One of the more popular tax planning strategies is “income splitting.” To the extent income can be shifted within a family unit from a higher income earner to a lower income earner, less income tax is paid and more after-tax income is retained within the family unit.
As one might guess, the government has a wide array of tax laws to maintain fairness and ensure tax revenues are not inadvertently stifled through income shifting. The shifting of income among family members within the context of family- owned businesses was commonplace in the 1990s. To curtail the common strategy of paying dividends to minors on shares of private non-arm’s length companies owned by a trust, a new tax referred to as “kiddie tax” (or more formally, “tax on split income”) was introduced in the 1999 federal budget, beginning with the 2000 taxation year. Rather than attribute the dividends to the parent, kiddie tax was structured to tax the dividend income in the hands of the minor child, but at the highest marginal tax rate.
The kiddie tax rules were expanded in the 2011 federal budget to include capital gains realized by minors on the sale of private company shares to a non-arm’s length person. The rules deem that the capital gain realized is re-characterized as a taxable dividend. Effectively, this prevents the ability to make use of the preferred rate of taxation available for capital property, and to access the capital gains exemption when the shares are disposed of in a non-arm’s length situation.
The 2014 federal budget proposes to expand the kiddie tax rules even further. It states that, to the extent a minor realizes business or rental income from certain partnerships or trusts, the income will be treated as “split income.”
In simple terms, the kiddie tax rules identify situations where income is earned by a minor from private company shares, and redefines that income as “split income.” Split income is removed from the calculation of regular taxable income for the minor, and is instead taxed at the top federal marginal tax rate plus the top marginal tax rate for the province of residence. The tax on split income and the tax on regular taxable income are added together to determine the minor’s overall income tax liability for the year.
In general terms, split income is defined as:
- Taxable dividends received by a minor from a private corporation;
- Capital gains realized on the disposition of shares of a private corporation to a non-arm’s length party;
- Shareholder benefit amounts realized by the minor from private corporations;
- Partnership income allocations derived from the provision of goods, services or property rental to a non- arm’s length entity (i.e., sole proprietorship, corporation, partnership);
- Allocations of income from a trust that can reasonably be considered taxable dividends or shareholder benefits from a private corporation; or
- Income derived from the provision of goods, services or property rental to a non-arm’s length entity.
It should be noted that the kiddie tax rules do not apply to income received on property inherited by the minor as a consequence of the death of a parent, or as a consequence of the death of any person, if the minor is enrolled during the year as a full-time student at a post-secondary educational institution, or the minor qualifies for the federal tax credit for mental or physical impairment.
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.