. Why?
First, greater fairness can only be achieved if you’re looking at the entire tax-paying population in perspective. According to a recent National Post analysis, taxes paid by the top 10 per cent of income earners in Canada account for more than half of the income tax paid in this country in any given year. The idea that the wealthy don’t pay their fair share is a persistent myth.
Second, while the government argues that their new tax rules will only impact about 2.5 per cent of all Canadian-controlled private corporations (CCPCs), we need to question their analysis. Take the new passive income rules, which will be extraordinarily challenging to administer.
Finance claims that the impact of the rules will be limited, because only 47,000 CCPCs currently earn passive income in excess of $50,000 a year. But in my opinion, what they assumed will be included as passive income will capture many more CCPCs, unless they have ‘carve-outs’ for specific assets such as shares in a subsidiary operating company or real estate.
If not, then any CCPC with these types of investments will eventually be caught under the rules. Moreover, they assume that grandfathered assets would include existing investment portfolios, but any reinvested income earned from those portfolios would be caught under the new rules, meaning more income pools to track. This will result in massive administrative headaches for the Canada Revenue Agency. And that’s without considering the other three income pools that also need to tracked under the proposed rules.
Also, how many of the CCPCs cited in their review are, in fact, inactive or bare trusts? Considering that their analysis employs a base line of 2014 passive income, it invariably excludes entities that had investment gains that have not been realized in that year. Assuredly, many more companies will be caught under the rules in future years when such gains are ultimately realized.
I would argue that there are significantly more CCPCs that will be affected by the new rules—namely, all of them.
Last point: the government has concluded that these changes will raise another $1 billion a year in the short run, and an estimated $6 billion annually by 2037. Weren’t these changes not supposed to be about raising additional revenue? And at best, these revenue estimates seem flawed. We can be virtually assured that taxpayer behaviour will change dramatically if these changes are implemented as proposed, meaning their estimates will be nowhere near accurate over time. I believe they could, in fact, wind up delivering negative benefits.
I could go on, but the key takeaway here is that the government’s proposed tax changes make far more sense from the perspective of a political party attempting to retain middle-class voters than one intent on crafting fully coherent tax policy.
Entrepreneurs should contact their accountants and tax lawyers now, and begin adjusting their tax-planning strategy in anticipation of the storm ahead.
Armando Iannuzzi, Partner