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Income Splitting Tax Law Changes to Hurt Dentists

By December 27, 2017December 14th, 2021Corporate

The U.S. just passed a major tax overhaul (the first since 1986) that will decrease corporate tax rates from 35 to 21 percent.  The idea here is that the tax savings will be used to create jobs and reinvest in R&D, infrastructure, etc.  Some are saying, based on what’s been done in the past with big corporate tax breaks, that the money saved will be used to reward shareholders by paying out dividends or buying back shares.  Some companies are already talking about paying bonuses to their employees and going on a hiring spree.  Time will tell if cutting taxes results in more and better jobs.

So what’s going on in Canada?  It’s been confusing to say the least.  First, there was an all-out assault on those greedy dentists, doctors, lawyers, accountants – pretty much anyone who was a professional – because of perceptions that they earned a lot of money.  Income splitting?  How dare they!  Earning passive income in their corporations?  Shame on them!  Multiplying the lifetime capital gains exemption?  How Rude!

But the problem, whether the Liberals could foretell it or not, was that by attacking these professionals, they were attacking EVERY small business owner – including farmers and fishers.

OK, said the Liberals.  So we’ll make things better by not going after capital gains and watering down the whole taxation of passive income thing we originally proposed.  But we’re keeping our wonky and unclear proposal on income splitting with family members because at least we can do something there…

But then the Liberals started to take a lot of heat – Finance Minister Morneau personally – for what he knew and did with his shares of his family’s pension company and whether it constituted a conflict of interest.  So things died down a little bit with the whole ‘let’s go after doctors, dentists, etc.’.  And then things got even worse for the Liberals with the Paradise Papers, because it was discovered that BILLIONS of dollars from Liberal campaign financiers were being diverted OFFSHORE.  BINGO!!!!

If Trudeau and Morneau want to go after anyone to help raise taxes for their endless spending on infrastructure (with no apparent plan on how much it will cost), they should be going after the offshore entities.  They should tell them – like the Americans are now doing – that if you bring in your money back to Canada to invest HERE – that you’ll be taxed at the low corporate tax rate (say 15%) and that’s it.  No penalties or interest or anything else.  Now you can bring your money back here in 2018 and not worry.  And the government now has their tax dollars to use on infrastructure.

But no… that would be a smart move.  So the Liberals won’t do that.  Instead, they’ll slightly lower the corporate tax rate (from 11% now to 10% in 2018 to 9% in 2019) as a way to give a crumb while stealing the cookie.  So they’d rather not go after their friends parking money offshore; but it’s OK to go after the little guy?  WTF…

So where are we at now?  Well, as of a few weeks ago, the Liberals once again tweaked their proposals to try to persuade people that it (1) won’t affect that many (only 45,000 family businesses) and (2) will help the government raise the taxes it needs for infrastructure and (3) it’s easy and simple to follow.  And with respect to the latter 2, I’m highly skeptical…

OK, so what does this mean for dentists?

New tax rules may be coming.  They’re called a “Tax on Split Income” and they’re at the highest tax rate!  The only way for them not to apply is to fit within an “exclusion” – of which there are “excluded business”,  “excluded shares” and earning a “reasonable return”.  Let’s talk about each in turn with respect to dentists and their dentistry professional corporations and SIDE corporation (hygiene corps, technical services corps, management corps, etc.).

Well, let’s take a look at the typical professional corporation.

Bottom line: if dividends are paid from a Dentistry Professional Corporation to an adult spouse who owns 50% of the common equity shares (though they are NOT a dentist) AND THEY ARE NOT AND HAS NOT BEEN EVER actively involved in the business, TOSI applies under the proposed rules.  Why?  Because the Dentistry Professional Corporation is NOT an “Excluded Business” and the Shares upon which dividends are paid to the spouse are NOT “Excluded Shares”.

Here’s the rationale…

FIRST, TOSI doesn’t apply to so-called “Excluded Businesses”.  An “Excluded Business” is a business in which the individual receiving the dividends would have been actively engaged on a REGULAR, CONTINUOUS, and SUBSTANTIAL BASIS in the taxation year in which an amount is received OR in any five (5) previous taxation years.  An individual will be deemed to be actively engaged if they work in the business at least 20 hours per week during the portion of the year that the business operates or meets that requirement for any five (5) prior years (need not be consecutive).  In our hypothetical example, the spouse wouldn’t meet this test because they have NOT EVER been actively involved in the business.

SECOND, TOSI doesn’t apply to “Excluded Shares”.  “Excluded Shares” are shares of a corporation that has the following characteristics: (1) less than 90% of the corporation’s business income came from providing services and the corporation is NOT a professional corporation; (2) the shares represent more than 10% of the value and equity of the corporation and (3) all or substantially all (80-90%) of the income of the corporation is not derived from another Related Business in respect of the individual receiving the dividends.  So, in our example, the dividends received by the spouse wouldn’t qualify as “Excluded Shares” because the corporation IS a professional corporation.  The government is singling out dentists and doctors with this provision.

THIRD, if the person receiving the dividends is 25 years or older and the dividends they receive represents a “Reasonable Return”, then TOSI won’t apply to that extent (that it was a “reasonable return”).  A “reasonable return” is hard to define.  The draft legislation says it takes into consideration the following factors relating to the relative contributions of the individual receiving the dividends: the work they performed in support of the related business (the dental practice), the property they contributed in support of the related business, risks assumed, and such other factors as may be relevant.  WTF???  Likely a dentist’s family member won’t be able to meet this “reasonable return” test because they don’t co-guarantee the loan used to buy the equipment and leaseholds, don’t work in the office with the dentist, and don’t assume much risk (because they’re not the dentist).

What about hygiene, technical services, and management corporations?

Many dentists have used another corporation to provide services to the dentistry professional corporation for years, as a way of income splitting with spouses and family members (parents, children, etc.).  Well dividends paid from that “SIDE corporation” to a dentist’s spouse who IS NOT AND HAS NOT BEEN involved in will LIKELY be subject to TOSI.  Here’s why:

FIRST, TOSI doesn’t apply to an “Excluded Business”.  In our example, unless the family member of the dentist who received dividends from this SIDE corporation are actively involved in the business (e.g. providing administrative functions like bookkeeping / payroll / reception services, perhaps is a hygienist or an assistant, etc.), they will NOT meet the 20 hour threshold rule. The CRA is of the view that the individuals receiving the dividends should keep timesheets, schedules or logbooks to prove that they’ve been meeting this 20 hour threshold rule.  An excluded business is one that the individual receiving the payment is engaged on a regular, continuous and substantial basis in the activities of the business in that current tax year or any five (5) prior tax years.  The last part is a somewhat saving grace.  That suggests that, if the taxpayer receiving the dividends TODAY was at some point in the past 5 years, contributing at least an average of 20 hours per week during the portion when business operated, then they could receive dividends and those dividends wouldn’t fall under TOSI.  So hypothetically, if an adult family member of the dentist DID work an average of 20 hours per week THIS year in the SIDE Corporation, they could stop working and still receive dividends for the next 4 years without working at all in that SIDE Corporation?  Could this be a regular habit of having a family member work once every 5 years just to avoid TOSI?  Just keep in mind that the proposed definition of an excluded business means a business where the individual receiving the dividends is engaged on a regular, continuous and substantial basis in ANY five (5) prior taxation years.

Second, what about “Excluded Shares”?  Well, the individual receiving the dividends can clearly own more than 10% of the votes and value of shares of the SIDE Corporation; and this SIDE corporation likely isn’t a professional corporation.  So we’re good there to avoiding TOSI according to the definition of “Excluded Shares”.  But what about the other 2 tests?  That’s where we run into trouble.  First, it’s more than likely that 90%+ of the business of this SIDE corporation is to provide services.  And second, all or substantially all of the income of the corporation is income that IS NOT derived from a related business.  What’s a “related business“?  Well, that’s a business carried on by the dentist (an individual who is RELATED to the individual getting dividends in the SIDE Corporation).  So if the dentistry professional corporation (carried on by the dentist) is providing all or substantially all of the SIDE Corporation’s income and the shareholder of the side corporation is related to the dentist, then that shareholder wouldn’t be holding “Excluded Shares”.

Third, what about a “Reasonable Return” exclusion?  Well, once again, this is going to be difficult to justify given that the dentist’s family member earning those dividends from the SIDE business didn’t (per our example) work or contribute property or assume risks to help support the related business (i.e. the dental practice).

The Content of this post is provided for informational purposes only. It is not intended to be legal, financial, tax, or other professional advice of any kind. You are advised to contact DMC (or other counsel) to seek specific legal advice concerning your individual situation.