Ottawa has turned income-splitting rules into an absolute nightmare for small businesses
As every reader will surely recall, the federal government issued a number of tax proposals for private corporations last summer. The government ultimately abandoned or replaced all of them, except for new rules that address so-called “income splitting.” Those rules, now in force, are extraordinarily complex and will impose a heavy compliance burden on small business. The rules should be set aside.
Income splitting involves diverting dividend income (and certain other types of income) from one family member to another member in a lower tax bracket. The planning is disarmingly simple.
For example, assume that an individual resident in Ontario — Sophie — owns a private corporation. Sophie has three children who are pursuing post-secondary education and have little in the way of income. If the corporation pays a dividend of $25,000 to each child, there will be little if any tax to pay on those dividends after deducting federal and provincial “dividend tax credits.” By comparison, if Sophie is in the top tax-rate bracket, her tax on a dividend of $75,000 to herself would have been over $35,000. And so, with a flick of her accountant’s pen, Sophie saves tax of about $35,000 a year.
This type of planning did not work with children under age 18. Minors are taxed at the highest rate on the entire amount of such dividends. So why didn’t the government simply extend the existing rules to older children — age 18 to 24 for example — and eliminate most of its concerns and revenue loss with a word or two of legislation? That apparently would have been too easy for the bureaucrats in Ottawa.
Instead, the government enacted a tortuous new package. There are pages of new rules that tax dividends from family businesses, and more pages of exemptions from the rules. There are definitions of “source individual” and “specified individual”; of “related business” and “excluded business”; of “reasonable return” and “safe harbour capital return.”
But what does it all mean? In short, it means that many family members — of all ages — now have to convince the tax authorities that their contributions to the family business are meaningful enough to justify the dividends they receive. Otherwise, they risk punitive tax rates on the dividend income.
Under these rules, if family members are over age 24 and have not worked an average of 20 hours a week in the business, they may have to prove that their contributions to the business are reasonable — in terms of work performed, property contributed, risks assumed and any other “relevant factors” — all as compared with such contributions by their relatives.
Here is one example. Let’s say Tony and his wife Joyce own an incorporated renovation business. Tony works 40 hours a week in the business, and Joyce works 10 hours. When the business started several years ago, the company required a loan, and Joyce and her parents guaranteed the loan. The company is about to pay a dividend. How much can be paid to each of Tony and Joyce without running afoul of the new rules? Who knows? It all depends on the perceived value of the couple’s respective contributions. How valuable are Tony’s hours as compared with those of Joyce? And what value should be placed on the loan guarantee? The business could not have started without the loan, but the loan has since been repaid. This is an absolute nightmare.
There is an exception. The new rules do not apply to certain family members, provided (in part) that the company earns less than 90 per cent of its income from a service business. Tony and Joyce are out of luck — they operate a renovation service business. In fact, the tax authorities recently stated that over 75 per cent of Canadian small businesses are service providers, and that most of these therefore do not qualify for this exemption. In other words, the government enacted an exemption that most businesses can never access.
Last December, the Senate finance committee warned that the income-splitting rules would be complex, would rely on the subjective determinations of tax auditors and would inevitably lead to disputes and litigation. The committee recommended that all of the private corporation proposals (including the income-splitting proposal) be withdrawn and that the government undertake a comprehensive review of Canada’s tax system with a view to enhancing Canadian competitiveness. Today, Canada faces new challenges, including tariffs, trade and the potential impact of increased U.S. tax competitiveness. It is time for tax reform in Canada, and a good place to start would be the taxation of corporations and their shareholders.
Allan Lanthier is a former chair of the Canadian Tax Foundation and a retired partner of Ernst and Young.