Income Tax Act Rule Change on Income Sprinkling

AFA 517

Income Tax Act rule change on Income Sprinkling

Dr. Mark Feigenbaum, FCPA, FCA

Ryerson University

Taxation for Managers and Financial Planners

Janathan Yoganathan

500 641 320

Bill Morneau the Finance Minister finalized certain changes to the Income Tax Act regarding “Income sprinkling” to family members. In this report I will discuss the rule change using concepts from “Income taxation planning and decision making”, the impact that would mean to a client or the public as a whole, and lastly what policy objective the government is hoping to achieve by this change, and my opinion of the change including my belief on the desired effect.

Under tax planning there can be a transfer of income to another person who is at not arm’s length of you. A person who is defined as not arm’s length is considered anyone who is a member of family (such as a parent or child) to the owner of a business/corporation. Income sprinkling is dividing up profits of a business among members of family, who are income taxed at a lower rate. Income sprinkling is considered tax avoidance. “Generally, tax avoidance involves transactions which, while legal in themselves, are planned and carried out mainly to avoid, or defer tax payable under the law”. An owner of a corporation can provide a salary cheque or dividends to a family member who receives low income, therefore being income taxed under a lower tax bracket.

 A business may be permitted to divide its income among family members. When a salary is paid to a spouse or a child, business income is reduced, and the salary to the family member may be taxed at a lower rate. However, such compensations must be for genuine services, and the related salary must be reasonable. The original proposal for the income sprinkling rule change was designed to crack down on business owners who are sprinkling income to family, when those family members were not contributing to the business whatsoever. Therefore, these people must be taxed at the highest marginal tax rate, cancelling out any tax advantages gained.

The changes to the Income Tax Act regarding income sprinkling will only affects Canadians who have their company incorporated; by doing so establishing a Canadian – Controlled Private Corporation (CCPC). These people are considered the top wealthiest citizens of the country. But if a member of a business owner’s family falls under any of the following categories, the CRA will automatically decide not to tax them at the highest marginal rate:

1. A family member who is over 18, and has made substantial labour contributions to the business. Average over 20 hours of work per week during the year or during non consecutive five pervious years.
2. The family member is 25 or older, and owns a percentage of the business that is equal or greater than 10 percent. Off- ramps do not apply to service based or professional businesses.
3. The family member is the business owner’s spouse, provided that the business owner him/herself meaningfully contributed to the business and is aged 65 or over. This off- ramp is introduced “in recognition of the special challenges associated with planning for retirement”.

Business owners who sprinkle income will need to verify that they meet the qualifications to have sprinkled income taxed at the lower rate, and the CRA will take them at their word. However, audits can be conducted to prove if owners are being legitimate or not. In October 2017, Bill Morneau confirmed that he was adjusting proposals on passive income so only about 3 percent of the wealthiest privately owned corporations will have to pay higher taxes.