The Reasonableness Test to Resolve Income Sprinkling in Canada

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Finance Minister Bill Morneau has recently revealed changes in the Income Tax Act, affecting small businesses all over Canada. The change in the Tax Act was revealed during the summer, heavy with criticism and controversy, addressing the illegitimate use of income sprinkling by small business owners.

Income Sprinkling

Income sprinkling is a financial manoeuvre done by small business owners in hopes of reducing income tax. It divides profits among family members who are under lower tax brackets and do not contribute to the business. This is all to minimize the tax rates. Income sprinkling is only legitimate towards family members who actually contribute to the business.

The Reasonableness Test

“Bright-line” tests were introduced by Finance Canada to make sure that legitimate family members who contribute to the business are still legally eligible to receive income. The test filters those who are legitimate contributors, and those that simply included so to minimize owed tax. Those who benefited from the illegitimate use of income sprinkling go through the “reasonableness test” review by the Canada Revenue Agency. The test will determine how much of a family member’s income will be subject to the highest marginal tax rate.

However, there are exceptions to the “reasonableness test”:

• If a spouse included is over 65 years old.
• People over 18 who make a “substantial labour contribution” with at least 20 hours of work time per week.
• People over 25 who own 10 per cent or more of a business that earns less than 90 per of its income from the “provision of services.”

The changes made in the Income Tax Act by the finance government were measures taken to implement fairness in the tax system. There are mixed reactions to the revelation of the changes, but ultimately, the changes aim to make sure that those who contribute to businesses-not limited to family members-still are legitimate tax paying employees, and not burdened by income sprinkling.

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