Small Business Corporation Tax Changes for Income Sprinkling and Others

Income sprinkling:

By income sprinkling with regard to the small business corporation means reducing the income of the corporation by paying salaries mostly among the family members and thereby reducing the overall tax burden in the family considering overall situation.

On July 18, 2017, current Finance Minister presented the tax changes in a manner that it will levy a Tax on Split Income (TOSI) unless it is from an “Excluded Business”.

The above modified tax changes received Royal Assent on June 21, 2018 and therefore has become the part of the Income Tax Act since then.

When does the Income sprinkling rules not apply?

Over the Age of 18 years:

An Excluded business is the one in which you ( should be over the age of 18 years) were “actively engaged on a regular, continuous and substantial basis in the activities of the business” either in the year in question or any of the five prior tax years, which need not be consecutive.

You will be considered to be actively engaged in the business if you work at least an average of 20 hours per week. For a seasonal operations, you only need to work for at least 20 hours during the season.

Over the Age of 25 years:

If you are over the age of 25, corporation could also be exempt from TOSI rules if you hold the “Excluded shares” which means you hold at least 10% of both the votes and the value of the shares and earn less than 90% of the income from services. However, this rule does not apply to Professional Corporation or Services Corporation.

Over the Age of 65 years:

The rules of income sprinkling does not apply to the business owner’s spouse, provided owner meaningfully contributes to the business and is aged 65 or over.

Capital Gains from qualified small business corporation, qualified small farm or fishing property:

Any capital gains arising from the sale of qualified small business corporation or qualified farm or fishing property will not be subject to TOSI.

Passive Income Rules:

Passive income for a corporation is the one which is not an “active income’. Such incomes usually means income by way of interest, rent, royalty, foreign dividend etc. unless such incomes are earned by more than five full time employees in which case it will be treated as an active income.

Now, the new rules propose that earning such passive incomes inside the small corporation will attract additional taxation. However, there is a basic threshold of $50,000 per annum for levy of the additional taxation for corporation. If passive income exceed $50,000 per annum, ability of small business corporation to claim a deduction of Small Business Deduction (SBD) will reduce by an amount equivalent to $5 for every $1 extra (above $50,000) of passive income. This means that at $50,000 of passive income, SBD limit will be $500,000 (maximum) and it will be NIL at passive income of $150,000 (extra $100,000 passive income will wipe out SBD limit of $500,000).

Again, the corporation may not necessarily pay extra tax if the active income is less than the maximum limit of $500,000.

With regards to the rule of calculating passive income, following should be kept in mind:

Ø  Investments income earned on the existing investments made in the corporation will also be considered for counting the limit of $50,000. This is relevant in view of the fact that earlier government had promised not to consider grandfather investments in the corporation.

Ø  Incidental income earned on the investment will not be considered as an investment income.

Ø  The logic of laying down the investment income threshold of $50,000 is that a Canadian small business owner invest through his corporation $1 million Dollar and earn $50,000 at an estimated 5% annually.

Ø  Investment income in associated companies must be aggregated to arrive at the limit of $50,000 annually.

Ø  If there is an extra tax levied due to investment income exceeding $50,000 in a year, there will be a higher dividend tax credit and that should offset the higher tax paid through corporation, more or less. This higher dividend tax credit can be availed off when the investment income is paid out in the form of dividend.

Ø  There will be a refund of taxes at a different rates when the dividend is paid out from the corporation. Different rates of refund of taxes arise due to the fact that active income would have been taxes at a different rate compared to investment income exceeding $50,000.

Ø  Small Business Corporation will have to utilise the balance of refund of taxes at a lower rate first and then exhaust the refund of taxes at a higher rate. Hence this ordering rules will apply.

Ø  Investment income will not include the capital gains arising from the sale of active business assets, or sale of shares of a small business corporation or a rental income characterised as an active income or most death benefits received from life Insurance. 

Disclaimer: Any discussion on this blog relating to tax matters is purely for educational purposes and not taking any specific actions based the general tax rules described therein. Your tax situation could be different and as a result there may be different tax strategies applicable in your case. We do not claim the tax situations described above to be exhaustive or conclusive. In case of any specific tax situations or problems, you are advised to seek professional advice.