The new tax law proposals have been generating a lot of press. The government is spinning misinformation, and nobody is quite sure what the fuss is all about. So we decided to have our tax consultant, Mark Lencucha, FCPA, FCA, TEP, FEA, draft a number of articles that will hopefully explain these proposals with a more relaxed style. Some are quick. Some are tough sledding, but we hope you enjoy them and share them with your friends!
If you pay dividends, or wish to protect your capital gain exemption in particular, we recommend a sit down sooner than later. We hope these rules are either dropped, seriously modified, or repealed when a new government takes charge. For now, we must treat them very seriously indeed.
Pivotal LLP Chartered Professional Accountants
**The views, thoughts and opinions expressed in this article belong solely to the author and not necessarily to the Partners or staff of Pivotal LLP**
Income Splitting: A Fireside Chat With Your Tax Auditor!
By way of background, in this world there are several types of income splitting:
As you can see, it depends who you are; whether you are friend or foe. The pensioned class are encouraged to income split by favorable law, you are pilloried in public.
Rather than go through a bunch of technical stuff (TOSI, specified individuals, connected persons, split income....blah blah blah) we thought we could fast forward to listen in on a audit…coming to a theatre very near to you…soon! Let’s call the tax auditor “A” and you “You”…
A: I notice that both of you received dividends last year from your company. This has raised a red flag with us, and I’m here just to make sure there are no abuses occurring.
A: Are you among the top 1% of income earners?
You: Wow! I don’t know, let me check the list…Bill Gates, Mark Zuckerberg…Trudeau, Morneau! Whew! I’m not on the list. No wonder it’s called a “Sunshine” list…look at all those wealthy people.
A: Well then you should be just fine. We’re really only after those dastardly 1%-ers, but we have procedures to carry out first. A few questions. Nothing threatening.
A: You seem like nice people, but unfortunately my job is to believe the worst of you. To ensure I remain independent and show no favoritism. So let’s start there…I think your dividends are totally unreasonable and we must apply the full extent of the law.
You: LOL…NOT! What’s going to happen to me?
A: Well, it works like this. We pretend each of you are earning more than $300,000 and then earned the dividend on top of that. You pay the tax rate normally reserved only for the rich and famous! Aren’t you thrilled that you too can be rich and famous?
You: Well…But…I guess it would be nice…
A: It’s OK, we might still get you out of this…You have defences, three only, we designed the game like baseball. I will pitch you three questions. If you strike out, I have no choice but to do what must be done.
You: Only three questions? Only three ways to defend myself? Who set those questions?
A: We did! You must prove to me that your dividends are “reasonable” based upon three defences… your effort, your capital contributed or risk. Neither I, nor the Courts can listen to anything else, no matter how sympathetic we may be, or eloquent you may be.
A: First. I notice you each take a small salary. Do you pay yourself a reasonable salary, too little, or too much (editor’s note – “too much” is a trick question leading to a terrible place).
You: We pay ourselves fairly. We have a great management team now so we just provide a little oversight. We thought a modest salary was fair.
A: Good! A reasonable salary has been paid, properly compensating your efforts, so we cannot accept anything beyond that as reasonable. STRIKE 1!!
A: Second. I notice you are owed a $100,000 shareholder loan and have $100 invested in shares. I’m going to give you a break here. I will concede that it is reasonable that you should have taken a 5% interest and dividend but did not. I’m happy to announce that $5,005 of your dividend is home safe! But you took so much more! STRIKE 2!
You: Not even a base hit??
A: Third. How much did you risk? I see a$100,000 loan and $100 of share capital. Anything else?
You: We risked everything to guarantee the bank, we had to borrow another $100,000.
A: OK. I’ll give you another 2% for guarantee fees so another $2,000.
A: There! $7,005 is safe. Regrettably the rest of your dividends are utterly unreasonable, and the law is the law. The assessment will be in the mail. You are free to object and complain through formal channels including Appeals (A heaven on earth where weary auditors go when promoted) and Court (entry fee $50,000 or so). Have a nice day!
A: (quietly to self) - “What a great day, what an amazing Tax Auditor I am. Nailed my TEBA! (Editor’s note - TEBA is “Tax Earned by Auditor”, a statistic kept by the government, no doubt to keep their auditors under the gun and motivated. I hope those Auditors report those tax earnings when they file their tax returns!).
This little exercise is not the end of it. These same tests can eliminate your capital gain exemption. CRA is always assumed correct. Reasonable salary? We can look at comparable jobs. Reasonable expenses? We can look for what others do.
But a “reasonable dividend”? In my humble view, all dividends are reasonable…your efforts, capital and risks originated the business, which eventually produced real extra income available for you to distribute by dividend. Facts, not some nebulous nonsensical rules and the argument department of the CRA!
Ingenuity. Ideas. Risk. Debt. Luck. Perception. Hard work. All of these can contribute to a successful business, and many businesses fail, leaving those families poorer for their risk taking.
What is then a reasonable reward? I would say it is whatever the company has earned, does not require, and can afford to distribute. Even under their tests! But I doubt it will be so simple.
More fun coming up! Look for our next article! - Mark Lencucha
Caution to Reader: I like tax auditors when we get to meet and spar over the law! Good people. Tough job. This is parody only! These articles are statements of opinion! Sadly, I’m not an academic or researcher, it’s just me. Blame my friend Mr. Google if there are any factual errors, or omissions. Blame me if there are misunderstandings! - Mark Lencucha