Tax change answers — Part 1: Income splitting

There’s a reason most farms pay accountants to provide tax planning advice. Taxes are complicated. Add multiple pages of new information, unclear definitions, ‘tax cheat’ accusations, some emotional rhetoric, and it’s a challenge, even for accountants, to assess what Finance Minister Bill Morneau’s proposed tax changes could mean for an individual farm business.

We’re going to try to cut through the politics and noise in a podcast series looking at the three main areas the Liberals are trying to change when it comes to taxing businesses that operate as private corporations (and partnerships, in some cases): income splitting, passive income, and restrictions on capital gains.

“We’re going to see a lot of family farm businesses pay more tax under the new rules than they did before,” states Jesse Moore, senior manager, tax, with BDO, leading off part one.

“I don’t really have anything good to say about these changes. At the end of the day, I think this is just going to have a negative impact.”

Income splitting or sprinkling is the practice of sharing income within a family so the family as a whole pays less tax. To prevent having business owners ‘sprinkle’ income to family members who aren’t involved in the business, the federal proposal would introduce a ‘reasonability test’ on dividends paid and capital gains realized by family members. Income beyond this ‘reasonable’ return would be taxed at the highest rate for the province.

How much compensation is allowed without triggering the higher tax rate will be based on labour and capital contributions, risks family members have assumed, and previous remuneration, notes Moore. Family members under the age of 25 will face tighter restrictions.

“The way I read the legislation is they’ll have to demonstrate they’re basically working in the business on a full-time basis,” he says.

By making it more difficult to split income with off-farm family members, there’s uncertainty about how a non-active family member who has built equity in the business will be able to extract that value and how retiring farmers will transfer estate wealth to children who aren’t active in the family business.

Adding more uncertainty — the definition of “reasonable.” “It’s going to mean something different to the farming business, to the tax advisor, and my biggest concern — how’s CRA going to view what’s reasonable?” notes Moore.

“I think we’re going to have a lot of issues with CRA. There’s so much uncertainty there. I can see a lot of our clients battling this out with CRA, possibly having to go to tax court. And I can see a lot of family businesses having to rearrange their structures based on the current proposal.”

Moore also points out the changes to income splitting apply to partnerships in addition to incorporated businesses.

Stay tuned for part two, where we’ll take a look at the proposed changes to how passive income held within a private corporation is taxed.

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