This is the fourth article in a series of articles examining the new Canadian federal legislation targeting income splitting (the “New Rules”) that applies as of January 1, 2018. You may also refer to our previous articles for an overview of the new income splitting rules, the importance of the rules for the "related business" concept, and the significance of the new rules for partnerships in Canada.
This article examines how the New Rules will affect the two main tax benefits provided by the following typical corporate structure involving a family trust:
This structure provided two main tax benefits under the old rules:
- income splitting - Opco would pay dividends to the trust and the trust would distribute those dividends to the business owner’s spouse and adult children who would be in a lower tax bracket than the business owner, thereby reducing the family’s overall tax burden. This strategy was particularly effective when directing income to adult children who were attending university and had no other sources of income; and
- multiplication of lifetime capital gains exemption - on a sale of the business, the trust would sell the shares of Opco and allocate the resulting capital gain to the business owner’s spouse and adult children. The trust’s beneficiaries would then each claim his or her lifetime capital gains exemption, thereby reducing or eliminating the capital gains tax that would otherwise be payable on the sale.
Bad news - new rules severely limit income splitting tax benefit
Under the New Rules, dividends paid by Opco to the trust and distributed by the trust to the business owner’s spouse and adult children will be subject to “tax on split income” (“TOSI”) and taxed at the top marginal rate (thereby eliminating any income splitting tax benefit), unless the family member qualifies for an exclusion from TOSI.
Family members who fall into either of the following categories will automatically be excluded from TOSI:
- adults aged 18 or over who are (or have been in any five prior taxation years) actively engaged on a regular, continuous, and substantial basis in the business (this requirement will be met where the individual works at least an average of 20 hours per week in the business, and may be met under other circumstances); or
- where the business owner is aged 65 or over and would be excluded from TOSI (e.g. if he or she is actively engaged on a regular, continuous, and substantial basis in the business), then the business owner’s spouse is automatically excluded from TOSI regardless of the spouse’s age.
Family members aged 25 or over (and family members aged 18-24 who have contributed their own capital to the business) who do not fall into these categories will be subject to a reasonableness test to determine how much, if any, of their dividend income will be subject to TOSI and taxed at the top marginal rate. We discussed this reasonableness test in our second article.
Significantly, dividend income paid to a trust and allocated to the business owner’s spouse and adult children will not qualify for the exclusion from TOSI for family members aged 25 or over who hold 10% or more of the votes and value of Opco, since they do not hold shares of Opco directly. We discussed this 10% safe harbour corporate exclusion in our third article.
It is important to note that although this article focuses on dividends, under the New Rules TOSI can also apply to other types of income such as interest and certain capital gains.
Good news - new rules do not affect multiplication of lifetime capital gains exemption tax benefit
The trust can still sell the shares of Opco and allocate the resulting capital gain to the business owner’s spouse and adult children. Under the New Rules, the business owner’s spouse and adult children can then each claim their unused lifetime capital gains exemption to reduce or eliminate the capital gain (provided the shares of Opco qualify as “qualified small business corporation shares” eligible for the exemption). Given that as of 2018 each individual can claim a lifetime capital gains exemption of up to $848,252, this can be a very significant tax benefit.
Example: application of New Rules
Audrey is 65 years old and used to be the sole shareholder of a company that operated a successful human resources business (“HRco”). 80% of HRco’s business income is from providing human resources services and 20% is from licensing proprietary software.
Several years ago, Audrey exchanged her voting common shares for voting preferred shares with a redemption value of $3M (and a nominal tax cost) and retired, having worked for HRco for over 25 years. New non-voting common shares were issued to a discretionary family trust (the “Family Trust”) at that time for nominal consideration, and are now worth $3M.
The beneficiaries of the Family Trust (all of whom are residents of Canada) are listed as follows:
- her husband, Bob, who is 60 years old and has never been involved in the business; and
- their three daughters:
- Chelsea, who is 18 years old and attends university in Canada;
- Dana, who is 25 years old and works the odd shift from time to time at HRco while attending university in Canada; and
- Eva, who is 27 years old and has been a full-time employee of HRco for the past several years.
In recent years, HRco has paid annual dividends of $120,000 to the Family Trust, and the Family Trust has distributed $40,000 to each of the three daughters.
Under the old rules, dividends paid by HRco to the Family Trust and distributed by the Family Trust to the three daughters were taxed at significantly lower rates than if they had been paid to Audrey and taxed at her comparatively high rates (and in some cases the dividends were not subject to any income tax by virtue of various tax credits available to the daughters).
Under the New Rules, on the other hand, dividends paid by HRco to the Family Trust and distributed by the Family Trust to the daughters will be taxed as follows:
- dividends received by Chelsea will be subject to TOSI and taxed at the top marginal rate (thereby eliminating any tax benefit of income splitting with her);
- dividends received by Dana will be subject to the reasonableness test to determine how much, if any, of those dividends will be subject to TOSI and taxed at the top marginal rate (thereby potentially eliminating any tax benefit of income splitting with her); and
- dividends received by Eva will be excluded from TOSI because she is actively engaged on a regular, continuous, and substantial basis in the business (thereby preserving the tax benefit of income splitting with her).
By transferring shares from the Family Trust to Dana such that Dana holds 10% or more of the votes and value of HRco, Dana could potentially qualify for the 10% safe harbour corporate exclusion, since she is aged 25 or over and HRco should meet the requirements for this exclusion (i.e. it is not a professional corporation, less than 90% of its business income in the last taxation year was from the provision of services, and none of its income is derived from another business “related” to Dana). As an aside, it should be noted that transfers of shares of Opco from the Family Trust to beneficiaries who are residents of Canada will not cause any immediate tax.
As for Audrey and her husband:
- dividends or other income (such as redemption proceeds on the redemption of her preferred shares) received by Audrey will not be subject to TOSI because she was actively engaged on a regular, continuous, and substantial basis in the business in at least five prior taxation years; and
- dividends received by Bob will also not be subject to TOSI because Audrey is aged 65 or over and would not be subject to TOSI herself on such income (as set out above).
On a sale of the shares of HRco to an arm’s length purchaser, provided the shares qualify as “qualified small business corporation shares” and none of the family members have claimed any of their lifetime capital gains exemption in the past:
- Audrey will realize a capital gain of roughly $3M, which she should be able to reduce by $848,252 by claiming her lifetime capital gains exemption; and
- the Family Trust will also realize a capital gain of roughly $3M, which it should be able to eliminate altogether by allocating the gain to Bob and the three daughters and having each of them claim his or her lifetime capital gains exemption (i.e. $848,252 x 4 = over $3M in total available lifetime capital gains exemptions).
With respect to the typical corporate structure involving a family trust described above:
- the bad news is that the New Rules will severely limit the income splitting tax benefit; but
- the good news is that the New Rules will not affect the multiplication of the lifetime capital gains exemption.