Curtailing Income Splitting Opportunities for Small Business Corporations

If the proposed July 18, 2017 legislation is passed, commencing in 2018, tax at top marginal tax rates may apply to dividends paid directly or indirectly through a family trust to an adult. Previously this tax burden or what was commonly called “kiddie tax” applied to dividends paid on private corporation shares to a minor directly or indirectly from a family trust.

What now is called split income or split portion, the basis of this taxation will now include capital gains arising on the disposition of private corporation shares held by minors and by adults, held directly or indirectly from a family trust, as well as to income earned on split income to those ages 18-24.

The capital gains exemption (“CGE”) that would otherwise be available on the sale qualified small business corporation shares (“QSBC”) to the vendor or to the trust beneficiary may also be denied. Prior to 2018, one could allocate the capital gain realized in the trust to any discretionary beneficiary regardless of age and therefore multiply the CGE times the number of beneficiaries. Commencing in 2018, for purposes of the CGE, the value accrued while the vendor was a minor is excluded from the portion otherwise eligible for the CGE.

Generally speaking, the new rules will apply if the recipient was not active in the business, the amount paid exceeds a prescribed rate of return or the recipient did not assume sufficient risk. The active business test is tighter for those older than age 17 and younger than age 25. This is CRA’s concept of a reasonable test that presently lacks sufficient guidance on how to interpret and to implement it.

With respect to dividends, any type of shareholding could be affected, even common shares or special/ preferred shares that were issued as part of an estate freeze years earlier, where in most cases, the shareholder is no longer active in the business.

For those potentially affect by this high rate tax commencing in 2018, one may consider paying additional dividends by the end of 2017 to get them up to the top tax bracket.

There is a special 2018 election where one may bump the basis of the shares to fair market value as at the date of the election selected at any time in 2018, using the pre-2018 rules. The shares must be QSBC shares which means that at the date of the election, 90% of the fair market value of the assets must be used in an active business carried on in Canada, and during the preceding 12 months, a 50% test in lieu of 90% must be met. For normal sales the 12 months is 24 months. If the election is contemplated say for December 31, 2018, the CCPC must meet the 50% test by the end of this year which not a lot of time to purify the corporation of non-active assets such as a passive investment and excess cash not required for working capital.

The election should be considered where there is significant unrealized appreciation in the shares and of course if it is anticipated that the corporation may not be a QSBC in a future year, regardless if the shares are owned directly or held by a family trust. Valuations may be considered here.

The election is not available for minors unless there is an actual disposition in 2018.