Tax on Split Income (“TOSI”) Update

I have written several times on the Tax on Split Income ("TOSI") legislation and the impact these rules will have on small business owners and their families. However, the last time I wrote on this topic was in early January of this year when I discussed the December 13, 2017 update of the rules.

While the December 2017 update provided much clarity, the actual application of the rules is far from simple and further clarity is still required from the CRA on several fronts. I had hoped to have an update post on these rules several weeks ago, but for various reasons I could not provide the blog post until today.

As I have transitioned from tax to Wealth Advisory over the last couple years, I felt I should have a tax expert write this post. Thankfully, Howard Kazdan, a Senior Tax Manager with BDO Canada LLP, agreed to write an update on the TOSI rules; although, with this legislation, the devil is in the details, so you must review with your professional advisor.

Many of you will be familiar with Howard's writing as he has provided guest posts in the last couple years on such topics as What Small Business Owners Need to Know - Management Fees - The Importance of Having Proper Support and how 2016 tax changes Made Reviewing Your Will a Must.

I thank Howard for his excellent TOSI update posted below.

Tax on Split Income (“TOSI”) Update

By Howard Kazdan

If you own a Canadian private corporation, and wish to split income with your family members, you now have to deal the Tax on Split Income (“TOSI”) rules, which are complicated and full of uncertainty.

These rules were effective January 1, 2018, but since this is the transition year, taxpayers have the opportunity to rearrange their affairs by December 31, 2018, to avoid the application of these rules in 2018.

Prior to the introduction of the TOSI rules, there were restrictions in place to prevent income splitting on certain types of income with family members under the age of 18. The TOSI rules extend and expand those restrictions to adult family members who are not actively involved in the business. Generally, where family members can demonstrate that they have made legitimate and meaningful contributions to the business, the TOSI rules should not apply.

Any income caught under the TOSI rules will be subject to tax at the highest personal marginal tax rates, eliminating any advantage of income splitting.

In some cases, structuring put in place many years ago may no longer meet all of the original objectives, unless a further reorganization is undertaken.

What type of income is subject to TOSI?

The TOSI rules will apply to many types of income earned from a private corporation, including:

•  Dividends and shareholder benefits;

• Income received from a partnership or trust where the income was derived from a related business, or the rental of property in certain cases;

• Income on certain debt obligations (e.g., interest); and

• Income or gains from the disposition of certain property disposed of after 2017. However, if the shares of a corporation qualify for the capital gains exemption ("they are qualified small business corporation shares”), then taxable capital gains on the disposition of those shares will not be included in TOSI.

TOSI does not apply to:

• wages paid for work performed which are subject to a separate reasonableness test.

• capital dividends

• second generation income earned on a distribution previously subject to TOSI.

Is there any way out of TOSI?

If certain exceptions are met, TOSI may not apply to distributions from a private corporation:

Excluded shares

The “excluded shares” exception can apply where corporate distributions are paid to individuals who are 25 years of age or older. This will exempt distributions from TOSI where the individual owns shares with at least 10% of the votes and value of the company; where less than 90% of business income of the company is from services, and where less than 10% of the company’s gross income is earned from a related business.

Since there is a requirement for the individuals to hold shares directly under this exception, if an individual owns shares through a beneficial interest in a family trust, they will not be able to rely on this test to escape TOSI. Professionals will also not be able to rely on this test to be exempt from TOSI.

There is lack of clarity on exactly what is considered to be a service – for example, if goods are sold, they could potentially be considered to be service income, if they are incidental to providing a service. 

At a conference held in October 2018, the CRA shed some light on their views with respect to whether shares of a holding company may qualify under the excluded shares exception. In general, if its income is from carrying on a business, the purpose of which is to earn investment income, then it may qualify if the ownership and related business tests are met. This may be the case even if the capital used to buy portfolio dividends was originally derived from dividends previously received from a related operating company. Note that the distribution of the original capital may be subject to TOSI, therefore, only the income earned from the original capital would escape TOSI.

Due to all of the conditions that need to be met and many other technical requirements not discussed in this blog, this is considered one of the hardest tests to meet and you need to discuss and review this with your accountant.

Excluded Business

The “excluded business” exception can apply to any family member who is 18 years of age or older. To qualify for this exclusion, the family member must be engaged on a “regular, continuous and substantial basis” in the business in the year or for any five previous years. A bright line test has been established by the CRA so that an individual is considered to be actively engaged in the business if the person works at least an average of 20 hours per week in the business during the portion of the year in which the business operates in the taxation year or for any five previous years. However, there

is still some subjectivity to this test.

Also, in some cases, record keeping of time spent in the business by owners may not have been perfect, so there could be an issue of proving that the test has been met. It will be key to maintain proper file documentation to support any filing position taken in filing tax returns.

Reasonable Return

The reasonable return exception can apply for adult family members who are 25 years of age or older. In this case, a reasonable amount of dividends can be paid to these individuals and not be subject to TOSI if the amount paid represents a reasonable return on their contribution to the business (e.g. work performed, property contributed, risks assumed). This is an extremely subjective test, so your files will need to be adequately documented in order to support your position in case the CRA comes knocking.

There is also a reasonable return exception for family members between 18 to 24 years of age, however, the amount representing a reasonable return is limited to the prescribed rate of interest (currently 2%) on any investment made by that individual, into the business.

Other Exceptions

• There are certain exclusions from TOSI where the spouse who contributed to the business is aged 65 or over.

• Special rules will apply to ensure that individuals who inherit property will benefit from the same tax treatment realized by the deceased individual, had the deceased continued to own the property:

• An amount will be deemed to be excluded from TOSI for a surviving spouse if that income would have been excluded from TOSI if it was earned by the deceased in their last taxation year.

• Similarly, if income would have not been considered to be TOSI if it was earned by the deceased individual from whom the property was inherited, then such income will generally be excluded from TOSI for other individuals over 17 years of age.

•  TOSI should not apply in the case of marriage breakdown or on deemed capital gains on death.

Next Steps:

If these rules sound complicated, that’s because they are! Each corporate situation is unique with respect to every shareholder.

Before making any further distributions, or undertaking any reorganizations, it is suggested that you consult with your tax advisor on how the TOSI rules may impact you and your family for 2018 and onwards.

Note from Mark: 

1. As noted above, the rules are complex and unique to each situation. Thus, I nor Howard will answer any questions on this blog post.

2. If you have not already met with your professional advisor, you only have a couple weeks to rearrange your affairs for 2018. Thus, time is now of the essence and you may need to act immediately. 

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

What Small Business Owners Need to Know - Management Fees - The Importance of Having Proper Support

Management fees may be used to reduce taxes amongst a corporate group and/or to gain access to a greater small business deduction (i.e.: a company with taxable income pays a management fee to reduce its taxable income to a related company with losses that can absorb the management fee income and not pay taxes).

In other cases, management fees are used by an owner-manager as a “lazy” way to pay salaries to the owner.

Sometimes these fees are well thought out and supported with documentation. However, I also see these fees paid recklessly. In either case, the use of management fees have some risk associated with them, as they are often challenged by the Canada Revenue Agency ("CRA") where they are not considered reasonable and justifiable. 

Today, Howard Kazdan, a tax expert with BDO Canada LLP, discusses management fees and what kind of support is suggested to strengthen the payer’s case for deducting such fees.

I thank Howard for his excellent post

Management Fees – The Importance Of Having Proper Support

By Howard Kazdan

As noted above, management fees are often used as a tax planning tool. Of course, to be effective, the fees must be deductible to the payer.

The criteria that are required for the management fees to be considered deductible, were established by the courts many years ago:

1. The expense must have been incurred (either actually paid or subject to a legal liability to pay);

2. The fees must have been incurred for the purpose of income from a business and

3. The fees must be reasonable in the circumstances.

In order to make a determination of whether the fees are deductible, the courts may:

1. Require documentation to support the expense, for example an intercompany agreement and/or invoices for work done.

Where the only documentation for intercompany fees is an accounting journal entry, the courts have concluded that such entries are not sufficient to establish that the amount was incurred during the year and represent a true liability at year end.

2. Require evidence from the corporation describing what services were provided and how incurring the expense contributed to the process of earning income.

3. Require evidence of the basis for the amount of fee, since a bona fide fee for service should be based on services performed and not profit. If a payment is based on profit (which may not be known until after year end) the CRA may argue that the payment is a distribution of profit and not a deductible expense.

The CRA has administratively allowed corporations to bonus down to the small business limit and considered such bonuses as reasonable when paid as salary to owner-managers. This administrative position is not available when such amounts are paid as management fees. In the latter case, the CRA will look at the nature of services performed, the time spent to perform those services and whether the fees paid are similar to what would be paid to other arm’s length sources.

Taking the above into consideration, successful claims of management fees that have been subject to CRA review and the courts have the following similarities: 

(a) written management fee agreements/service arrangements be in place describing services, fees, responsibilities

(b) documentation of a bona-fide business purpose for the intercompany fee (for example, use of a management corporation to keep compensation of key management confidential). 

(c) adequate records to keep track of services provided (time sheets)

(d) periodic invoicing rather than only once at the end of the year

(e) company rendering the servicing invoice should have the staff and ability to provide the services. 

(f) the fee should be based on services provided, not profit.

Claims which have not been as successful generally lack the above noted characteristics (for example, there is no agreement; could not provide details of services provided; company earning the income did not have the ability to provide the services; general lack of documentation other than journal entries).

In reviewing management fees, the CRA may send a questionnaire. It is possible that even if the deduction is disallowed in one entity, the company including the fees as income will still be taxed (effectively double taxation). This is why you will want clear documentation that fees are bona-fide management fees and treated consistently each year. 

Don’t forget that such fees may be subject to GST/HST unless the entities qualify for the closely related exception and the Form RC4616 has been properly filed. 

In addition to the criteria already discussed, an additional reason to issue invoices is GST/HST. An invoice will provide clarity on timing of when GST/HST is payable (i.e. when fee becomes legally enforceable) and ensure there is adequate documentation for the company incurring the expense, in support of any ITCs claimed.

If you or your related companies use management fees as a tax planning tool, ensure you review the criteria noted above with your accountant. 

Howard Kazdan is a Senior Tax Manager with BDO Canada LLP. If you would like to engage Howard for tax planning, he can be reached at 905-946-5459 or by email at hkazdan@bdo.ca

This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.

The Registered Disability Savings Plan – A Government-Assisted Savings Plan for Family Members that Qualify for the Disability Tax Credit

Last week, Katy Basi wrote about using Henson Trusts to estate plan for disabled beneficiaries.

Today, Howard Kazdan, a tax expert with BDO Canada LLP, discusses what a Registered Disability Savings Plan is and where it may be a useful tax planning vehicle for the parents of a disabled child.

I thank Howard and Katy for their excellent posts.

The Registered Disability Savings Plan – A Government-Assisted Savings Plan for Family Members that Qualify for the Disability Tax Credit

By Howard Kazdan

A Registered Disability Savings Plan (“RDSP”) is a savings plan that is intended to help parents and others save for the long term financial security of a person who is eligible for the disability tax credit (“DTC”). A person is eligible for the DTC only if a medical practitioner certifies on Form T2201, Disability Tax Credit Certificate, that this person has a severe and prolonged impairment in physical or mental functions. This form must also be approved by the CRA.

Where you have a family member living with a physical or mental disability, consideration should be given to opening a Registered Disability Savings Plan.

What is an RDSP?

RDSPs are tax deferred savings plans which can provide long-term financial benefits for a disabled individual resident in Canada. Qualifying individuals may receive grants and bonds that the Government of Canada contributes to the RDSP.

How does the RDSP work?

RDSPs can be opened by either a beneficiary who has reached the age of majority and is contractually competent to open an RDSP for themselves or, before 2019, by their parents or other legal representative.

There is no limit to how much can be contributed to an RDSP in any particular year, however, the lifetime maximum contribution limit is $200,000. Contributions can be made until the end of the year in which the disabled person turns 59.

It is important to note that there is no tax deduction for contributing to an RDSP. These plans are somewhat similar to a Registered Education Savings Plan (if you have opened such an account for your child’s education). On the flip side, when the original contributions are withdrawn, the disabled individual will not be taxed on those contributions. However, income earned and government grants (discussed below) and bonds received will be taxed when they are paid out of the RDSP. If the plan is established for a long period of time, and the investments earn a good rate of return, then this may provide a long deferral from paying tax.

Subject to certain contribution and age limits, RRSP/RRIF proceeds can be transferred to an RDSP through a will if the disabled individual is financially dependent upon the deceased. This allows parents or grandparents of a disabled individual, to tax and estate plan for a future contribution to an RDSP and may provide you with comfort if it is not otherwise possible to maximize the contributions before this point.

Government Grants

The Government of Canada pays a grant to the RDSP, until the end of the year in which the beneficiary turns 49, that is dependent on the beneficiary’s family income and the amount contributed. The maximum grant is $3,500 each year, to a lifetime maximum of $70,000. The contribution rules allow for a 10-year carryforward of entitlements, for those who qualify but cannot contribute every year.

Beneficiary's family income	Grant**	Maximum
$90,563 or less
on the first $500	$3 for every $1 contributed	$1,500
on the next $1,000	$2 for every $1 contributed	$2,000
more than $90,563 or no income information at available at CRA
on the first $1,000	$1 for every $1 contributed	$1,000
**The beneficiary family income thresholds are indexed each year to inflation. The income thresholds shown are for 2016.

For minors, family net income is that of their parent(s) or legal guardian(s). From the year the beneficiary turns 18, family net income is the combined net income of the beneficiary and their spouse.

The Government of Canada may also pay up to $1,000/year, to a maximum of $20,000, in a Canada disability savings bond to low-income Canadians until the beneficiary turns 49. No contributions are required once the RDSP is opened.

Taxation

Since RDSPs are intended to be a long-term savings vehicle, if money is withdrawn, all or part of the government grants and bonds that have been in the RDSP for less than 10 years may have to be repaid. The beneficiary must repay $3 for every $1 that is taken out, up to the total amount of grants and bonds paid into the RDSP in the last 10 years. This can be very punitive if funds are required urgently.

The minimum regular scheduled payments that must begin when the beneficiary turns 60 are determined by a complicated formula.

If an RDSP terminates because the beneficiary no longer qualifies for the DTC or dies, then:

• grants and bonds that have been in the plan for less than 10 years must be repaid, and

• amounts paid to the beneficiary or his/her estate related to investment income, grants and bonds will be taxable.

If you are disabled, or have a disabled child, you should consider opening an RDSP if you have not already done so, to provide additional government-assisted long-term financial security. Before opening the plan, confirm with the Canada Revenue Agency that the DTC eligibility status of the plan holder is up-to date so the DTC can be claimed and the benefits of an RDSP can be enjoyed. This should be monitored in the future so the benefits are not lost. RDSPs can be a useful tax planning tool for the parents of a disabled child. However, as noted above, there are many rules for which you need to familiarize yourself with. Howard Kazdan is a Senior Tax Manager with BDO Canada LLP. He can be reached at 905-946-5459 or by email at hkazdan@bdo.ca This site provides general information on various tax issues and other matters. The information is not intended to constitute professional advice and may not be appropriate for a specific individual or fact situation. It is written by the author solely in their personal capacity and cannot be attributed to the accounting firm with which they are affiliated. It is not intended to constitute professional advice, and neither the author nor the firm with which the author is associated shall accept any liability in respect of any reliance on the information contained herein. Readers should always consult with their professional advisors in respect of their particular situation. Please note the blog post is time sensitive and subject to changes in legislation or law.