While the recent tax changes affecting private corporations were presented as a means of targeting high-income individuals looking to shift income to family members in lower tax brackets, the true impact of the rules extends much further than simply income splitting and actually affects the way Canadians transfer wealth between generations and engage in estate planning.
Both the extension of the tax on split income (TOSI) rules and the new rules limiting passive income earned inside a private corporation have impacted common estate planning practices in Canada.
The TOSI rules work to remove the benefits of income sprinkling by imposing tax at the highest marginal rate on amounts that would be considered split income—such as dividends from private corporations—when they are paid to certain related individuals. The specific details surrounding the rules and the various exclusions can be found here, but the intention is to link the contribution that a person makes to a business—either through labour, capital or risk—to the return the individual takes from the business. As a result, income earned from share ownership may not be taxed at the shareholder’s personal tax rate, which, from an estate planning standpoint, is a shift that is highly important.
A few of the specific provisions that are relevant from an estate planning perspective are as follows:
In determining how income and gains earned on inherited property will be treated for TOSI purposes, the legislation has outlined specific rules that will differ depending on the age of the recipient, as well as the relationship between the recipient and the deceased.
A general exclusion exists if an individual is under 25 years of age and is inheriting property from a parent (or anyone if the individual in question is a full-time student or eligible for the disability tax credit). Income or gains on such property will be fully excluded from TOSI. For all other individuals who are at least 18 years or older and do not meet the criteria mentioned above, income or gains earned on inherited property are not generally excluded in any way. Instead, the recipient of the property will inherit the contributions of the deceased with respect to the property, and those specific contributions will be used to assess whether TOSI will apply on any income or gains, based on the specific criteria.
For example, in the case that parent worked an average of 20 hours per week in Opco for at least five years—criteria that would exempt the parent from TOSI under the “excluded business” test—and the parent passes away and leaves his/her Opco shares to a 30 year-old adult child, dividends received by the adult child from Opco would also be excluded from TOSI as the adult child would have inherited the labour contributions made by the parent during his/her lifetime with respect to Opco.
Income splitting with a spouse becomes easier once a taxpayer reaches 65 years of age. TOSI will not apply on an amount received by an individual from a related business if the individual’s spouse has attained the age of 65 during the year and the amount itself would have been excluded from TOSI had it been received by the spouse directly.
Gains on death
One helpful addition to the new rules, from an estate planning perspective, is that any capital gain incurred as a result of a taxpayer’s death will be excluded from TOSI. This was a necessary addition to ensure that taxpayers were not being unnecessarily punished for circumstances out of their control and it is a helpful exclusion to keep in mind when going through the estate planning process.
The new rules around passive income earned inside a private corporation work by restricting a corporation’s access to the small business deduction when passive income earned exceeds a certain threshold. For a corporation with active business operations that is relying on the small business deduction, losing even a portion of this deduction could result in a significant increase in taxes payable due to the large spread that can exist between the small business tax rate and the general corporate rate in certain provinces. The impact here is that it becomes less advantageous for a taxpayer to save for retirement within their private corporation. From an estate planning perspective, this, again, represents a shift.