It’s getting to be a nasty habit of the Federal Government: dropping major tax legislation on us just as everyone is leaving for the holidays. It happened last July – and again now (December 13th 2017).
What was so urgent that needed releasing ? The “TOSI” (tax on split income) rules that our Government considers an important priority. They say that these changes will raise an additional $200 million in tax. In view of the fact that the annual deficit is currently projected at almost $18 billion, we can think of some other things that could perhaps use some attention, but never mind.
Please note: it’s important that we emphasize up front that salaries and wages (reported on a T4 slip) are not subject to these new provisions – the Government appears to be satisfied that the long-established principle that such earnings must be reasonable in the circumstances already prevents taxpayers from paying their spouses $100K for doing the banking, and other shenanigans.
These tax changes are really the tax world’s equivalent of an earthquake. Out of the blue, we now have the concept of “earning a dividend”, rather like a job. For instance, to avoid TOSI individuals have to be actively engaged on a regular, continuous and substantial basis. That’s a provable average of at least 20 hours per week, according to CRA.
In addition, the Department of Finance clearly has a “hate” on for service businesses, as opposed, for example, to a seller of goods. “Professional corporations” and businesses basically dedicated to the provision of services are intended to be caught by these rules. That’s awfully discriminatory for what are probably the majority of businesses in this country.
Such an approach has never been attempted on such a scale, and, assuming this recent Bill is passed in its current state, it seems to us to be almost certain to be challenged in Court, with one possibility being the eventual overturn of the whole thing. While that might be pleasant to contemplate, the problem is that such a Court decision, if it ever did happen, would be years away, leaving taxpayers floundering on their own, in an ocean of uncertainty.
But wait: maybe that should be our strategy: clog the Courts with tens of thousands of tax appeals ? Hold that thought.
TOSI (Tax on Split Income)
TOSI currently applies to dividends, capital gains, and other “income splitting” structures received by minor children (under age 18). As TOSI is now being re-written, it will (as of January 1, 2018) now apply to recipients of certain types of income by persons of ALL ages (except at age 65 – more comments on that to follow).
Excepted are capital gains arising on the sale of farm property, gains realized on “qualified small business corporation (QSBC)” shares, gains that might otherwise arise as a consequence of marriage breakdown, or the deemed disposition arising on death. Thank goodness – those events are serious enough, all by themselves !
The QSBC exception will be most valuable to business owners who can qualify, since it is a means of multiplying the exemption across all family members, regardless of age. A family of 2 adults and 3 children, for example, could qualify for tax exemption on a total of $4.2 million in gains – which is nothing to be sneezed at.
A great relief to our older clients will be that dividends paid won’t be subject to TOSI if the active shareholder is 65 or older (while the spouse receiving the dividend could be younger than that). That fits well with the notion that holding company accumulations are, in many or most situations, intended to provide a retirement income to business owners. This rule is apparently designed to dovetail with the ‘pension splitting’ rules that are already permitted by law.
The TOSI serves to apply the top marginal rate of tax applicable to ‘ineligible’ dividends (43.7% in B.C., in 2018, for example) to the affected income. Since that’s ridiculous, a TOSI is obviously to be avoided, at all costs.
Dividends will, for the first time, be subject to a “reasonableness test” which, in all honesty, will likely catch almost all of our clients. Thus the major impact of this change will be to concentrate income in the hands of the principal income-earner. That’s guaranteed to cost those who have been using income splitting strategies in the past a lot more tax, starting in 2018.
The government is, in fact, so dedicated to the idea of eliminating income splitting benefits for “professionals” (doctors, lawyers, accountants, and a host of others) that it has even gone beyond that, extending the new rules to all businesses who derive their income from services.
Canada has a great many private corporations involved in providing services, and to discriminate against them, versus, say, companies engaged in selling products seems unduly harsh.
Much of the TOSI exclusions centre on something called “business income”, and while the reader might be forgiven for assuming that such a thing would, by now, be well understood – actually, we’re far from it. The Income Tax Act has always taken effort to distinguish “income from property” from “income from business”, and yet the definition of “business” in the Act is “an undertaking of any kind, whatever”. It seems that “undertaking” excludes passive investing, but that’s not a certainty.
The new rules require direct share ownership by any individual seeking to avoid the application of TOSI. So does this basically spell the end of family trusts ? Stand by for more information on this topic, as many of our clients have profitably utilized family trusts for years. While many such trusts are getting old, there may be some “housecleaning” needed if the supply of income splitting candidates has dwindled away. And don’t forget that all trusts have a deemed disposition date on the 21st anniversary of their creation, which could trigger large and unwanted capital gains. Usually, prior to that time, trusts are wound up, by way of tax-free distribution of the trust’s capital (most importantly, the shares of the subject corporation). This may motivate a lot of trusts to pack it in – but you must be cautious. Trusts are likely still the best (and possibly only) way to multiply the capital gains exemptions on the eventual sale of a family QSBC (see other reference herein) – so it’s best to discuss all this with us before doing anything drastic.
Are ‘IPPs’ an answer?
The TOSI rules are certainly intended to restrict the amount of income that can be “split” with a spouse. Most concerns should be alleviated by simply waiting until age 65, but some clients may want to revisit the concept of setting up their own formal pension plans, known as the “individual pension plan (IPP)”. The reason: it’s possible for the recipient of benefits under an IPP to split up to 50% of that income with his or her spouse, once pension payouts have begun. Thus, it may be possible to do an “end run” around the new restrictions, using some pre-existing planning possibilities.
One interesting factor in all of this could yet throw a ‘wrench’ into the Government’s plans: the Senate. This non-elected body, which has caused frustration on many past occasions, might ride to our rescue, and refuse passage of this Bill on the basis that these changes are so fundamental to established tax practice, they require a Royal Commission to consider. The last Royal Commission on taxation was formed in the 1960’s, which led the taxation of capital gains and a huge overhaul of the Income Tax Act at the end of 1971.
It’s also important to note that these TOSI rules are just the opening act – the July 2017 pronouncement included possible new taxes on holding companies and other corporate accumulations of investment capital that some commentators have been calling confiscatory. And that’s despite the fact these accumulations have been completely legal for decades. Most of the time, they merely serve as a form of “do it yourself” pension plan for their owners. Too bad that those owners have to first earn the money that goes into these plans – unlike the incredibly expensive pensions that members of Parliament enjoy, but that very few Canadians are even aware of: as much as $2 to $3 million, each).
We’ll keep you posted on developments, as they occur !
The Lohn Caulder Team