Earlier this year, the federal government announced new and tighter rules around income splitting and taxes on passive income for corporations. Given those changes, there may be some things you can do to prepare yourself for the end of this tax year. Chris Gandhu, High Net Worth Planner at TD Wealth, speaks with Kim Parlee.
Thank you for having me.
OK, three things we want to review today, essentially-- I'm sure there's lots more we're going to focus on, three. What are some of the three things we should be paying attention to?
Well, as you mentioned, the tax law on split income rules-- they came into effect as of Jan. 1, 2018, but there's still some planning you can do with them. Then the passive income proposals came in Feb. They became law in the summer. And they take effect for corporations next year. And then, of course there's something on the radar not yet changed yet, but CRA has prescribed recently something to watch out for.
OK. Let's run into each one of those. And let's start with the income splitting rules. Quickly, tell us what they are again and then what you need to be thinking about this year.
Right. So I mean, basically income splitting is taking income from a high rate taxpayer and trying to shift it to a lower rate taxpayer, of course, to save some tax money. In the corporate context, this is done when you have two individuals as shareholders of a company. Now you have the ability to, in a discretionary fashion, stream dividends-- maybe a little bit less to the higher rate taxpayer and a bit more to the lower rate taxpayer.
And these new taxation on split income rules, of course, effectively try to stop that splitting of dividends. And they're basically saying, look, if the dividend is split income dividend, then we're going to tax the dividend at the highest possible rate, which of course takes an advantage away.
OK. But there is something happening in terms of some special transition rules this year. I know you wanted to highlight-- just things to keep in mind.
Yeah. I mean, even though initially you may be caught by the taxation on split income rules, there are some very specific exemptions that may apply. The one in particular that I want to talk about is what's called an excluded share exemption. Now of course, as with everything in tax, it is quite technical. There's a bunch of boxes to check off.
But one of the boxes is, did you as a taxpayer actually directly own your share in the operating entity? If you didn't, then just by virtue of that fact, your shares will not qualify as an excluded share. Now there's a lot of planning done where, for instance, a family trust may be the shareholder, and you may own your shares as a beneficiary of the trust-- so indirectly, right?
So you're now in a disadvantaged position, because if you receive a dividend through the trust, well, guess what? Those shares do not now qualify, right? If you fix that structure and receive the shares once the shares do qualify, that dividend is no longer split income, but it may be otherwise.
Now the special transition rule that you alluded to is basically saying, look, 2018 was the first year when these rules came into effect. If you fix this by the end of 2018, so we still have a month to do that, then even though you may have received dividends earlier on in 2018 when the shares didn't qualify, guess what? Those are sort of grandfathered, and they won't be caught by the TOSI rules.
And this is why we're talking about this right now, to give people the time to actually make any of these changes they need to do. OK.
So new income splitting rules-- let's talk a bit about passive income. We noticed how unpopular this was in a lot of ways. But tell us in terms of just what the change was, and then, what the net effect is for people who need to be watching this.
Right. So you know, in sort of tax geek terms, the passive income rules restrict a corporation's ability to use a small business deduction. What does that really mean? So if you think about a company, it really can have different types of income. So a business may have business income. Let's call it active.
And that's from the actual whatever the business is?
That's exactly it.
And the business may have non-business income, such as rents, dividends. Maybe there is a accumulated retained earning that are spinning off this type of thing. That’s called passive income.
Now active income, up to the first $500,000, is taxed at a very low rate of tax. And the $500,000 is a small business limit. Any active income in excess of the $500,000 is still taxed at a lower rate, but not as low. And we call that the general corporate rate of tax.
I'm from Calgary. So in Alberta, the low rate would be 12%. The general corporate rate is, for example, 27, which is still better than what an individual would be--
What these new rules say is that look, if you're earning passive income inside your corporation-- the rents, dividends, royalties, things like that-- and once your passive income exceeds $50,000, every dollar in excess of $50,000 reduces your small business limit by five. All right? So the viewers can do the math.
Basically, once a passive income hits $150,000, you have a $100,000 excess. Multiply that by 5. Your small business limit is now nil. Effectively, what these rules are doing is they're forcing more of that active income to be taxed at the general rate as opposed to the small business rate.
Right. OK. So anything in terms of-- from a planning perspective-- you think you need to kind of put in place for that right now?
Yeah, absolutely. First thing, you have to sort of ask that seminal question, do these rules even impact me?
There is a lot of businesses out there that aren't earning any active income, anyhow. They may be, for instance, investment holding companies. Right? They don't get the small business rate. Don't worry about these rules.
There's a lot of privately owned corporations, but that are quite large. And they also don't get access to the small business rate. So they don't need to worry about it.
But if you do need to worry about it, I'd say, maybe, three things. Number one, you should talk to your investment advisor. Because there may be an opportunity not to earn so much of the dividends and the interest, but maybe tweak your portfolio so it's geared towards capital appreciation with capital gains you control when you trigger that income.
So it may be a bunch of years where you don't trigger the income. You still qualify for the small business limit. And then you sort of do a big bath approach. And there is one year when you don't get it, and that's OK.
You may want to look at some corporate strategies, such as an individual pension plan or perhaps a corporately owned life insurance. Because here's two examples where money that's earned inside these plans doesn't impact your small business limit either, right? And finally, I'd say maybe you review everything and you decide, hey, retaining money inside the corporation and accumulating assets just isn't a good strategy for me anymore.
And that's OK. Because there may be a way to extract those assets and just make investments personal. Right? And of course, personal income won't impact your small business limit.
It won't. Everything you say-- just want to hang on every word here. It's all such good stuff. OK. I've only got about 60 seconds. And I do want to talk about prescribed loan.
You said this was something that a change that-- one is happening, one that may be coming. Is that correct?
Right. So the prescribed rate loan, we see it very commonly in prescribed rate loan planning. The rate is set by CRA. But legislatively, the rate is tied to Bank of Canada's 90 day T-bill rates.
I just want to back up to one thing. Prescribed loan would be how you lend money to a relative or a non-arm's length? Is that a way to look at it?
That's exactly right. Because if you lend money otherwise, there is rules that would try to attribute that income back to you.
If you make the loan at CRA's prescribed rate or higher, then the attribution rules don't apply.
Right? So say it was set at 1% for many, many years. Earlier in 2018, it bumped up from one to two. I was looking at the T-bill rates. They're creeping up close to 2%, which means in 2019, it may go up to 3. So if you need to do some prescribed rate loan planning, it's better done sooner rather than later.
Great information. So glad you're coming on in November to tell us all this now. Chris, thanks so much.