My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with BDO. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. My posts are blunt, opinionated and even have a twist of humour/sarcasm. You've been warned. Please note the blog posts are time sensitive and subject to changes in legislation or law.

Monday, February 24, 2020

Update on TOSI – Questions Answered and Remaining Ambiguities

My last blog post regarding Tax on Split Income (“TOSI”) was posted back in December of 2018. Since then, some tax practitioners have done their fair share of hair-pulling and sobbing over the TOSI rules now in effect. Some saw these rules get passed into law and decided it was a good time to retire. I refuse to retire before the Maple Leafs win that Stanley Cup, so I’m sticking around and digging into the TOSI rules (although based on the Leafs recent play, I may have to select other retirement criteria).

The main complaint from my tax colleagues and our corporate clients is not the new legislation’s complexity but its perceived vagueness. In an attempt to cover all the bases, the Department of Finance created a piece of legislation that is sometimes unclear – which makes advising clients a bit like throwing darts at a moving target.

(So much so that the upcoming new edition of the Canadian Tax Foundation’s book on the taxation of private corporations includes key TOSI info for the tax community. Shameless plug: BDO is co-writing this much-anticipated publication. The book will be out later this year and we will provide an update when it is available).

To get you updated on TOSI, I invited Robert Wyka to discuss and break down the recent developments. Rob is a senior tax accountant in BDO’s Markham office.
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By Robert Wyka

Over the past year, the CRA has provided some clarifying commentary on issues raised by the tax community. Below we discuss some of the items that the CRA has clarified along with remaining uncertainties. Much of the commentary comes from recent technical interpretations and CRA comments at various tax conferences where the CRA was asked how TOSI applies in a variety of circumstances.

Excluded business – The 20-hour test 


The TOSI excluded business exception can be met if a family member who is 18 or older works in the business on a “regular, continuous and substantial basis” in the current year or any five previous years. The legislation provides a “bright-line” test of 20 hours a week. This means that if your spouse or adult child regularly works at least 20 hours per week the exclusion is met and dividends paid to them would not be considered split income (assuming they are shareholders in the corporation).

On the surface, this appeared to be a straightforward test to meet. However, as people are starting to apply these rules to their own situations, some interesting questions arise:
  1. What if my business is seasonal and only operates for part of the year?
  2. What if the nature of the business does not require that many hours? For example, if the husband and wife are the only employees and can run the business with 30 hours of work a week total.
  3. What if I worked for more than 20 hours a week consistently but took a period of time off for maternity leave?
  4. Do the previous five years have to be consecutive?
  5. I married an ex-employee who worked for me several years ago - would they meet this exclusion?
It is important to remember that the 20-hour test is not in-and-of-itself the rule, but rather a tool to assist in determining whether you meet the excluded business criteria – if you work 20 hours a week, you will automatically qualify for this exclusion. The CRA has also confirmed that the requirement to be involved in the business on a “regular, continuous and substantial basis” can be met despite working fewer than 20 hours per week or taking a period of time off. The CRA warns, however, that this depends on the facts of your particular case and highlights the importance of proper recordkeeping. Finally, the 20-hour requirement applies to the portion of the year in which the business operates. If a business is seasonal, one can still meet the exception if at least 20 hours are worked per week when the business is operational.

The CRA has also confirmed that years for the “previous 5 years test” do not have to be consecutive.

Finally, if you marry an ex-employee who subsequently acquires shares of your corporation, those years they worked when not married to you still count for this test. HR types typically advise people not to date co-workers and subordinates, but it appears that, from a tax planning perspective, it just may pay dividends. 

Dividends


It is interesting to note that despite there being strict “reasonability” rules regarding paying related individuals’ salaries, the same may not be true for dividends. At the 2019 STEP conference, CRA was asked to comment on the “excluded business” test using the following fact pattern:
  • Individual X owns and operates a professional corporation, Xco.
  • Spouse Y owns shares of Xco and works as a receptionist for 20 hours a week, thus meeting the bright-line test.
  • Typically, a part-time receptionist working these hours would earn $18,000 per annum. However, because Y is a shareholder, Y receives a dividend of $150,000 each year.
The CRA confirmed that the $150,000 dividend would not be subject to TOSI, as the excluded business exception applies. This may be useful to keep in mind when contemplating remuneration strategies.

If you want to rely on this exclusion, thorough payroll records to support hours worked in the business will need to be available. 

TOSI after death


The death of a taxpayer triggers several serious tax consequences. Some of the most impactful tax planning we do as tax practitioners involves structuring people’s affairs in a way to minimize tax consequences as a result of death.

TOSI is no exception. Thankfully, there is relief for taxpayers who receive shares from spouses upon death. These “piggy-back” tax rules require you to look at how the income would have been treated in the original spouse’s hands. If the income would have been excluded from TOSI if earned by the deceased spouse, the same treatment will apply to the surviving spouse. However, what happens when both spouses die and shares are passed down to surviving children?

The CRA was asked to contemplate the following scenario:
  • Mr. and Mrs. A own all the shares of Opco, which operates a services business.
  • Mrs. A has been actively engaged in the business for at least five years, whereas Mr. A has not been actively engaged in the business.
  • Mrs. A passes away and all her shares are gifted through her will to Mr. A.
  • Subsequent distributions from Opco to Mr. A would not be split income as Opco would be deemed to be an excluded business in respect of Mr. A.
  • How will the deeming rules apply if Mr. A subsequently dies and those shares are gifted to the children as a consequence of his death?
The CRA’s response confirmed that in this situation the attributes of the original deceased parent – Mrs. A – would be transferred down to the next generation when Mr. A ultimately dies and his surviving children inherit the shares of Opco. Thus, Mrs. A’s “good attributes” could ultimately extend to the surviving children after Mr. A passes away, and thus TOSI would not apply to any dividends paid on such inherited shares. 

Multiple businesses


As if the TOSI legislation weren’t complicated enough, the CRA has made it clear that in situations where a corporation operates multiple “businesses,” certain amounts may have to be separately tracked on a business-by-business basis.

Let me illustrate this with an example:
  • Mr. A owns and operates a business through a corporation, BuildCo. His business specializes in two areas: construction, and property management.
  • Mrs. A works 40 hours a week handling the property management side of the business.
At first glance, it appears that Mrs. A meets the “excluded business” exception as she works, on average, over 20 hours per week. Unfortunately, it is the CRA’s position that the construction and property management endeavors represent two separate businesses. Each business is to be evaluated separately for the purposes of TOSI.

In the above scenario, Mrs. A would meet the excluded business criteria only for income derived from the property management business and NOT the construction business. This of course requires businesses to separately track the income and subsequent distributions for each business. 

Corporations that provide services


Typically, if the corporation is not a professional corporation, earns income from unrelated sources, and the specified individual owns directly 10% or more of the votes and value of the corporation, income distributions will not be subject to TOSI. However, an issue arises if the corporation provides “services.” As a condition for the excluded shares exception, the corporation must have less than 90% of its business income from the provision of services; otherwise, TOSI applies (unless another exclusion can be met).

There was some confusion regarding what “business income” meant for purposes of TOSI, as it is undefined. The CRA has clarified that they interpret it to mean gross business income, not net income. Some ambiguity remains for those business owners whose corporation earns service and non-service revenue. In certain circumstances, it may be difficult to determine what is and is not a service, or if the services provided are incidental to the activities generating the non-service revenue.

Consider, for example, a business that sells, installs, and repairs washing and drying machines in condominiums. The sale of the machines is not a service. What about the installation and repair? One can argue that the installation is merely incidental to the non-service item – the sale of the machine. Repair is more ambiguous. Are you repairing machines you previously sold, or are these machines purchased somewhere else but just need repair?

Depending on the facts of your situation, it may not be clear what is, and is not, a service. If you feel that your company may be approaching that 90% threshold, it would be prudent to do a more detailed analysis. The CRA has provided additional guidance and examples here.

Just as with the excluded business exception, the CRA recognizes and expects that taxpayers will have a greater compliance burden as they will now have to track specific revenue streams to ensure they are on side. If your corporation has multiple businesses or a mix of service and non-service revenue sources, speak with your accountant. Your bookkeeping may have to be modified in order to appropriately track these items. 

TOSI in retirement


A common retirement strategy for successful business owners is to sell their business and use the proceeds to purchase an investment portfolio to fund their retirement. This can take either of these forms:
  1. The corporation sells all of its assets and closes down the business. The resulting proceeds are used to purchase an investment portfolio. The corporation now no longer operates the original business but is simply used as a vehicle to hold the investment portfolio.
  2. A holding company is incorporated, which in turn sells the shares of the operating company. The holding company then uses the sale proceeds to purchase investments.
Let us consider scenario #1 for a moment using the following facts. Assume that when WidgetCo was operational, it was an excluded business for Mr. A. Dividends could be paid to Mr. A without triggering TOSI, because he was actively engaged in the business. Fast-forward to today, when there is no Widget business, just the investment portfolio. Can Mr. A still rely on the excluded business exception when receiving dividends from accumulated earnings (i.e., a dividend paid out of historical earnings, not from income derived from the investment portfolio) once that excluded business no longer exists? Based on an August 2019 Technical Interpretation, the answer would be no.

The dividend income will not be subject to the TOSI rules when it is received by “an individual who has attained the age of 17 before a particular taxation year, [and] if it is derived directly or indirectly from an excluded business of the individual for the year." 

The CRA’s position is that although the dividend income in scenario #1 is derived directly or indirectly from an excluded business, it would not be considered derived from an excluded business of Mr. A “for the year." Because WidgetCo’s business was no longer operating in the year the dividend was received, the income cannot be considered to be derived from that business for the year.

Scenario #2 has an analogous analysis and conclusion. 

What about the excluded share exception?


In a June 2019 Technical Interpretation, the CRA was asked to analyze a situation that resembles scenario #2 outlined previously. In this case, the CRA was asked if a taxpayer could rely on the excluded share exemption.

One of the requirements to meet the definition of “excluded shares” is that “all or substantially all of the income of the corporation for the [previous] taxation year … is income that is not derived, directly or indirectly, from one or more related businesses … other than a business of the corporation.”

This criterion creates an issue in Holdco-Opco structures. If Holdco’s only income is from Opco (a related business), being dividends or a capital gain on the sale of Opco, then shares of Holdco are not “excluded shares.” If the proceeds of Opco’s sale are reinvested by purchasing publicly traded securities, at what point does the CRA consider the funds held in Holdco not to be “derived directly or indirectly from a related business” (Opco)?

The CRA explained its position as follows:
  • Year of sale – Holdco shares would not be eligible for excluded share treatment. Holdco’s income from the prior year (or current year if this is the first year of Holdco’s incorporation) was derived from a related business (dividends from Opco and/or the capital gain on sale).
  • One year after sale – Holdco shares would not be eligible for excluded share treatment. Holdco’s income from the prior year is derived from the capital gain on sale of Opco, and any dividends paid prior to the sale.
  • Two or more years after sale – Holdco shares would be eligible for the excluded share exception (assuming all other conditions are met). None of its income from the prior year was derived directly, or indirectly, from Opco.
The different treatment of excluded business and excluded shares is important to consider when planning for retirement or a corporate reorganization. Whether or not a TOSI exclusion applies may change after a restructuring or business sale. 

What is a business?


For adults, TOSI only applies to amounts received from a “related business.” However, when considering the aforementioned retirement scenarios, is sitting on a beach drinking mojitos and collecting dividends really a “business”? After all, how is this any different from holding the investment portfolio in an RRSP or a TFSA? One would think that if no business is present, TOSI should not apply.

The CRA has illustrated a few examples that seem similar to the retirement scenarios I outlined above and did not analyze whether a business even exists. When pressed for more information, the CRA responded that for the purposes of those illustrations, they assumed there was a sufficient level of activity to consider the income derived from a business. It remains unclear how these passive investment corporations will be treated, but it appears the threshold level for considering them to be a business is quite low.

Reading this may frustrate those readers who have incorporated and own rental properties. Rental income is generally taxed as investment income as opposed to income from an active business because of its passive nature (unless you have five or more employees). This results in these corporations not being able to use the more favourable small business tax rates. It seems contradictory that the CRA in one circumstance sees your rental business as passive and thus not privy to lower corporate tax rates but, for purposes of TOSI, sees it as a business from which certain income may be subject to the TOSI rules. 

Reasonable return


If you are not able to fall into the more clearly defined exclusions, one last hope is the “reasonable return” exclusion for individuals 25 years of age or older (there is a more restrictive reasonable return test for individuals aged 18 to 24). However, this exclusion has probably the vaguest criteria to satisfy.

The legislation stipulates that you meet this exclusion if the income received is “reasonable” when regarding factors such as:
  1. Work performed
  2. Property contributed
  3. Risks assumed
  4. Total amounts paid/payable
  5. Other relevant factors
What is reasonable is incredibly subjective. The CRA has provided some basic guidance on their website. The guidance provided is useful in determining whether or not the individual should be receiving income at all. However, as soon as you answer in the affirmative, the question of “how much?” remains unanswered. How much work or risk is required per dollar of remuneration? If you are planning remuneration in advance, how confident can you be that the income you want to pay would meet this exception? Is $100,000 too high, or could you have paid more?

It is very difficult based on a vague set of factors to quantify what level of income is acceptable. It would be wise to try to meet one of the other exclusions and not rely on this one. 

TOSI story – Chapters remain to be written


If you have managed to read this far, you likely have realized TOSI is still very complex - even with the various clarifying statements and Rob's explanations. In all honesty, I had to ask Rob to clarify for me certain parts of his discussion.

TOSI's application is also very case-specific, and it requires a thorough understanding of your business and the role certain individuals play within it. It has become more important than ever to speak with your tax advisor. With proper planning, a good tax practitioner will ensure that your corporate structure and remuneration planning is done properly to reduce any potential TOSI impact.

I anticipate that we will write another TOSI update article in the future to discuss how the CRA is enforcing these rules. This will start to become clear once the CRA begins to issue reassessments, and taxpayers go to court to challenge those reassessments.

Due to the complexity of the TOSI rules, we won’t address any specific questions on this blog post in the comments section. You need to speak with your accountant who is aware of your specific fact situation. In the meantime, make sure you are keeping proper records.

BDO Canada LLP senior tax accountant Robert Wyka is based in Markham and can be reached at rwyka@bdo.ca.

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.

Monday, February 10, 2020

Why Can’t People Get Their Financial Affairs in Order?

Over the last year I have met several potential client's for BDO’s Wealth Advisory Services (from both inside and outside BDO). In two specific cases, the meetings went well, and as I often do; I undertook some initial basic discovery about the prospective client’s financial affairs and personal objectives, among other things.

In both these cases, the individuals were either in the midst of selling a business or had sold their business for millions. I thus suggested they may wish to update their wills to reflect their change (or upcoming change) in financial circumstances.

I was shocked that each of the potential clients sheepishly answered they did not have wills to update. I was astonished that these highly sophisticated business people did not have wills. (I know what you’re thinking: Mark, you’ve written on this issue numerous times, like this post on Canadians not writing wills and this one on famous people who had no will, why can't you give this a break. But let just say I sometimes figure if I keep hoping, things will change - sort of like the Maple Leafs prolonged Cup drought).

The excuses


I asked the two individuals, why they had no will. One said it has been on their to-do list for several years and with the sale about to happen it will now move up the list. The other answer had something to do with bad karma in writing a will.

It seems to me that Canadians do not make wills for the following reasons (there are far more, but I will stick with five):
  1. We love to procrastinate
  2. It is a bad omen to make a will
  3. “I am young, so I don’t need to”
  4. People aren’t sure how they wish to distribute their estate
  5. Some people are oblivious about the impact on their family (dying without a will leaves a mess for the surviving spouse, children, and executors to clean up an estate)

Has your business advisor harassed you to draft a will?


I remember thinking how Prince’s team of advisors could ever have allowed him to not have a will when I wrote the post on famous people dying without a will. When meeting the two people above, I wondered: had their advisors not spoken to them about this topic?

I think many advisors do ask their clients about their personal affairs, including their wills, but may give up when no action is taken or just keep reminding and harassing them to no avail. But I also think many advisors get caught up assisting their clients with their business affairs and often do not connect the business and personal sides. This is why I really like my wealth advisory gig: I get to connect these two aspects and integrate a client’s business, personal, retirement and estate planning into one.

I know many advisors read this blog, so advisors, at your next meeting with any client, circle back on what happens if they die (if you do not have an advisor, have this conversation with yourself :). Make sure they have these basics covered:
  1. Will and a secondary will for their corporate interests if their province allows
  2. Power of attorney for finances
  3. Power of attorney for personal care (medical)
  4. Insurance in case of death

I am not letting you off easy


If you are reading this and don’t have a will, powers of attorney or life insurance on your life to support your family if you pass away, you need to get over whichever one of the five hang-ups you have for not dealing with these matters and consider the mess you will leave your family without a will or any of the other key items. Do it for them—today, this week or this month; not “sometime before year-end."

The content on this blog has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The blog cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information on this blog or for any decision based on it.

Please note the blog posts are time sensitive and subject to changes in legislation.

BDO Canada LLP, a Canadian limited liability partnership, is a member of BDO International Limited, a UK company limited by guarantee, and forms part of the international BDO network of independent member firms. BDO is the brand name for the BDO network and for each of the BDO Member Firms.