New Rules on Income Sprinkling Remain Ambiguous
By: Nizam Shajani, CPA, CA, MBA, Partner
The new rules around income sprinkling remain ambiguous. Effective January 1, 2018, family members now have to convince the tax authorities that their contributions to the family business is meaningful enough to justify the dividends they receive or fall within one of the exempting rules. Otherwise they risk paying tax at the highest marginal rate.
What is Income Sprinkling?
Income sprinkling is a new term introduced by our finance minister that is the movement of a dividends from one family member to another to take advantage of the progressive tax rates. Someone earning a dividend from a family business at the top tax bracket may pay 41.64% tax whereas if $25,000 of that income were earned by their child while in post secondary school – there may be little to no tax owed on that $25,000. This simple movement would save that family more than $10,400 in tax payments. Add in a second child and a spouse, plus take advantage of the bottom tax brackets – and you have some serious tax savings through this tax plan.
However, effective January 1, 2018 there are measures to make income sprinkling more difficult or at least riskier. This is because in the 2017 federal budget, the government expanded rules around tax on split income (TOSI).
Before the rule changes, TOSI applied the highest marginal tax related to split income of certain family members under the age of 18. This includes private company dividends, capital gains and certain income from partnerships or trusts. This was known as the kiddie tax rules.
The new rules extend TOSI to certain family members over the age of 17. This now includes a spouse and adult children. To pay them a divided from your family business and not have those dividends taxed at the highest marginal tax rate – you will now have to qualify in certain categories that include excluded shares, excluded business or prove a reasonable contribution.
If you are over 24, you can be exempt from the new TOSI rules if you hold ‘excluded shares’. These are shares in a private corporation which give you 10% of both the votes and value. This is not available for professional corporations or service-based businesses.
If you are at least 18, you can be exempt from the new TOSI rules if it comes from an ‘excluded business’. This is one in which you were actively engaged on a regular, continuous basis in the current or in any of the five previous years (which need not be consecutive). You are considered to be actively engaged if you work in the business at least 20 hours per week on average. This is also known as the bright line test.
If you are over 24 and have not worked an average of 20 hours per week in the business, you will have to prove your contributions to the business are reasonable in terms of work performed, property contributed, and risks assumed along with any other relevant factors – and compare this with the contributions of your relatives to that business. This area remains ambiguous.
Businesses that wish to pay dividends will now have to be aware of new terms that include source individual, specified individual, related business, excluded business, reasonable return and safe harbour capital return – along with testing the dividends issued for the exempting rules and documenting reasonable contributions each year.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action.