Mismatched Tax Rules On Income Splitting Show The Government Is Getting Dressed In The Dark

A young relative showed up at a family gathering last week in flip-flops with one white sock and one black. She shrugged when I pointed it out, saying she’d been rushing and hadn’t noticed. I was the first person all day to say anything.

A kid in my high school class 40 years ago did the same thing on purpose. Everyone thought he was strange. Today, nobody bats an eye until someone points it out.

The Income Tax Act has many pairs of mismatched socks. Legislators are often more comfortable with a provision’s politics than with how it clashes with the rest of the act or with the unintended consequences that follow.

One example that has bothered me since 2017 is Section 143 , the so-called Hutterite rule . If a religious congregation — as the act defines it — runs a business communally, such as a Hutterite colony’s farm, the act deems a trust to exist.

Broadly speaking, the trust can elect to split income each year among adult members by formula: one per family gets a full share, the others a half share. No one has to prove hours worked or capital contributed.

This wasn’t an accident. It traces to Wipf vs. the Queen in 1975: the court ruled a Hutterite colony wasn’t a commercial enterprise generating individual profits. Parliament put that into Section 143 in 1977 in order to tax colonies “in the same manner as their non-Hutterian neighbours.” The Federal Court of Appeal reaffirmed it in 1979. Call this the white sock.

Now, the other foot. On July 18, 2017, finance minister Bill Morneau unveiled a package aimed at private businesses, framed as closing loopholes for wealthy Canadians trying to avoid higher tax rates and singling out income sprinkling among family members.

What followed, after significant backlash, was sweeping amendments to the tax on split income (TOSI) rules, applying them to various private interests, any income level, any family. Professional groups said the real target would be middle-class owners, not the wealthy.

Take a hypothetical Ontario couple who each own half the shares of BakeryCo, a business they started together. Mom drives the company; dad stays home raising their two young kids and isn’t active in it. Ignoring government benefits, BakeryCo is their only family income.

If dad receives certain income from BakeryCo, TOSI could tax that income at the highest rate instead of graduated rates simply because he’s not active in the business.

Say BakeryCo earns $100,000 in profits. At the small business rate, the combined federal and Ontario corporate tax takes roughly $12,000, leaving about $88,000 to pay out as dividends, split evenly at $44,000 each.

If TOSI didn’t apply, and that $44,000 was his only income, his tax bill after the basic personal amount and dividend tax credit would land around $1,100. With TOSI, the benefit of those ordinary graduated rates and personal credits disappears, and the dividend is effectively taxed at the top rate: roughly $21,000, or about 19 times higher, purely because of who he married and what he didn’t do at the bakery that year.

There’s an irony in Parliament’s reasoning for Section 143: it enables income splitting because members own no personal property at all – no individual claim, no individual profit to tax.

Flip that onto our hypothetical couple and it points the opposite way. The dad isn’t propertyless: Ontario’s Family Law Act already treats marriage as an economic partnership, entitling a spouse to an equalization of net family property, including growth in a business such as BakeryCo, regardless of who ran it.

But tax law treats his dividend as abusive income splitting, taxable at the top rate , regardless of what family law states about his stake in the business.

Through it all, the Hutterite rule was written into TOSI’s own exclusions on purpose. Parliament carved out any trust “deemed to be in existence by subsection 143(1)” and let colonies stay exempt, even before the 2018 amendments. Call this the black sock.

Our federal government also lets spouses split pension income with no test of the recipient’s effort; nobody asks a retired teacher’s spouse to prove she was actively engaged first.

Add that to the colony rule and matrimonial property law and a pattern emerges: Parliament has repeatedly recognized that income earned inside a shared economic unit doesn’t always belong to whoever’s name is on the cheque. A colony is a shared economic unit, as is a pension-splitting couple and a small business run by two spouses, one active and one not.

Yet one group gets formula-driven splitting with no strings attached. The other — risking the family’s capital — gets the harshest treatment via TOSI.

That’s not principled tax policy ; that’s a sock drawer nobody’s checked in decades: one deliberate quirky sock from 1977 and one rushed, mismatched sock from 2018, sitting side by side, nobody bothering to look down.

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Being deliberately quirky, like my old classmate, meant someone thought about it. Being accidentally mismatched, like my young relative, just means you were in a hurry and nobody caught it.

A proper review and reform of the act — one that looks at all the socks at once, not just whichever foot is cold that year — would restore fairness and stop our tax system from getting dressed in the dark.

I love Hutterite vegetables and other farm-fresh goodies as much as the next person. I feel the same about my neighbourhood family bakery, but I just wish I could buy their bread and pastries knowing their family gets the same tax treatment as the colony gets for its carrots and meat sales.

Kim Moody, FCPA, FCA, TEP, is the founder of Moodys Tax/Moodys Private Client, a former chair of the Canadian Tax Foundation, former chair of the Society of Estate Practitioners (Canada) and has held many other leadership positions in the Canadian tax community. He can be reached at kgcm@kimgcmoody.com and his LinkedIn profile is https://www.linkedin.com/in/kimgcmoody.
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