The federal government has unveiled its new proposal to curb "income sprinkling" by some small business owners to family members, with substantive changes to a much-criticized initial proposal unveiled in the summer.

But the government still intends to apply the new rules for the 2018 tax year to reduce the illegitimate use of income sprinkling, a tax-planning measure to shift income to family members in a lower tax bracket as a way to reduce taxes owed.

Finance Canada said Wednesday the new changes will ensure legitimate contributors to a small business will still be eligible to receive income from the business. The government has introduced a number of "bright-line" tests that will be used to weed out those who stand to benefit financially from business operations but have few day-to-day dealings with the company.

A "reasonableness test" was unveiled last July to determine legitimate contributions, but small business owners and business groups were unhappy with the increase in paperwork.

Now, no reasonableness test will be needed for family members:

A spouse over age 65.

Over 18 who make a "substantial labour contribution" of at least 20 hours per week.

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."

Those who do not meet these "bright-line" tests — as usual, a tax-filer would self-assess if they meet the qualifications on their tax return — will then face a reasonableness test review by the Canada Revenue Agency.

The government initially intended to expand an existing "kiddie tax" — which blocks proprietors from transferring income to minors in a lower income bracket — to include adult children and other family members. The kiddie tax levies the highest marginal tax rate on that income, making sprinkling a less desirable measure.

Now, the reasonableness test will be used to determine how much of a family member's income, if any, would be subject to the highest marginal tax rate for those who do not pass one of the "bright-line" tests.

"This is part of our goal of making the tax system fair. For the three per cent of businesses that pass some of their revenue to family members [through income sprinkling], they're going to have to make sure these rules are considered appropriately," Finance Minister Bill Morneau told reporters after question period Wednesday.

Finance Minister Bill Morneau introduces new rules on when income sprinkling can be used to reduce a small businesses taxable income. 0:19

"They'll just have to show the amount of revenue they're passing to their spouse or children is reasonable. It's a way to clarify the situation in a simple way … 97 per cent of small businesses will have absolutely no change in their situation."

CARP, the organization that advocates for Canada's seniors, welcomed changes that will allow sprinkling among those aged 65 and over.

"Legislative changes that enable seniors to better care for themselves and their spouses in retirement will help ensure peace of mind and financial security for Canadians as we age," the group said in a statement.

The Canadian Federation of Independent Business (CFIB), which has stridently opposed the tax changes since the initial rollout in July, said Morneau has "dropped a lump of coal" on business owners before Christmas.

"Business owners will be worried that they could see their red tape burden increase significantly in order to prove they qualify for one of the exemptions or can meet the 'meaningful contribution' test," Dan Kelly, the CFIB president, said in a statement.

"It is deeply worrisome that the CRA — the same agency that thought it was a good idea to tax the dishwasher's discount on his pizza lunch — will now be asked to determine whether the contributions of a mom and pop shop warrant the salary and dividends paid to mom and pop each year."

While the new rules go into effect Jan. 1, Finance Department officials pointed out Wednesday that businesses have until Dec. 31, 2018 to adjust to the changes before filing their 2018 taxes.

Earlier this fall, after weeks of criticism about both his proposals and his own personal wealth management, Morneau announced changes to the initial tax change proposals he put forward in July — including a pledge to drop the current small business tax rate from 11 per cent to nine per cent.

The Conservative finance critic, Pierre Poilievre, said the party will reserve judgment on the changes until it has had the chance to consult with those affected by the small business tax tweaks.

"He has once again introduced a cobweb of complicated rules and taxes that will keep small businesses scrambling right through the Christmas period and after," he said.

Senators want changes scrapped or delayed

Wednesday's announcement comes on the same day the Senate's national finance committee issued a report — after a months-long cross-country fact-finding investigation on the proposed changes — demanding the government scrap the proposals or, at the very least, delay implementation until Jan. 1, 2019, a year later than planned.

"This is not some exercise to embarrass the government, indeed Minister Morneau endorsed our investigation at the outset," Sen. Percy Mockler, the Conservative chair of the committee, told reporters. "We believe there is too much confusion for the government to proceed on the timeline it has suggested."

Senator Anne Cools, Senator Percy Mockler, Senator Elizabeth Marshall of the Senate Committee on National Finance host a press conference on the findings of its report on the federal government's proposed changes to the small business tax regime. (Sean Kilpatrick/Canadian Press)

The 50-page report documents a host of witnesses demanding senators urge the government to withdraw the proposed changes entirely. "We are inclined to agree. We are not convinced that the government has made a good case for its proposals," the report states.

The committee said it was particularly troubled by plans for the so-called "reasonableness test" for income sprinkling, warning it could lead to arbitrary decisions by Revenue Canada bureaucrats. "The difficulty of understanding and complying with the rules will lead to uncertainty, foster tax appeals and litigation," the report reads.

Beyond the specific changes to the small business tax regime, the Senate said the government should immediately begin a comprehensive review of the entire tax code — something that has not be done since the 1960s, when the government of the day launched a royal commission on the matter.

Sen. Elizabeth Marshall, a Tory member of the committee from Newfoundland and Labrador, said the tax system has become a "ponderous and unwieldy monster" after years of haphazard additions. "An independent review should take place regardless if the government moves forward with its proposed changes," she said.

Not one of the Trudeau-appointed Independent senators were present for Wednesday's press conference, leading to questions as to whether the critical report was rammed through by Conservative appointees. Mockler insisted a majority of the committee — comprising five Conservatives, five Independents and two Senate Liberals — backed the report.

Morneau, who said the government will review the Senate findings, made note of the fact the report was not produced unanimously, raising doubts about the partisan nature of its content.