26 What is the Kiddie tax? What are the tax implications? Why does it exist?

Prior to the creation of the Kiddie tax rule, high-income business owners would attempt to split their income using their child to lower their own (business owner) tax payable. This would be done by making the child a shareholder of the business. Then the business would hand out dividends to the child who wouldn’t have any substantial income. Since the child has no substantial income, they would be in the lowest tax bracket and could offset some of the tax payable with the use of the child’s tax credits. Therefore, most of these dividends given to the child would become tax-free.

The following is an example of a business owner paying a dividend to his child (rather than to himself) without Kiddie tax implications.

In this simplified example Gianna will pay no tax on the dividend as the dividend tax credit offsets the tax payable at the low marginal rate.   Dividends received beyond the 1st marginal tax bracket could be further sheltered by Gianna’s personal tax credit. Kobe is in the highest tax bracket so, if he were to receive this dividend himself, he would be taxed at a much higher rate.

Many tax planners began to take advantage of this income splitting technique. In the year 2000, the Canadian government decided to add section 120.4 “Tax on Split Income” also known as Kiddie tax, to the Income Tax Act. It states, “Certain passive income of individuals under the age of 18 would be taxed at the 29% tax rate” (Income Tax Act, 120.4. The government amended section 120.4 in the year 2016, to reflect on the current highest marginal tax rate of 33%.  So dividends paid to children, like Gianna, are now taxed at a 33% federal rate…and it gets worse, they won’t let her use her personal tax credits either (see below).

The types of passive income or “split income” that became subject to this tax rule, include the following: “Taxable dividends, shareholder benefits on unlisted shares of Canadian and foreign companies and income from a partnership or trust where the income is derived by the partnership or trust from the business of providing goods or services to a business carried on by a relative of the child or in which the relative participates” (Income Tax Act, 120.4). The only deductible credits against this tax are the dividend and foreign tax credit associated with the amount included in the passive income. Therefore, the child cannot use their own personal tax credit or any other tax credit to reduce the tax payable on passive income indicated in section 120.4 of the ITA.

The following is an example of a business owner handing out a dividend to his child with Kiddie tax implications.

Due to the Kiddie tax rule, Gianna’s dividend will be taxed at the highest marginal rate of 33%. She will be able to deduct the dividend tax credit to lower her tax payable. However, she is no longer able to deduct her basic personal tax credit against the $2,640 of tax payable on this dividend.  Ultimately there is no tax benefit in Kobe paying dividends to Gianna.

Capital gains were not mentioned in section 120.4 in the year 2000. That led to tax planners structuring a system that would allow them to convert dividends into capital gains as a new method of income splitting. However, in 2011, the Kiddie tax rule was expanded to cover some capital gains.

Subsection 120.4(4) was added and states, “The capital gain of a specified individual (under the age of 18), from a disposition of certain shares that are transferred to a person that does not deal at arm’s length with the individual, is subject to the tax on split income” (Income Tax, 120.4(4)). This subsection was amended to reflect on only individuals under the age of 17. Excluded from this subsection are capital gains on publicly traded shares and capital gains on shares of a mutual fund corporation. If a capital gain follows the ruling in subsection 120.4(4), the full amount of capital gain will be taxed at the highest marginal tax rate.

Interactive content (Author: Emily Yeung, January 2020)

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Reference and Resources:

• ITA – 120.4, 120.4(4)

January 2020