Sillier than ever on income ‘sprinkling’
Last week, the Department of Finance rel eased revised proposals to address “income sprinkling” — proposals scheduled to take effect January 1st. While the rules are not the most complex in the history of Canadian tax, they are among the most absurd.
The tax policy concern is legitimate. An individual who owns a private corporation can arrange the corporation’s share structure so that other family members — such as a spouse and children — own shares as well. Income, including dividends and capital gains, can then be realized by family members who are at lower rates, or who may not be taxable at all. Existing law — the “split income” rules — addresses income sprinkling for children under age 18, by taxing dividends at the highest marginal tax rate (unless the income is from certain inherited property). However, the rules do not apply to adult family members. So how best to address this? Here’s one idea.
If an individual has a significant interest in a private corporation’s business, extend the split- income rules to other family members age 18 to 24, and apply the rules to both dividends and capital gains, with no reasonability exceptions. One or two lines of legislation would capture most of the tax at issue, while avoiding the uncertainties, compliance costs and endless disputes with the tax authorities that otherwise lie ahead.
But that would have been too easy. Here is a flavour of the new rules from Finance: If a spouse, child or sibling is over 17 years of age, dividends received from private corporations may be split income and be taxed at the highest marginal rate, unless the individual is actively i nvolved in the corporation’s business on a “regular, continuous and substantial basis,” either in the year or in any five prior taxation years (including years before 2018). An individual is considered to have met this test if he or she worked an average of 20 hours a week in those years.
And how does someone demonstrate compliance with the 20- hour requirement? The Canada Revenue Agency says that taxpayers should keep timesheets, schedules or logbooks. But that is not how family businesses operate. And there will generally be no records whatever for years prior to 2018, before Finance dreamt up this test.
There are other possible exceptions ( or “off ramps,” as the Finance backgrounder calls them). For example, the rules will not apply to individuals age 25 and over, if the individual owns at least 10 per cent of the corporation’s shares, the corporation is not involved in certain professions ( including medical, dental, legal and accounting) and the corporation is not in a service business. Say what? An individual is exempt if the corporation buys and sells widgets but, if it carries on a service business, the exception does not apply? Hair stylists, plumbers and welders are out of luck. So is every other service business, such as web designers, commission sales agents and engineering and construction businesses. If there is any possible reason for this distinction between sales and service, Finance has not disclosed what it is.
For spouses, the rules cease to apply at age 65. Beyond these exceptions, the rules apply to the extent that an amount exceeds a “reasonable return,” a subjective measure that considers the relative contributions of the individual to the business as compared with other family members, in terms of work performed, property contributed, risks assumed, and “such other factors as may be relevant.” Good luck in balancing all of these factors, and arriving at an amount that the tax authorities accept.
There are additional rules for capital gains. And these are the new simplified tests, ostensibly designed to provide greater certainty and reduce taxpayers’ compliance burdens.
The rules that were floated in the summer would have also denied multiple claims by family members to the lifetime capital-gains exemption. In perhaps its most baffling move, Finance abandoned this initiative — an absolute windfall to family members. What Finance should have done was allow only one exemption per married couple.
Finance received thousands of submissions from concerned taxpayers and advisers during the consultation period. The Senate finance committee warned that the income- sprinkling proposal would be complicated to apply, require significant paperwork, and inevitably lead to disputes and litigation. No matter. With the curious exception of the capital- gains exemption, Finance decided that every last dollar of income which should arguably be taxable must be taxed, irrespective of the disruption and mayhem that results. Damn the torpedoes, full speed ahead. Taxpayers and their advisers can figure out the rules, and then decide how best to deal with the consequences.
It is time to bring some common sense to bear. Abandon these proposals and adopt a simpler and more sensible approach. And then let private corporations do what they do best — carry on business.