On 21 June 2018, legislation including measures announced in the 2018 Canadian federal Budget in February received Royal Assent. While cutting the rate of corporate tax for small businesses, Budget Implementation Act, 2018, No.1 (Bill C-74) also includes anti-avoidance measures for businesses with passive income and receiving tax refunds linked to dividend distributions, and to prevent the practice of "income sprinkling".
Small Business Tax Rates
The legislation includes a gradual reduction in the small business tax rate from 10.5% to 10%, effective 1 January 2018, and to 9% from 1 January 2019.
The budget legislation limits the ability of businesses with significant passive savings to benefit from the small business tax rate. It will achieve this by phasing out access to the lower rate for associated Canadian-controlled private companies (CCPCs) with between CAD10m (€6.5m) and CAD15m of aggregate taxable capital employed in Canada.
The bill also limits the tax advantages that larger CCPCs can obtain by accessing refundable taxes on the distribution of certain dividends. The Government has proposed that CCPCs should no longer be able to obtain refunds of taxes paid on investment income while distributing dividends from income taxed at the general corporate rate. Refunds continue to be available when investment income is paid out.
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Income sprinkling is a technique used by some high-income owners of private corporations to divert their income to family members with lower personal tax rates.
The new rules seek to determine whether a family member is significantly involved in a business, and thus is excluded from potentially being taxed at the highest marginal income tax rate (known as the tax on split income or TOSI).
The measures extend the application of the TOSI rules to individuals over the age of 17, but only with respect to income derived from a "related business".
The changes include "bright-line" tests to automatically exclude individual members of a business owner's family who fall into any of the following categories:
- The business owner's spouse, provided that the owner "meaningfully contributed" to the business and is aged 65 or over.
- Adults aged 18 or over who have made a substantial labour contribution (generally an average of at least 20 hours per week) to the business during the year, or during any five previous years. For businesses with seasonal operations, such as farms and fisheries, the labour contribution requirement will be applied for the part of the year in which the business operates.
- Adults aged 25 or over who own 10% or more of a corporation that earns less than 90% of its income from the provision of services and is not a professional corporation.
- Individuals who receive capital gains from qualified small business corporation shares and qualified farm or fishing property, if they would not be subject to the highest marginal tax rate on the gains under existing rules.
Individuals aged 25 or over who do not meet any of the exclusions described above would be subject to a "reasonableness test" to determine how much income, if any, would be subject to the highest marginal tax rate.
The new rules apply the 2018 and subsequent tax years.
The Government estimates that less than 3% of CCPCs will be affected by the above-mentioned changes, a figure equating to roughly 50,000 private corporations. However, the income sprinkling rules are expected to increase small firms’ record-keeping and administrative requirement, and significantly increase their tax compliance burden.