Kiddie tax was introduced in 2000 in order to neutralize an increasing trend towards splitting dividend income with minor children. The March 2011 Federal Budget expanded these rules to include certain capital gains realized by minor children with respect to the disposition of shares of private companies to non-arm’s-length persons.
Kiddie tax was designed to curb the use of “dividend sprinkling” and management services structures. The tax applies to dividends and shareholder benefits received by a minor from a related private corporation, and income from a trust or partnership if it is derived from the provision of property or services by a person related to the minor. The targeted income is subject to income tax at the highest rate in the province of residence. By taxing this split income at the top marginal tax rate, the tax savings are neutralized.
The extension of the kiddie tax rule will convert certain capital gains realized by minors after March 21, 2011, into taxable dividends, which will then be subject to taxation under the kiddie tax rules. The capital gains affected are those from dispositions to non-arm’s length parties (i.e., parents, family trusts, companies controlled by parents, etc). Since the capital gain is converted into a taxable dividend, the capital gains exemption will no longer apply and will not be available to reduce the resulting income tax liability. It is important to note that commonly used estate planning strategies designed to crystallize the capital gains exemption, which involve a disposition to non-arm’s-length parties, may be impacted if there are minor children involved who would be subject to the current kiddie tax rules.
These new rules will catch some of the new income splitting techniques that arose after the introduction of the original kiddie tax rules. One such strategy was to pay a stock dividend on the shares held by the minor child. A stock dividend is taxed as a regular dividend based on the amount of the paid-up capital allocated to the shares. The shares issued as the stock dividend would have a high fair market value, a low adjusted cost base and a low paid-up capital, with little or no income tax implications. The minor would then sell the shares issued as the stock dividend. The income tax implications would have been a capital gain with a 50% inclusion rate, which might have been eligible for the enhanced capital gains exemption.
A child who inherits shares from a parent’s estate will not be subject to kiddie tax. As well, kiddie tax will not apply where both parents of a child are not resident in Canada.
The extension of the kiddie tax rules to cover certain capital gains has created a need to re-think commonly used planning strategies. In all likelihood, income splitting will continue to thrive because of the savings that are possible, and the government will continue to monitor the resulting new strategies, eager to introduce new legislation designed to maintain the integrity of the Canadian tax system.
E.O. & E.
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Contributors to this edition:
James W. Kraft, cpa, ca, mtax, tep, cfp, clu, ch.f.c.
Deborah Kraft, mtax, tep, cfp, clu, ch.f.c.