In the past, Canada’s income tax system allowed a lot of scope for moving income around within a family to reduce the family’s overall tax burden. This is known as “income-splitting”. It is done when a person in business or a profession, operating as a corporation, shifts some of the profits to other family members by paying them dividends.
A high-income taxpayer in a high tax bracket could reallocate income to a spouse or children who are in lower tax brackets. Where allowed, that can lead to substantial tax savings, but the rules on this were significantly tightened in 2018. Despite strong opposition from small business groups, Parliament passed the Budget Implementation Act, 2018, making changes to the Income Tax Act that restricted the option of income-splitting.
Substantial Potential Savings from Moving Money into Lower Tax Brackets
Canada has what is known as a progressive rate income tax rate system. That means that the tax rate goes up as a taxpayer progresses up the income scale. This is a “Robin Hood” type tax policy. The philosophy behind it is that somebody who already has a high level of income can afford to give up a larger proportion towards the costs of running the government and the government’s transfers to those who are less well off.
It is because of progressive taxation that income-splitting is controversial, and where it is allowed it can lead to substantial tax savings.
For example, if there is only one person in a family who is receiving income, and earns an income of $400,000 per year, the family’s total income tax bill will be about $180,000. If instead two individuals each make $200,000, the family’s tax bill drops to about $146,000. If four individuals each make $100,000, the family’s total tax bill drops to about $108,000. This example is perhaps somewhat unusual, but it is indicative of the potential for substantial savings in some situations.
In the past, court decisions, going all the way up to the Supreme Court of Canada, have taken a lenient attitude toward income-splitting. A business owner was permitted to set up a special class of shares that was gifted to family members. Dividends declared on those shares would be taxed in the hands of the shareholder at his or her lower tax rate. Specifically, the courts found that, under the terms of the Income Tax Act as it stood prior to 2018, it did not matter that the taxpayer receiving the dividends had not made any contribution to the business.
Amendment to the Income Tax Act Imposes Tax on Split Income
The new rules place more emphasis on the contribution of the individual. Many of the remaining income-splitting opportunities are restricted to individuals who have reached the age of 25, meaning that there is less scope to do it with adult children of the owner (e.g., university students) during the period of their life when they have little or no other income. Prior to 2018, there was already a “kiddie tax” that penalized dividends paid to children 17 or younger, but the new provisions have added another seven years onto this.
The amendments to section 120.4 of the Canadian Income Tax Act, which has the title of “Tax on Split Income” (TOSI), took effect for the 2018 tax year. TOSI is a harsh measure: if a taxpayer receives dividends that are deemed to be “split income”, the taxpayer is charged tax at the top marginal tax rate, which is currently about 53.5% in Ontario.
Special Restrictions on Professional Corporations
Those who previously took advantage of income-splitting through professional corporations have been particularly impacted by the amendment. For example, physicians and dentists were permitted to issue shares to family members for the purpose of income-splitting, as a policy concession from the Ontario government. By contrast, some professions were never allowed to split income due to provincial restrictions on share ownership (e.g., lawyers in Ontario).
Section 120.4 is particularly tough regarding professional corporations. There is a category referred to as “excluded shares” of an active business, where income-splitting continues to be permitted much as it was previously. Section 120.4 specifically states that a professional corporation cannot have excluded shares. On the other hand, the Income Tax Act uses a narrow definition of professional corporation, in s. 248(1): “professional corporation means a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor.” Therefore, an incorporated architect, engineer or real estate agent would not be caught by this.
In spite of the inability to issue excluded shares, dividends paid to a family member from a professional corporation in exchange for a specific service can still escape TOSI. The CRA provides the example of a spouse who permits the family home to be used as collateral for a business loan. In that case, the dividends must represent an amount that approximates the market value of such a loan guarantee.
Excluded Shares and the Issue of Services
If a corporation can issue excluded shares, dividends paid on such shares to a shareholder over the age of 24 can escape TOSI. Unfortunately, one of the requirements to qualify for excluded shares is rather unclear. Section 120.4 stipulates that “less than 90% of the business income of the corporation … was from the provision of services.” Surprisingly, nowhere does the Act define what the word “services” means for this purpose. There is uncertainty among tax law specialists about what this means, as discussed in the newsletter of the Canadian Tax Foundation.
Is a service anything that is not a physical good, or only more narrowly defined personal services? Are the blueprints produced by an architect or engineer a service? Is the “manufacturing” of computer software a service? It would seem to be an odd economic policy if the government wants to tax the production of computer hardware much more favorably than computer software, given that the latter is nowadays more important to competitiveness. Time will tell how this is interpreted, and it is likely that there will be some court battles about it before it is resolved.
The Canada Revenue Agency has provided a web page with 12 different examples of business situations and how the new TOSI rules will apply to them. None of the examples directly address the question of what kind of service disqualifies a corporation from having excluded shares. However, one of the CRA’s examples concerns a “franchised food court stall” and states that this qualifies for excluded shares. Statistics Canada’s economic classification system defines restaurants as a service business, but this example suggests that the CRA intends to use a narrower definition of services that is more lenient. This would mean that a wider range of businesses would qualify to have excluded shares that avoid TOSI.
Only voting shares can be excluded shares. Therefore, taking advantage of the excluded share provision may have implications for corporate governance.
Generally, even if the shares are not excluded shares, the TOSI rules still allow income-splitting through dividends where the family member has been actively engaged in working on behalf of the corporation. This is referred to as an “excluded amount”, which is covered in the next topic.
Income received through dividends from a corporation would be an excluded amount, and therefore not subject to the higher tax on split income, if the individual made contributions of capital or work to the corporation. The amount paid in dividends cannot exceed what is a reasonable return for the contribution. On its web page, the CRA has laid out in general terms its philosophy regarding how this will be enforced:
“In determining whether the payment is a Reasonable Return, the Agency does not intend to generally substitute its judgment of what would be considered a reasonable amount unless there has not been a good faith attempt to determine a reasonable amount based on the Reasonableness Criteria. In those cases, taxpayers should expect the Agency to review the payment based on all of the relevant facts and circumstances to determine whether the amount of the payment is reasonable and taxpayers should be prepared to support their position that the amount of the payment is a reasonable amount not subject to the tax on split income.”
Being actively engaged through work is defined in s. 120.4 as providing on average at least 20 hours of work during the business’s operating season. Moreover, the amount must represent a “reasonable return”. When it is a reasonable return with respect to work, it is defined as being reasonable in relation to “the work they performed in support of the related business.”
Some of the language on the CRA’s page suggests a degree of leniency, not triggering TOSI if the amount of the dividends paid “is similar but is not the same as the salary that [the corporation] would pay to an arm’s length employee.”
An alternative that is often used in family-owned businesses is that family members are paid salaries by the business for the work they contribute. This is a legitimate expense of the business, and the rule for this has always been that the salary paid must be reasonable, and in line with what a non-relative would be paid for doing the same work.
As suggested above, there might be some greater discretion about the amount paid when it takes the form of dividends rather than salary. In some circumstances, there can also be other advantages to paying for work through dividends rather than a salary. For one thing, there is greater flexibility. A business owner may not know until the end of the year whether the business will make any profit at all. If there are profits to distribute, it can all be done through dividends at the end of the year. If instead salary had been paid on a weekly basis throughout the year, the business owner would have had to decide on its level before the existence of a profit was known. Payroll deductions for income tax on this salary would have already been required to be remitted to the government. In addition, there will also be some other payroll taxes on salaries, which can be avoided through dividends.
Relatives of the controlling shareholder are generally exempt from Employment Insurance premiums, but Canada Pension Plan premiums are mandatory, representing 10.9% of salary, to an annual maximum of $6,366 per person in 2021. That provides a benefit in the form of a future pension entitlement, but some people believe they can do better by investing on their own behalf. They may prefer not to participate in the CPP. In some businesses, WSIB and EHT premiums may also be required for employees.
Lifetime Capital Gains Exemption and Older Owners
One major area of income-splitting remains in effect if the right conditions are met, including the shareholders all being older than 24 years of age. The TOSI rules allow splitting of the capital gains from the sale of the shares of a small business corporation for accessing the Lifetime Capital Gains Exemption. As the name implies, there is a lifetime limit on this per person, which is about $883,000 as of 2020. The limit is per person, rather than per corporation. If four members of a family each own one-quarter of the shares of a qualified small business corporation, the effective amount of the exemption would be four times that basic amount, possibly providing more than $3.5 million of tax-free capital gains. There are strict rules for eligibility, including a requirement that the gain is ascribable to assets used in an active business (rather than passive investments).
Finally, a corporation, including a professional corporation, can accumulate savings from previous retained profits. These can be invested in bonds, real estate, or the stock market, and earn interest, rent, dividends, or capital gains. This is referred to as “passive income” earned within the corporation. If the primary owner of the business turns 65 and retires, income from this source can be shared with a spouse through dividends (regardless of the receiving spouse’s age), without the TOSI penalty. There was already a tax rule that allows the splitting of pension income with a lower income spouse. This exemption from TOSI is therefore a fairness provision for people who were self-employed, for whom their corporation may take the place of a pension. Even for younger people setting up new corporations, this is something to factor into their long-term plans for retirement.
The Complication of Family Dynamics
Income-splitting means that the primary owner must relinquish some amount of ownership and control over the corporation by giving shares to his or her spouse and children or other close relatives.
Any planning about the corporate structure and distribution of shares should factor in family dynamics and the associated risks. Unfortunately, marriages can break down. The gifting of shares may not create much in the way of additional risks in the case of a married spouse, as property equalization rules on marriage breakdown would usually require the sharing of increases in wealth regardless. However, it would make a difference in the case of unmarried common-law spouses, where currently Ontario law does not require such equalization. This is just one reason why the best plan will depend on your personal circumstances, and it is prudent to obtain professional advice.
The payment of dividends is always at the discretion of the directors of the corporation, and there is no obligation to pay the same rate of dividends, or any dividends, on the different classes of shares. However, there are still formal obligations of the corporation to all the shareholders, and therefore shares should not be distributed without forethought. Even minority shareholders may sue the corporation for what is known as “oppression”. Gifting shares to children who might be uncooperative (or have disputes with their own spouses) could create undesirable and unforeseen complications many years down the road. Some of the most bitter corporate litigation occurs among close family members.
TOSI is a complex provision, and this brief survey can only scratch the surface. Moreover, the revision itself is quite new, and the CRA’s own understanding of it will evolve with experience.
The examples discussed here indicate that, while income-splitting has been significantly curtailed, it is far from having been entirely eliminated.
Therefore, in setting up a new corporation, it still often makes sense to have multiple classes of common shares that are distributed to family members. After the corporation is already up and running and profitable, the shares will generally be deemed to have greater value, and there would be adverse tax costs to distributing them at that time. The tax savings from this strategy are not as expansive as in the past, but they can still be significant, so it makes sense to explore the option of doing so.
Peter Spiro is counsel to Rogerson Law Group for tax and estate litigation and planning. This article is for general information purposes and you should seek specific advice for your particular situation.