Guidance on the application of the split income rules for adults

Notice to the reader 

This measure has received Royal Assent.

The Department of Finance consultation paper, Tax Planning Using Private Corporations, released on July 18, 2017, included proposed amendments to expand the existing tax on split incomeFootnote 1 to restrict income sprinkling involving adult individuals. The consultation period for public comments on the paper ended on October 2, 2017. Based on the comments received during that period, revised draft legislative proposals were released on December 13, 2017 (the "Proposals").  These new rules are proposed to be applicable to the 2018 and subsequent taxation years.

Overview

The Proposals will expand the tax on split income to amounts received by an adult individual.  In this context, "split income" will generally include dividends or interest, but not salary, paid by a private corporationFootnote 2 directly or indirectlyFootnote 3 to an individual from a related business ("Related Business")Footnote 4 in respect of the individual and certain capital gains unless the amount falls within a specific exclusion (the "Excluded Amount" or "Excluded Amounts").

Under the Proposals, the following will be Excluded Amounts from split income:

Where the individual acquired a property as a consequence of the death of another individual, special rules will apply for determining whether a payment from property is derived from an Excluded Business in respect of an individual, is a Reasonable Return on contributions made to a Related Business or is income from, or a taxable capital gain from the disposition of, Excluded Shares.

General comments

The following examples are intended to provide guidance on how the Canada Revenue Agency (the “Agency”) will administer the Proposals and the Excluded Amounts from split income.

In determining whether the payment is a Reasonable Return, the Agency does not intend to generally substitute its judgment of what would be considered a reasonable amount unless there has not been a good faith attempt to determine a reasonable amount based on the Reasonableness Criteria.  In those cases, taxpayers should expect the Agency to review the payment based on all of the relevant facts and circumstances to determine whether the amount of the payment is reasonable and taxpayers should be prepared to support their position that the amount of the payment is a reasonable amount not subject to the tax on split income.

The Agency’s approach to the interpretation and the application of the Proposals will develop over time based on our experience in dealing with specific factual circumstances and whether our approach is adequately addressing the tax policy concerns underlying the Proposals.

Examples

The following examples are intended to provide general guidance on how the Agency intends to administer the different Excluded Amounts.  The examples assume that all of the taxpayers are residents of Canada at all relevant times and that the amounts received by the individual would otherwise be split income from a Related Business unless the payment is of an Excluded Amount.  It is also assumed in the examples that, unless otherwise stated, shares of a corporation were not acquired as a consequence of the death of a person, and individuals between the age of 18 and 24 did not otherwise make a capital contribution to the Related Business with Arm’s Length Capital.  Where relevant, the examples indicate where the payment could be considered more than one kind of Excluded Amounts but such additional comments are generally for illustrative purposes only and may depend on a review of the facts and circumstances of the particular case.

Example 1: Dividends to adult child away at school

Facts

Conclusion

The Proposals will apply to the amount received by Child 1 from the Family Trust.  The amount received by Child 1 will be split income and subject to tax at the top marginal rate.

Explanation

The distribution received by Child 1 will be split income unless it is an Excluded Amount.  In general, a payment received by an individual will be an Excluded Amount if (i) the amount is paid directly or indirectly from a business other than a Related Business; (ii) the amount is received from an Excluded Business; (iii) the individual is between the ages of 18 and 24 and the amount does not exceed: the Safe Harbour Capital Return, or a Reasonable Return on contributions of Arm’s Length Capital; (iv) the individual is age 25 or over and the amount is from Excluded Shares; or (v) the individual is age 25 or over and the amount represents a Reasonable Return based on:

In the circumstances, the amount received by Child 1 will not be an Excluded Amount and will be split income.  Child 1 is between the ages of 18 and 24 and has never worked in the business.  As a result, the amount received by Child 1 is not from an Excluded Business in respect of Child 1 as Child 1 has not been Actively Engaged in the activities of the business. As well, because Child 1 has never contributed property in support of Opco’s business, Child 1 cannot rely on the Safe Harbour Capital Return, or a Reasonable Return on contributions of Arm’s Length Capital.

If the Family Trust had distributed any part of the dividend to Child 2, the full amount of the dividend would have been subject to the higher tax on split income under existing law as Child 2 is a minor.  There is no change in the law in this respect.

Example 2: Funding start-up business

Facts

Conclusion

The Proposals will not apply to the higher interest received by Mother.  No change in treatment.

Explanation

The interest paid to Mother from Foodco on the loan by Mother will be split income unless it is an Excluded Amount.  In the circumstances, the higher interest charged by Mother on the loan will be an Excluded Amount because it is a Reasonable Return based on the property contributed and the risk assumed by Mother by lending money to Foodco. In the circumstances, paragraph 20(1)(c) should also not apply to limit the deduction of any part of the interest expense by Foodco.

Example 3: Dividends to spouse

Facts

Conclusion

The Proposals will not apply to the dividend received by Spouse B.  No change in treatment.

Explanation

The dividend paid by Opco to Spouse B will be split income unless it is an Excluded Amount.  The dividend paid by Opco to Spouse B is not received from an Excluded Business in respect of Spouse B as Spouse B has never worked at the business and is not Actively Engaged in the activities of the business.  However, Spouse B holds shares that qualify as Excluded Shares.  As such, the dividend received by Spouse B will be an Excluded Amount.

For greater certainty, the dividend paid to Spouse A will be an Excluded Amount and will not be split income. See Example 3A below.

Example 3A: Dividends to spouse

Facts

Conclusion

The Proposals will not apply to the dividend received by Spouse A.  No change in treatment.

Explanation

The amount of the dividend paid by Opco to Spouse A will be split income unless it is an Excluded Amount.  In the circumstances, the dividend paid by Opco will be an Excluded Amount because it is received from an Excluded Business in respect of Spouse A.  Spouse A is deemed to be Actively Engaged in the activities of the business for the year.  This is because Spouse A has worked in the business at least an average 20 hours per week during the taxation year. Also, Spouse A holds shares that qualify as Excluded Shares.  As such, the dividend received by Spouse A will be an Excluded Amount.

Example 3B: Dividends to spouse

Facts

Conclusion

Explanation

Spouse B holds shares that qualify as Excluded Shares.  As such, the dividend received by Spouse B will be an Excluded Amount.

Example 3C: Dividends to spouse

Facts

Conclusion

The Proposals will not apply to dividend received by Spouse B.  No change in treatment.

Explanation

The dividend received by Spouse B will be split income unless it is an Excluded Amount.  Spouse B does not hold shares that qualify as Excluded Shares since Opco is a professional corporation and Spouse B owns only non-voting shares. However, the dividend will be an Excluded Amount as a Reasonable Return based on the risks assumed in respect of Opco’s business.

Example 4: Dividends paid to adult children active in the family business

Facts

Conclusion

The Proposals will not apply to the amounts received by Child 1 and Child 2 from Children’s Trust.  No change in treatment.

Explanation

The amounts distributed to each of Child 1 and Child 2 will be split income unless they are an Excluded Amount.  In the circumstances, the distribution of the dividend paid by Farmco will be an Excluded Amount because it is received from an Excluded Business in respect of each of Child 1 and Child 2.  They will each be deemed to be Actively Engaged in the business because each works in the business at least an average of 20 hours per week during the taxation year.

Example 4A: Dividends paid to adult children active in the seasonal family business

Facts

Conclusion

The Proposals will not apply to the amounts received by Child 1 and Child 2 from Children’s Trust. No change in treatment.

Explanation

The amounts distributed to each of Child 1 and Child 2 will be split income unless they are Excluded Amounts.  In the circumstances, the distribution of the dividend paid by Farmco will be an Excluded Amount because it is received from an Excluded Business in respect of each of Child 1 and Child 2. They will each be deemed to be Actively Engaged in the business because each works in the business at least an average of 20 hours per week during the portion of the taxation year that the farming business operates.

Example 4B: Dividends paid to an adult

Facts

Conclusion

The Proposals will not apply to the dividends received by Sibling A and Sibling B.

Explanation

The dividends paid to Sibling A and Sibling B will be split income unless it is an Excluded Amount.

In the circumstances, the dividend paid by Opco to Sibling A will be an Excluded Amount as it is received from an Excluded Business in respect of Sibling A. Sibling A is deemed to be Actively Engaged in the activities of the business.  This is because Sibling A works in the business at least an average of 20 hours per week during the taxation year.  Also, Sibling A holds shares that qualify as Excluded Shares.  As such, the dividend received by Sibling A will be an Excluded Amount.

The dividend paid to Sibling B will be an Excluded Amount.  The dividend paid to Sibling B is not received from an Excluded Business in respect of Sibling B as Sibling B is not Actively Engaged in the activities of the business.  This is because Sibling B works in the business less than an average of 20 hours per week during the taxation year and the performance of the work is not sufficiently regular, continuous, or substantial based on the facts and circumstances.  However, Sibling B holds shares that qualify as Excluded Shares.  As such, the dividend received by Sibling B will be an Excluded Amount.

Example 5: Dividends paid to an adult under age 25

Facts

Conclusion

The Proposals will apply to the distribution received by Grandchild 1 from the Family Trust.  The distribution received by Grandchild 1 will be subject to the higher tax on split income.

Explanation

The distribution received by Grandchild 1 will be split income unless it is an Excluded Amount.  In the circumstances, the distribution will not be considered an Excluded Amount.  Grandchild 1 is between ages 18 to 24. The distribution will not be received from an Excluded Business in respect of Grandchild 1 as Grandchild 1 is not Actively Engaged in the activities of the business.  This is because Grandchild 1 works in the business less than an average of 20 hours per week in the taxation year; and the performance of the work is not sufficiently regular, continuous or substantial based on the facts and circumstances.  As well, because Grandchild 1 has never contributed property in support of Opco’s business, the distribution will not be a Safe Harbour Capital Return, or a Reasonable Return on contributions of Arm’s Length Capital of Grandchild 1.

Example 5A: Dividends paid to an adult under age 25

Facts

Conclusion

The Proposals will apply to the distribution received by Child from the Family Trust.  The distribution received by Child will be subject to the higher tax on split income.

Explanation

The distribution received by Child from Family Trust will be split income unless it is an Excluded Amount.  In the circumstances, the distribution will not be an Excluded Amount.  Child is between the ages of 18 to 24.  The distribution will not be received from an Excluded Business in respect of Child as Child is not Actively Engaged in the activities of the business.  This is because Child works in the business less than an average of 20 hours per week during the taxation year; and the part-time work is not sufficiently regular, continuous or substantial based on the facts and circumstances.  As well, because Child has never contributed property in support of Opco’s business, the distribution will not be a Safe harbour Capital Return, or a Reasonable Return on contributions of Arm’s Length Capital of Child.

Example 5B: Salary paid to an adult under age 25

Facts

Conclusion

The Proposals will not apply.  No change in treatment.

Explanation

Section 120.4 does not apply to salary.  In the circumstances, section 67 should also not apply to limit the deduction of the salary expense by Opco.

Example 5C: Dividends paid to an adult age 25 or over

Facts

Conclusion

The Proposals will not apply to the amounts received by Grandchild 1 and Child.  No change in treatment.

Explanation

The distribution received by Grandchild 1 and Child will be split income unless it is an Excluded Amount.  Grandchild 1 and Child are over age 25.  In the circumstances, the amount received by Grandchild 1 and Child will be an Excluded Amount as a Reasonable Return based on the work performed by Grandchild 1 and Child in support of the business.

Example 6: Estate FreezeFootnote 6

Facts

Conclusion

The Proposals will not apply to the proceeds received by Parent A when Opco will repurchase the freeze shares over time.  No change in treatment.

The Proposals will not apply to the payments received by Child 1.  No change in treatment.

The Proposals will apply to the payments received by Child 2 but will not increase the rate of tax paid on the amount received by Child 2.

Explanation:

The amounts received by Parent A, Child 1 and Child 2 will be split income unless it is an Excluded Amount.

In the circumstances, the dividends deemed to be paid by Opco on the repurchase of the freeze shares held by Parent A will be an Excluded Amount as the dividend is received from an Excluded Business in respect of Parent A. Parent A was deemed to be Actively Engaged in the activities of the business.  This is because Parent A worked in the business at least an average of 20 hours per week in any the five prior taxation years of Parent A.

In the circumstances, the distribution paid to Child 1 will be an Excluded Amount as the dividend is received from an Excluded Business in respect of Child 1. This is because Child 1 is deemed to be Actively Engaged in the activities of the business.  Child 1 worked in the business at least an average of 20 hours per week during the taxation year.

In the circumstances, the distribution paid to Child 2 will not be an Excluded Amount.  As Child 2 does not own shares of Opco, the Excluded Shares exception is not available.  Child 2 was not Actively Engaged in the activities of the business during the taxation year.  The distribution is also not a Reasonable Return based on the Reasonableness Criteria.  In each case, this is because Child 2 has no involvement and has made no contribution in support of the business.  As Child 2’s income is already taxed at the top marginal rate, the Proposals will not increase the tax rate paid by Child 2 on the dividend.

Example 7: Sale to Child

Facts

Conclusion

The Proposals will not apply to the amounts paid to Parent or Child.

Explanation:

The amount received by Parent on the sale of the shares will be split income unless it is an Excluded Amount.  In the circumstances, the amount received will be an Excluded Amount because the shares of Opco are qualified small business corporation shares. It is also the case that the taxable capital gain would be from an Excluded Business in respect of Parent.  Parent is deemed to be Actively Engaged in the activities of the business because Parent worked in the business at least an average of 20 hours per week in each taxation year in any five prior taxation years.  The Opco shares also qualify as Excluded Shares of Parent.

The dividend paid to Child will be split income unless it is an Excluded Amount.  In the circumstances, the dividend paid by Opco will be an Excluded Amount as the dividend received is from an Excluded Business in respect of Child. Child is Actively Engaged in the activities of the business based on the facts and circumstances and the work performed by Child.  As well, for greater certainty, the dividend paid to Child could also have been an Excluded Amount as a Reasonable Return based on the Reasonableness Criteria and the amount at risk in Child’s acquisition and ownership of the business.  The Opco shares also qualify as Excluded Shares of Child.

Example 8: Retired Owner-Manager

Facts

Conclusion

The Proposals will not apply to the dividends paid to Sibling A or Spouse B.

Explanation:

The dividend paid to Sibling A and Spouse B will be split income unless it is an Excluded Amount.  In the circumstances, the dividend will be an Excluded Amount as Sibling A and Spouse B hold shares that qualify as Excluded Shares.

Example 9: Dividends paid to adults active in the business

Facts

Conclusion

The Proposals will not apply to the dividends received by Spouse A and Spouse B.  No change in treatment.

Explanation:

The dividends paid to Spouse A and Spouse B will be considered to be received from an Excluded Business in respect of Spouse A and Spouse B as they are both Actively Engaged in the activities of Opco’s business based on the facts and circumstances and the work performed by Spouse A and Spouse B.

Example 10: Dividends paid to adults shareholders

Facts

Conclusion

The Proposals will not apply to the taxable dividends received by Sibling A, Sibling B and Sibling C.  No change in treatment.

Explanation:

The taxable dividends paid to Sibling A, Sibling B and Sibling C will be considered to be a Reasonable Return having regard to the risks they assumed as directors of Real Estateco, their supervision of Third Party and their involvement in Real Estateco’s strategic decisions.  The taxable dividends will also be Excluded Amounts as Sibling A, Sibling B and Sibling C hold shares that qualify as Excluded Shares.

Example 11: Reasonable Return

Facts

Conclusion

The Proposals will not apply to the dividend paid to Spouse B.

Explanation:

The dividend paid to Spouse B will be split income unless it is an Excluded Amount.  In the circumstances, the dividend paid by Professionalco to Spouse B will be an Excluded Amount because it is a Reasonable Return based on the Reasonableness Criteria.  Spouse B works at Professionalco’s business.  While high, the amount of the dividend is comparable to the amount that was paid to an arm’s length person.  In general, the Agency will not substitute its judgment for what is a reasonable amount where the taxpayers have made a good faith attempt to determine a Reasonable Return based on the Reasonableness Criteria.

Example 12: Retired Shareholders

Facts

Conclusion

Explanation:

In the case of Spouse A, the dividend will be split income unless it is an Excluded Amount.  In the circumstances, the dividend will be an Excluded Amount as Spouse A holds shares that qualify as Excluded Shares.

In the case of Spouse B, the dividend will be split income unless it is an Excluded Amount. In the circumstances, the dividend will be deemed to be an Excluded Amount because, on the one hand, it would be an Excluded Amount in respect of Spouse A if it had been included in the income of Spouse A and, on the other hand, Spouse A is over age 65.  Indeed, if the amount had been included in the income of Spouse A, it would have been an Excluded Amount because, as discussed above, Spouse A owns shares that qualify as Excluded Shares.

Reasonableness criteria

For individuals age 25 or over who cannot rely on the Excluded Business and Excluded Shares specific exclusions, an amount can still be an Excluded Amount if it is a Reasonable Return based on the Reasonableness Criteria.  Specifically, the Proposals provide that the reasonableness of an amount will be evaluated based on one or more of the following criteria:

While the determination will be based on the facts and circumstances of each case, the following are some of the factors that will be considered in that regard.  This list is not to be considered exhaustive of the factors that could be relevant in any particular fact circumstance.

Similar considerations will be relevant to determine whether the individual is Actively Engaged in the activities of the business.

For individuals aged 18 to 24 who have contributed Arm’s Length Capital in support of a business, their Reasonable Return from the business will be based only on that property contribution of the individual.

Labour Contribution

In determining whether the amount received by an individual exceeds a reasonable amount having regard to the functions performed by the individual in support of the Related Business, factors that may be considered include the following:

Property Contribution

In determining whether the amount received by the individual exceeds a reasonable amount having regard to the property contributed in support of the Related Business, the factors that may be considered include the following:

Risk Assumption

In determining whether the amount received by the individual exceeds a reasonable amount having regard to the risks assumed by the individual in respect of the Related Business, the factors that may be considered include the following:

Total Amounts Paid

In determining whether a payment received by the individual exceeds a reasonable amount, account should be taken of other amounts previously paid to the individual.  This should generally include any payment of any kind (including salary or other remuneration or compensation, dividends, interest, proceeds, and fees), benefits, and deemed payments (as may be reasonably required in the circumstances).

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