Canada’s new income-splitting rules – Possible restructuring and the importance of the related business concept

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On July 18, 2017, the federal Minister of Finance, Bill Morneau, issued a news release indicating that the Department of Finance was setting out “Proposed policy responses to close loopholes and bring greater fairness to the tax system”. The public was invited to provide comments by October 2, 2017 regarding the related proposed legislation. The response was overwhelming, with over 21,000 submissions made by members of the Canadian public.

After considerable backtracking, the Department of Finance issued in haste revised draft legislation and explanatory notes on December 13, 2017. These new rules are to come into effect on January 1, 2018 with no further consultation with the public.

It should be noted that the draft legislation was issued on the same day that the Standing Senate Committee on National Finance released its report making the following recommendations:

  • The Department of Finance should withdraw the proposed tax changes respecting Canadian-controlled private corporations;
  • The Department of Finance should undertake a comprehensive review of Canada’s tax system; and 
  • The application of any proposed changes affecting Canadian-controlled private corporations should be delayed to January 1, 2019 if not later.

What is the thrust of the new tax?

The new tax on split-income (“TOSI”) will expand what was known as the “kiddie tax” which applied to children under the age of 18 years. The kiddie tax applied tax on the income caught under these rules at the top marginal rate of tax without the minor child having any access to tax credits for the basic personal exemption or many other credits.

In an expansion of the kiddie tax, the government now proposes to apply the TOSI in respect of amounts received by adult individuals from a “related business”. A business will generally be a “related business” if someone who is related to the income recipient is actively engaged in the business or owns significant equity in the corporation that carries on the business.

However, the proposed legislation now contains a number of exclusions from TOSI, one of which concerns individuals over the age of 24 receiving income from a related business and having a significant interest in the corporation carrying on the related business. This exclusion will neither apply to a professional corporation nor a corporation whose business income is 90% or more from the provision of services. 

Defining “related business”

One of the purposes of this article is to examine the uncertainties associated with the definition of “related business” under the new rules. 

A related business in respect of an individual subject to TOSI means: 

  • an unincorporated business carried on by a related individual at any time in the year;
  • a business carried on by a partnership, corporation or trust if a related individual is actively engaged on a regular basis in the activities related to earning income from the business;
  • a business of a partnership if a related person has an interest either directly or indirectly in the particular partnership; and
  • a business of a corporation where a related individual owns shares of the corporation or property that derives all or part of its fair market value from such shares where the fair market value of such shares and property together are greater than 10% of the fair market value of the issued and outstanding shares of the corporation carrying on the business.

10% safe harbour corporate exclusion

The draft legislation contains an exclusion from TOSI for adults aged 25 or over who own shares of a corporation with 10% or more of the votes and fair market value. This exclusion is not available if 90% of the business income of the corporation for the preceding taxation year was from the provision of services or if the corporation was a professional corporation. In addition, 90% or more of the income of the corporation for the preceding taxation year cannot be income derived directly or indirectly from one or more other “related businesses”.  We will call this exclusion the 10% safe-harbour corporate exclusion (you may refer to our recent article discussing the uncertainties regarding this particular exclusion for a more in-depth analysis).

Let us take a look at a standard estate freeze situation in which Mom owned the shares of an operating company that is a wholesale distributer of widgets (“Opco”). A number of years ago Mom decided that she had enough capital and converted her common shares of Opco into non-participating preferred shares. New common shares having a nominal value were issued to Mom’s children. One of the children is now 25 years old and is still in school at a U.S. university pursuing a PHD degree. 

Provided this child holds shares having 10% or more of the votes and equity in Opco, the child can receive dividends at graduated income tax rates and will be entitled to the non-refundable tax credits for the  basic personal exemption and tuition fees. This is a significant income-splitting opportunity. 
The business carried on by Opco is a related business since Mom is related to her children and is actively engaged on a regular basis in the activities of Opco related to earning income from the business.

Now imagine that Opco is wholly owned by a holding corporation (“Holdco”) and that the exchange of shares had occurred at the holding company level so that Mom owns preferred shares of Holdco and the two children own common shares of Holdco.  The only asset of Holdco are the shares of Opco and the only business of Holdco is acting as a holding corporation that receives dividends from Opco. The business carried on by Opco is still a related business in respect of the children.

When we look at the 10% safe-harbour corporate exclusion, it is clear that the child is entitled to the exclusion if the child holds common shares of Opco having 10% or more of the votes and equity of Opco.  However, for the reason mentioned in the next section, it appears that if the child owns shares of Holdco, the 10% safe-harbour corporate exclusion is not available.

No 10 % safe harbour corporate exclusion for holding company shareholders

As previously mentioned, the exclusion is denied if more than 10% of the income of the relevant corporation, (in this case, Holdco) for the preceding taxation year is income derived directly or indirectly from one or more other related businesses. This condition was included by the Department of Finance to avoid situations such as a corporate service business being reorganized where the building in which it carries on its business is transferred to a side corporation which charges rent thereby avoiding the services prohibition.

In the estate freeze scenario mentioned above, all of the income of Holdco is from dividends paid by Opco which carries on a related business.
Based on the present wording, it looks like the Holdco-Opco structure will not qualify for the 10% safe-harbour corporate exclusion unless the child holds shares directly in Opco.

There is another possible interpretation of the proposed legislation which would allow shareholders of Holdco to claim the exclusion. If the ownership of Opco shares and receipt of dividends on those shares is not considered a “business”, the receipt of dividend income from Opco would therefore not be from one or more “other” related businesses.

The Department of Finance issued a publication entitled “Guidance on the application of the split income rules for adults” at the same time as it issued its revised draft legislation on December 13, 2017. This Guidance publication sets out a number of examples which are intended to provide guidance on how Canada Revenue Agency will administer the new rules and the specific exclusions from split income.  

Example No. 8 in the Guidance publication sets out the case of two siblings who each own 50% of the shares of a corporation. The particular corporation used to carry on an active business which was wound down and now owns a portfolio of passive investment assets that requires sporadic management decisions and investment activity. The example concludes that dividends from the corporation will not be split income because of the 10% safe-harbour corporate exclusion. This seems to confirm that a corporation that owns a portfolio of passive investment assets will be considered to be carrying on a business-otherwise the application of the 10% safe-harbour corporate exclusion would not be necessary.

The case of Holdco which only holds shares of Opco and pays out to its shareholders all the funds it receives as dividends from Opco is even less clear. In this case, there is not even a portfolio of passive investment assets, just shares of Opco. Is there a business being carried on by Holdco?
It remains to be seen how Canada Revenue Agency will interpret the legislation.

Trust structures

It is conceivable that some trust structures may still be beneficial but their intricacies are beyond the scope of this article. It is important to note that any shares held by a trust will not qualify for the 10% safe-harbour corporate exclusion.

Restructuring

The proposed legislation gives individuals until the end of 2018 to reorganize share structures in order to qualify for the 10% safe-harbour corporate exclusion.  A good portion of 2018 may be required in order for tax professionals to get clarification from the Department of Finance as to how the definition of “related business” is to be interpreted.

In all circumstances it will be advisable, if not necessary, to review all corporate, partnership and trust structures to determine whether they are tax efficient or whether they need to be modified or terminated as a result of the application of the new TOSI rules.

Disclaimer

This summary is being provided as general information only and is not meant as legal opinion or advice. Each situation is unique and should be reviewed on its own, with the appropriate attention and care it deserves. Please do not hesitate to contact any member of our Tax Group if we can be of further assistance in this regard.