Income Splitting Post-Morneau’s Tax Proposals (Part II)

There are a number of methods used to accomplish income splitting, with advantages and disadvantages to each – for example, income could be split through paying salary to family members, dividends, or through the use of more complicated tools such as a family trust. The preferred method will depend on the tax and non-tax preferences of each business owner.  Click here for an update on the July 18th tax proposals that are proposed to be in effect beginning Jan 1, 2018. Also, refer to  Estate freezes , family trusts , and prescribed rate loans which are commonly used  to achieve income splitting.


With income splitting, it is important for both business owners and their accountants to be aware of section 67 of the Income Tax Act (the “Act”) which contains a “reasonableness test”. In essence, this rule provides that a tax deduction cannot be made unless it was “reasonable” – this includes salary, management fees, bonuses, rent, and in some cases, dividends can also be subject to a reasonableness test. Without planning and proper documentation, a CRA audit could lead to any of the above amounts  being challenged as being unreasonable. If CRA were successful, the amount would be disallowed as a corporate expense but would still be treated as income to the recipient. This results in double taxation, since the disallowed corporate expense will increase the income of the corporation (and its taxes) even though personal tax is being paid on the same amount.  In the case of a dividend, the unreasonable amount would be subject to TOSI and taxed at the highest marginal tax rate. 


As an example, a business owner may decide not to pay a large salary to themselves, choosing instead to split the amount by paying salaries to their spouse and children. As a result, each member of the family would pay taxes on their individual salaries in a lower tax bracket. The overall result is that less tax is paid by the family unit. This practice often raises “red flags” for CRA and attracts audits on the reasonableness of the salary amounts. Although there are no bright-line tests for what is considered a “reasonable” amount, auditors will often consider the services that were provided to the corporation by the family member, and compare the salary received against the salary that would be paid to an unrelated employee to provide the same service. The determination of reasonableness is entirely based on the facts in each case. A helpful rule of thumb that has been used by the courts in determining reasonableness is whether a reasonable person, having only the business considerations of the corporation in mind, would have contracted to pay that amount.  In the case of dividends being paid, the recently released legislation contains a number of factors (capital contributed, risks assumed, services performed, amounts previously received) which must be considered in determining reasonableness. 


Planning in advance of making payments to family members is crucial to withstanding a CRA audit.  Learn more about CRA’s  power to compel information. The job descriptions and services provided by family members should be documented carefully and in detail, particularly if there is special know-how or a unique skill being provided. The business should keep time sheets for each family member with the number of hours worked and the family member should be paid fair market value for their services.


If you or a family member has been audited or reassessed on the basis of an unreasonable amount of salary or bonus, having the proper documentation to support the amount paid will help with the fight against CRA. For additional assistance and an assessment of your situation, contact one of our tax lawyers for a consultation.