Sterling's Blog

Revisions to Income Splitting

On December 13, the Department of Finance released revisions to their Tax on Split Income (“TOSI”) proposals. In a future post, we will address the technical content of these proposals. For now, we wanted to address two glaring concerns.

You should contact us as soon as possible if:

  • You pay dividends to your spouse or family through your corporation or plan to do so in the future; or
  • Your corporation has significant retained earnings – the personal tax rate when taking this money out as dividends will increase as a result of the decrease in the small business tax rate.
The first two glaring concerns with the announcement are:

1)The timing of the proposals

The legislation was released on December 13, the last day the House sits. This prevented the Government from facing any accountability for their proposals.

Most importantly, however, the effective date of the legislation remained January 1, 2018 despite the very late changes to the laws. This means that corporate taxpayers have less than 20 days during the holidays to coordinate any necessary changes with their lawyers and accountants. This is a very punishing timeframe even for a simple change, but as you will see in the next post, these changes are anything but simple, with many different nuances to consider.

This timeframe means we need to hear from you as soon as possible in order to make any necessary changes prior to the year-end.

2)The government’s rhetoric

In announcing these proposals, Finance continued to rely on problematic rhetoric to try to justify their proposals, including describing the situations they are affecting as “unfair tax planning strategies”.

There is some new problematic rhetoric also. The government has addressed criticisms of their previous proposals on a gender basis with the following extremely insulting justification of how these changes will actually better be for women because it will cause them to enter the workforce:

Data show that men represent over 70% of higher-income earners initiating income sprinkling strategies, and women represent about 68% of recipients of sprinkled dividends (and 58% of recipients of income derived from trust and partnerships). While this income is of benefit for recipients, it also creates incentives that reduce female participation in the workforce. Increased participation of women in the workforce is a source of economic opportunity for individuals and is a major driver of overall economic growth.

New Estate Tax rules could cause disputes

Recently, I attended the Prairie Provinces Tax Conference hosted by the Canadian Tax Foundation. A common theme among the tax practitioners there was concern over the new rules established for "graduated rate estates", and how these new rules would impact a number of common estate planning techniques. The new rules take effect on January 1, 2016, and it is important to review your estate plan to ensure that the new rules do not have a negative affect.

In the 2014 Federal budget, the government introduced new rules for trusts created under a will, which were previously taxed at the same marginal tax rates as if they were individuals. According to the government, some planners were abusing this rule to multiply the savings available using low tax brackets, and it was creating an incentive to delay the distribution of estate assets. 

One common technique in estate planning is the use of spousal trusts, particularly in blended family situations. Spousal trusts generally allocate all of the income of the trust to the spouse, but upon the death of the spouse, the assets will be transferred to a different party, typically children from a previous relationship. It is an effective method of providing both for your current spouse and former children, but it also carried certain tax benefits. Previously, the income could be taxed partially in the trust and partially in the spouse's hands, which would result in the use of two separate graduated rates. 

Under the new rules, spousal trusts and any other separate trusts created under a will, including, for example, an insurance trust, are not considered graduated rate estates and therefore all of the undistributed income will be taxed at the maximum tax rate. This eliminates a primary tax benefit for using many of these structures, and may justify reevaluating the use of these trusts in your estate plan.

The biggest impact, however, isn't felt until the life beneficiary of the spousal trust also passes away. Previously, the trust was responsible for the tax liability of any assets that had a capital gain. However, the new rule reassigns the tax liability from the trust to the estate of the deceased life beneficiary, regardless of whether the estate is entitled to any of the income or assets that created the tax liability. The trust remains jointly and severally liable for the portion of the deceased's taxes that are a result of this reassigned income. There are not clearly defined restrictions on the CRA's ability to enforce this tax debt - they appear to be able to pursue the debt in the first instance through either the trust or the estate.

This tax situation creates potential disputes and conflicts of interest between the trustee of the spousal trust and the executor(s) or beneficiaries of the estate.

Consider the following example:

Alan married Beth. It was a second marriage for each of them. Alan had a child named Alice, and Beth had a child named Bob. Alan creates a will with a spousal trust assigning all income of the trust to Beth, and all remaining assets to Alice upon her death. Alan passes away first. Then Beth passes away.

If Beth dies in 2015, there will be no change, and the spousal trust will be responsible for the taxes, ultimately reducing Alice's inheritance.

If Beth dies in 2016, however, Beth's estate and the spousal trust will be jointly liable for the taxes, and it is not clear who the CRA will pursue first for the tax debt. If they pursue the spousal trust, it will reduce Alice's inheritance. If they pursue the estate, it will reduce Bob's inheritance. This introduces a potential for dispute and uncertainty between Bob and Alice into an area of law that is already rife with disputes.

The new rules may also affect several post-mortem tax planning techniques that can be used to reduce tax liability, particularly when shares of private corporations are involved.

Despite all the negatives associated with this change, there is a bright side - because the taxes should now be reported in the deceased's terminal return, the income can be sheltered by carry-over losses, charitable and medical tax credits, or other special tax provisions that apply to terminal returns.

While the Department of Finance is still accepting submissions regarding practitioner's issues with the new rules, it is unlikely they will be changed before coming into force on January 1, 2016. It is therefore important to ensure that your estate plan is reviewed by a tax or estate planning lawyer to reduce the potential for uncertainty or disputes, particularly if a spousal trust is involved.