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.

Investing Like Your Grandmother (or Grandfather). The Results May Surprise You

When I was a young accountant and happened upon an estate return, I was often amazed at how much wealth the grandmother had accumulated at death. This applied to grandfathers too, but women tend to live longer, so I noticed the tendency more with grandmothers. The accumulated wealth was typically in conservative marketable securities bought over many years.


What I found remarkable, as I saw this time and time again, was that blue-chip stocks dominated these portfolios. (Mutual funds were just coming into vogue and no one had heard of an exchange traded fund (ETF).) Each portfolio had the big Canadian banks, insurance companies, utility companies and the Bell Canadas, Canadian Tires and Thomsons of the Canadian stock universe, plus some large high-quality U.S. stocks sprinkled in. Being a naïve and arrogant young investor, I somewhat derisively at the time called these stock holdings “grandmother portfolios.”

As I look back, an older me should have given my younger self a good swat upside the head, as these portfolios hit on most of the critical tips investment managers and experts still suggest today (other than maybe a little more global diversification and possibly some alternative investments):

• They were fairly well diversified.
• They very rarely turned over.
• They contained stocks that generally paid dividends that grew over time.

Shredding my old tax returns – an eye-opening experience

So why am I talking about grandmother portfolios? Well, a couple months ago I followed my own advice and shredded some of my older personal tax returns. While shredding the returns, I entertained myself by looking at the income earned each year and the capital gains (Schedule 3), which detailed my stock dispositions for each year.

I have always liked to have some risk in my portfolio, and over the years have taken some shots with disruptive technology stocks, “find that big gold mine” stocks and “let’s hit the gusher” oil stocks, among other rather poor stock selections. However, I was astounded when I looked at how many of these flyers resulted in capital losses on my old returns.

The technology stocks included such household names as:

• Samsys Technologies (RFID readers)
• International Verifact (forerunners of point-of-sale payment terminals)
• GenSci Regeneratrion (bone repair and generation for dental use)
• Zeox Inc. (using Zeolite for environmental waste)

Some of the crazy gold picks included such sterling names as:

• International Pursuit
• Gerle Gold (actually looking for diamonds in the Northwest Territories)
• South Pacific Resources (a stock that followed in the draft of Bre-X when it was going up)

And the oil stocks included:

• Dome Petroleum (a famous oil stock for those of you of my vintage)
• Mart Resources (a Nigerian oil play)

The above names are meaningless, but entertaining to me and maybe a couple readers. But what shocked me about my shredding exercise was how many flyers I had actually gone for over the years. (I actually hit on a couple others, but that was luck and not relevant to this post.)

My point is, I was shocked at the time and effort — let alone the money — I wasted trying to chase down the next big thing. 

Moral of the Story

While I have slanted this post on purpose to make a point (I typically also had a substantial part of my portfolio in quality stocks and alike), in retrospect I would have had a larger nest egg if I had stayed away from the above speculative flyers and only bought higher grade stocks.

As an accountant I cannot tell you what stocks and bonds to purchase. But after my shredding exercise, I would suggest the following general investing principles be considered:

1. Buy high-quality stocks, ETFs or mutual funds.

2. Keep the turnover of these securities to a minimum.

3. Diversify across countries and sectors.

4. Consider stocks that pay dividends that grow over time.

5. Keep your flyers to a minimum — or better yet, don’t take any flyers.

In conclusion, invest like your grandmother.

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.

The Revised Tax On Split Income Rules

On December 13, 2017 the Liberals released a new and improved version of their income sprinkling/tax on split income (“TOSI”) proposals. The government’s backgrounder stated, “the revised draft legislative proposals include changes to better target and simplify their application”. I can agree with the targeted assertion; as some overly expansive drafting was corrected, but simplification, not in my world.

The new rules while more objective than the previous version, are still very subjective. In my opinion these revisions will just create more angst among the small business owners caught by these proposals and will result in court cases for years. Add in that these rules were released the week before the Christmas holidays and not issued in conjunction with the passive income rules that are supposedly to come in the next budget (planning for dividends may be dependent or intertwined with the final passive rules) and I don’t think the Finance Minister will be winning any politician of the year awards from any private business associations.

In my opinion, all these TOSI rules would not be necessary if the government would have simply disallowed income sprinkling for anyone under age 25 that that does not work full-time in a business and for all Canadians (whether business owners or not) started taxing spouses as a single-family unit. But then, nobody asked me.

Today, I will summarize whom I see as the winners and losers of these new proposals and those caught in the grey area. Finally, I will provide some details on the revisions to the TOSI rules.

As this legislation is new and will likely still require some clarification, I want to make it clear that this post is solely for general information purposes. You should consult with your professional advisor, so they can review these proposals based on your specific fact situation.

Scorecard

Winners

1. Business owners over 65

2. Individuals who inherited shares of a small business

3. Businesses where shares, votes and value are allocated evenly among family members and are not service businesses

4. Canadians who work at least 20 hours a week on a regular and continuous basis in the family business

5. Retired owners that were caught under the initial rules because they were considered related even though an arm’s length person now ran the corporation

Losers

1. Beneficiaries of shares held by Family Trusts

2. Professionals

3. Small businesses that provide services and do not sell products

4. Estate freezes recently undertaken and/or where there is large redemption value remaining in the preference shares issued upon the freeze

Unclear

1. Families were shares have already been distributed from a trust or were purchased upon incorporation and the parents have voting control

2. Estate freezes where most shares have been redeemed

The New Rules

The new rules are very detailed and I do not intend to regurgitate all of them here. I will summarize the rules only at a high level. For details and FAQ’s, please see this CRA link  (scroll half-way down the page to related products and you will see guidance and other more technical material).

The new rules have four key exclusions: 1. An excluded share test 2. Excluded business test 3. Reasonable rate of return test and 4. Retirement and inheritance exclusion.

I will summarize them below and discuss how they may affect you.

Excluded Shares- The share ownership test

The TOSI rules will not apply where you have attained the age of 25 and all of the following conditions are met:

• You own at least 10% of the outstanding shares of a corporation in terms of votes and value and the corporation meets all the following conditions:

(a) It earns less than 90% of its income from the provision of services

(b) It is not a professional corporation

(c) All or substantially all its income is not derived from a related business

At first blush, this test seems like a god-send for private corporations where family members are shareholders and have attained the age of 25. However, in many cases the parents have the majority of the voting rights and may have significant value in preference shares as result of a prior reorganization or estate freeze. Where the issue is only votes, you may be able to reorganize your corporate share structure to meet this condition as the government has stated that even though the rules are applicable January 1, 2018, you have until December 31, 2018 to get your corporate house “in order”.

This rule will essentially preclude the use of family trusts for income splitting purposes other than the capital gains exemption. It is important to note, that the TOSI rules will not apply to capital gains on the sale of qualified farm or fishing property and to the sale of qualified small business corporations (“QSBC”). Most private corporation owners reading this blog post have shares that either qualify as QSBC shares, or can be made to qualify for the capital gains exemption through a purifying transaction (see this post I wrote on this topic). The exclusion for the sale of these shares is not age dependent (however, where an individual is under 18 and the sale is to a related party, the exemption will be problematic). Not that I want to look a gift horse in the mouth, but we have all these complex rules to prevent income sprinkling and you are still allowed to allocate the 2018 exemption amount of $848,252 to a minor?

Professional corporations are excluded, as they have been one of the main targets of the Liberals throughout this whole debacle. However, pay careful attention to the word “services”. At first glance you think services is just another arrow aimed at professionals, but services as written (it is not defined anywhere) would seem to include the services of a barber, gardener, massage therapist, computer consultant etc. Many small businesses may not meet this exclusion if they don’t earn at least 11% of their revenue from the sale of products. In my opinion, this provision may “blow-back at the government once it is better understood; assuming the literal interpretation is the proper reading. It should be noted that if you and your spouse/children 18 years old and over meet the labour criteria for the excluded business test based discussed below, then having a service business will not in itself preclude you from income sprinkling.

The related business in (c) above is just a provision to ensure a service business does not impose another business between it and the family member to get around the rules, although, some tax observers are concerned this provision could accidentally cause issues where shares are held through a holding company. This is one area that the Liberals will need to clarify.

Excluded Business –The labour test

The TOSI rules will not apply where you are 18 or over and have been employed by an excluded business, which is “a business in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year of the individual in which an amount is received or in any five previous taxation years". The CRA states that “To access the exclusion in respect of five previous years of labour contributions, it is not necessary that the five previous years be consecutive or after 2017. Any combination of five previous years would satisfy the test”. The test will also account for businesses’ that are seasonal, such that the test will apply to the seasonal period

Finally, the CRA says “To provide greater certainty (but without limiting the generality of the test), an individual who works an average of 20 hours per week during the part of the year that a business operates will be deemed to be actively engaged on a regular, continuous and substantial basis for the year. If an individual does not meet the 20-hour threshold, then it will be a question of fact as to whether the individual was actively engaged in the business on a regular, continuous and substantial basis. However, even if an individual aged 25 or older does not meet the regular, continuous and substantial threshold, the TOSI will apply to amounts derived from a related business only to the extent that they are unreasonable (i.e., only the unreasonable excess will be subject to the TOSI)”.

This labour test is a fairly clear bright-line test; you must work over 20 hours per week for at least five previous years or you get into a subjective reasonability test that will likely result in most amounts being in excess of reasonability.

The CRA provided some guidance in the materials stating that records such as timesheets, schedules and logbooks will be sufficient to confirm the hours a person worked.

Reasonable Return on Capital Test

There are two tests within this exclusion:

1. Safe Harbour Test

2. Reasonable return test

Safe Harbour Test

Where an individual 18-24 years of age has contributed capital, and does not qualify for the excluded share or excluded business exclusions, they may still qualify for a “safe harbor exemption” (No that does not mean you take your money and hide it in a safe harbor in the Turks and Caicos).

It means that you will be provided an exclusion from TOSI income to the extent of your capital contribution x a prescribed rate (currently only 1%). i.e. If you contribute $100,000, you multiply the $100,000 x 1%=$1,000 and you can exclude $1,000. To be a blunt bean counter, this exclusion is pretty much useless, since a) The reality is that in probably 95% of the cases, most shareholders only contribute $100 or less to purchase their shares and b) as noted above, the low prescribed rate means even if you did contribute a fair bit of capital, such as $100k, your exclusion is still a meager $1,000.

Reasonable Return Test

For those 25 years of age and older, this very subjective test says that a reasonableness test is to be applied to such factors as:

• Work performed 
• Risks assumed by the individual in the business 
• Any other factors that may be relevant

Your guess is as good as mine as to how this would be applied. Consider Mr. A who is a shareholder and works full time in his business. His daughter also a shareholder, is a computer science student who comes up with a software application that leads to over one million dollars in new revenue for the business. What is her "reasonable" entitlement to dividends?

Retirement and Inheritance

The initial drafting of the proposals appeared to have inadvertently caused the TOSI rules to apply to retired private corporation owners and Canadians who had inherited private corporation shares. The new proposals have addressed these concerns.

The new TOSI rules provide the following exemptions:

1. Where an active owner-manager (someone who met the labour contribution rules) reaches age 65, the TOSI rules will not apply to their spouse (no matter their age). Note: these rules do not mean you can split your dividends like you do your pension income. They only allow you to pay dividends to your spouse who is not excluded by any of the provisions and avoid the TOSI rules where you are 65 or over.

2. If you are over 18 and inherit shares in a private corporation from someone who met the TOSI one of the TOSI exclusions, those shares will continue to be excluded.

Salary

The new rules do not apply to salary. However, there has always been a reasonableness test for salaries paid to family members vis a vie what would you pay an arm’s length persons and that rule will still apply.

Prescribed loans

The new rules do not appear to prevent the use of prescribed loans where you purchase public securities. See this blog and speak to your advisor about whether this strategy would be advisable for your situation.

At this time, I am not entirely comfortable answering questions on these proposals, until we have further clarity. So, if you ask a question or provide a comment on this post, I may not answer the question or will couch the answer. So please don’t expect definitive answers if you ask a question.

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 Best of The Blunt Bean Counter - Proprietorship or Corporation - What is the Best for Your (New) Business?

This summer I am posting the "best of" The Blunt Bean Counter blog while I work on my golf game. Today, I am re-posting a November, 2011 blog post on whether you should incorporate a new

or start as a proprietorship?  I also address the logical follow-up question for those that have already started their business as a proprietorship:  when should they convert their proprietorship into a corporation?

Proprietorship or Corporation - What is the Best for Your (New) Business?

Corporation – Non-Tax Benefit

The number one non-tax reason to incorporate a business is for creditor proofing. Generally, a corporation provides creditor protection to its shareholder(s) through its limited liability status, a protection not available to a proprietorship. (It is important to note that certain types of professional corporations while protecting your personally from corporate liability, do not absolve the individual professional from personal professional liability). Where an incorporated business is sued and becomes liable for a successful claim, the only assets exposed to the creditors are the corporate assets, not the shareholders personal assets.

In order to mitigate the exposure that a potential claim could have on corporate assets, a holding company can be incorporated. Once the holding company is incorporated, the active corporation can transfer on a tax-free basis the excess cash and assets to the holding company (as discussed in my blog creditor proofing corporate funds) to insulate those assets from creditors. The assets in the holding company cannot be encroached upon if there is a lawsuit against the operating company unless there was some kind of fraudulent conveyance.

The inherent nature of certain businesses leads to the risk of lawsuits, while other business types have limited risk of a lawsuit. Thus, one of your first decisions upon starting a business is to determine whether your risk of being sued is high and if so, you should incorporate from day one.

Corporation – The Tax Benefits

There are several substantial income tax benefits associated with incorporation:

1) The Lifetime Capital Gains Exemption

If you believe that your business has substantial growth potential and may be a desirable acquisition target in the future, it is usually suggested to incorporate. That is because on the sale of the shares of a Qualifying Small Business Corporation, each shareholder may be entitled to a $824,177 capital gains exemption. So for example, if you, your spouse and your two children are shareholders of the family business (often through a family trust), you could potentially sell your business for $3,300,000 tax-free in the future. It should be noted that typically businesses that are consulting in nature, have limited value, since the value of the company is the personal goodwill of the owner.

Where you start your business as a proprietorship, it is still possible to convert the proprietorship into a corporation on a tax-free basis and to multiple the capital gains exemption going forward. A couple of points are worth noting here: (1) incorporating a proprietorship after the business has been operating for a few years may result in substantial legal, accounting and valuation fees; and (2) the value of the business up to the date of incorporation will belong to you and will be reflected in special shares that must be issued to you (assuming you will include other family members as shareholders in the new corporation).

For example, let's say you operate a successful business which you started as a proprietorship because you were unsure of whether it would be successful. The business has taken off and you have engaged a valuator to value the business prior to incorporating. The valuator has determined that the fair market value of your business today is worth $500,000. Upon incorporation, the $500,000 of value would be crystallized in special shares that would be owned by you. The new common shares that would be issued would only be entitled to the future growth of the business above and beyond the $500,000 and thus, any future capital gains exemptions for the new common shareholders would only accrue on the value in excess of $500,000.

2) Income Splitting

A corporation provides greater income splitting opportunities than a proprietorship. With a corporation it is possible to utilize discretionary shares that allow the corporation to stream dividends to a particular shareholder or shareholders (e.g. a spouse or a child 18 years of age or older) who are in lower marginal income tax brackets than the principal owner-manager.

Dividends are paid with after-corporate tax dollars from the business, whereas salaries, the alternative form of remuneration, are paid with pre-tax dollars and are generally a deductible business expense. The deductibility of a salary by a business is subject to a “reasonability test”. In order to deduct a salary from the business’ income it must be considered “reasonable”. Unfortunately, there is no defined criteria as to what is considered “reasonable”; however, paying a family member a salary of $50,000/annually who has little or no responsibilities within the business is likely not “reasonable”. However, with dividends there is no such “reasonability test”, so paying a family member a dividend of $50,000 even though she/he may have little or no responsibilities within the business is perfectly acceptable. Salaries to family members can be paid in an incorporated business or unincorporated business; however, the dividend alternative is unique to a corporation. Sole proprietors cannot pay themselves a salary; they receive draws from the proprietorship.

3) Income Tax Rate

The first $500,000 of active business income earned in a corporation is currently subject to an income tax rate of only 15.0%  in Ontario. Since the personal rate on income can be as high as 53.53%, income earned within a corporation potentially provides a very large income tax deferral, assuming these funds are not required personally for living expenses. This potential 38% deferral of income tax allows you to build your business with pre-tax corporate dollars. It should also be noted that once you take the money from the corporation, in many cases you essentially pay the deferred 38% tax as a dividend.

Corporations – The Fine Print

1) Expenses

Many people want to incorporate their business because they feel they will be able to deduct many more expenses in a corporation. In a general, that is an income tax fallacy. For all intents and purposes, the deductions allowed in a proprietorship are virtually identical to the deductions permitted in a corporation.

2) Professional and Compliance Costs and Administrative Burdens

The costs to maintain a corporation are significantly larger than for a proprietorship. There are initial and ongoing legal costs and annual accounting fees to prepare financial statements and file corporate income tax returns. These costs can be significant in some cases and can even outweigh some of the tax benefits in certain situations.

In addition, the administrative burdens for a corporation are far greater and drive many a client around the bend. For example, in a proprietorship or partnership, the owner(s) can take out money from the corporation without payroll source deductions. This is not the case when the owner(s) take out money in the form of a salary from a corporation.

So Why Start as a Proprietorship?

If you do not have legal liability concerns and you cannot avail yourself to the enhanced income splitting opportunities with family members a corporation may provide, starting as a proprietorship keeps your costs down and reduces your compliance and administrative issues. More importantly, since most people need whatever excess cash their business generates in its early years to live on, there is generally little or no tax benefit from incorporating a business initially. Finally, a proprietorship essentially provides for an initial test period to determine the viability of the business and if there are business losses, the owner(s) can generally deduct these losses against his or her other income.

When to Incorporate your Proprietorship?

In my opinion, you should incorporate your proprietorship once it has proven to be a viable business and once it has begun to generate cash in excess of your living requirements, so that you can take advantage of the 30% tax deferral available in a corporation.

Once you satisfy the above two criteria and incorporate, you will then benefit from creditor protection and the potential income splitting opportunities with other family members (assuming you want to include other family members as shareholders) and potentially the capital gains exemption or multiplication of the capital gains exemption if you include other family members in the corporation.

There is no “one shoe fits all” solution in determining whether to incorporate a new or ongoing business; however, the answer should become clearer once you address the issues I have outlined in this blog.

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.

Foreign Exchange Translation on Capital Gains and Dividends

One question that constantly arises during income tax season is; what exchange rate should be applied to foreign transactions? The Canada Revenue Agency ("CRA") has re-iterated/set forth their position in respect of the translation requirements for capital gains and dividends and I discuss their views below.

Capital Gains

During a roundtable discussion at the October 2014 Association de Planification Fiscale et Financière (APFF) conference, the CRA was asked the following question:

Principales Questions: What is the CRA's position with respect to the use of average foreign exchange rates for the conversion of amounts of income and capital gains?

Position Adoptée: An average rate may be acceptable for items of income, but not for capital gains.

Raisons: The definition of relevant spot rate in subsection 261(1) provides that a rate other than the rate quoted at noon by the Bank of Canada at the relevant date may be used, provided it is acceptable to the Minister.

The above comment reflects that the CRA typically accepts the use of an average yearly rate for income items (dividends etc.) but expects you to use the Bank of Canada noon rate or other acceptable exchange rate in effect at the time of purchase and sale for any capital transaction.

While I would suggest that most accountants strive for reporting capital gains in this manner, many financial institutions and investment managers do not provide such information when they provide capital gain/loss summaries and thus, such reporting can be problematic. See this blog post by Justin Bender for an example of how financial institutions often report U.S. capital gains transactions.

I have also observed that when individual taxpayers prepare their own returns, very few report using the rate in effect at the time and most use an average exchange rate for the year for their capital gains reporting. Ignoring the ease of preparation, using an average rate can result in a significant under/over reporting of capital gains/losses where exchange rates fluctuate significantly.

I would thus suggest, you attempt to adhere to the CRA’s position of using the rate in effect at the date of transaction, especially for specific large transactions.

Dividends

As noted above, the CRA stated at the roundtable that an average rate may be acceptable for items of income. John Heinzl of The Globe and Mail addressed this issue in a recent Q&A column.

Here is the question and answer.

Q: I hold some U.S. stocks in a non-registered account and pay U.S. withholding tax of 15 per cent on the dividends. My tax slips provide the dividend and tax information in U.S. dollars. Given the currency fluctuations we’ve seen recently, how do I report these amounts on my Canadian income tax return?

A: Because U.S. dividends do not qualify for the Canadian dividend tax credit, in a non-registered account you would pay Canadian tax at your marginal rate on the full amount of the U.S. dividend – just as if it were interest income. To avoid double taxation, you may be able to claim the 15-per-cent U.S. tax withheld as a foreign tax credit on line 405 of your return.

For tax purposes, you’re required to convert foreign income and foreign tax withheld to Canadian dollars, using the Bank of Canada exchange rate in effect on the transaction date.

However, according to the Canada Revenue Agency, if there were “multiple payments at different times during the year,” it is acceptable to use the average annual exchange rate. This simplifies the process of converting U.S. dividends and tax withheld to Canadian dollars.

You can find a list of average annual exchange rates on the Bank of Canada website.

Between the foreign exchange compliance and the T1135 Foreign Reporting requirements (see next week's blog post), it is enough to make one want to keep all their investments in Canada to avoid the complications of tax reporting :)

Note: I have disabled the comment and question feature on the blog. Unfortunately, I just do not have the time to answer questions during income tax season. I will enable comments in May. Thank you for your understanding.

Money Sense - Retire Rich 2015 Giveaway

On April 8th in Oakville, Money Sense is presenting “Retire Rich 2015” a four hour evening of wealth-building insights and practical advice, in which you’ll learn the proven tactics and strategies that can help any Canadian establish a low-cost retirement plan for a rich and rewarding retirement.

The presenters include Bruce Sellery, Duncan Hood, Preet Banerjee and Dan Bortolotti, four of Canada’s leading retirement-planning experts.

Money Sense has provided me 6 tickets to giveaway to my readers. If you are interested, please send me an email to bluntbeancounter@gmail.com by April 3rd and I will select three winners (2 tickets each).

If you wish to learn about the event or register, here is the link.

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.

Discretionary Shares – A Tool In Your Income Splitting Toolbox

When incorporating your small business (or in some cases your professional corporation), there are a multitude of issues to consider. Some of these concerns were discussed in my blog on Advice for Entrepreneurs. One of the most important decisions to be made upon incorporation is the determination of the corporate structure. Today, I will focus solely on the benefits of using discretionary shares in that corporate structure.

I have previously discussed using a family trust as the shareholder of a new entity in my blog post Should Your Corporation’s Shareholder be a Family Trust instead of a Holding Company?
and thus, will not broach that topic today.

Discretionary Shares – What are They?

Discretionary shares allow a corporation to pay dividends on one class of shares to the exclusion of another class or at varying percentages. This concept is best illustrated through an example: If Mr. Bean has discretionary Class A shares and Mrs. Bean has discretionary Class B shares and the directors wish to pay a dividend of say $25,000, they could pay the entire $25,000 dividend to Mr. Bean and nothing to Mrs. Bean. Alternatively, they could pay the entire $25,000 to Mrs. Bean and nothing to Mr. Bean. They could also pay any other combination that totals $25,000; say $10,000 to Mr. Bean and $15,000 to Mrs. Bean, or $7,000 to Mr. Bean and $18,000 to Mrs. Bean.

This differs significantly from the standard garden variety common shares many lawyers automatically issue upon incorporation. Those shares pay dividends based on the ownership of the shares. So if Mr. Bean owned 35 common shares and Mrs. Bean owned 65 common shares, any dividends must be paid in the 35/65 ratio with no discretion.

The Income Splitting Benefit

Discretionary shares allow for income splitting with adult family members. Typically the shares are issued to the husband and wife or common-law spouses; however, in some cases it may make sense to issue shares to children, especially those 18 and over (the kiddie tax limits the benefits for children under 18).

The benefit is again best described by an example. Say Mr. Bean owns 75% of the common shares of Baked Beans Inc. and Mrs. Bean owns 25% of the common shares. Mr. Bean, as a working owner of the company, also receives a salary of $100,000. Under the above 75/25 ownership scenario, if a $100,000 dividend was issued and Mrs. Bean had no other income, Mr. Bean would pay approximately $27,000 in income tax on his $75,000 dividend (assume dividend is non-eligible), and Mrs. Bean would not pay any tax on her $25,000 dividend. However, if the shares had been set up as discretionary upon incorporation, the company could pay the entire dividend to Mrs. Bean and she would pay approximately $16,700 in tax, a $10,300 tax savings over standard common shares.

Another benefit of discretionary shares is that they can be issued to a holding company and used to creditor proof a company to ensure it qualifies for the capital gains exemption.

Why Not Always Use Discretionary Shares?

In some cases, spouses do not want their spouse involved in the corporate ownership; or if the spouses are involved, they prefer to own standard common shares, with at minimum 51% common share ownership. Not necessarily the best tax planning, but you would be surprised at how often people want this type of structure.

Be Careful

Care should be taken to ensure any other family corporations are not considered associated because of the discretionary shares; this would cause the corporations to have to share the $500,000 small business deduction.

While not relevant for a newly incorporated company; because of the income splitting opportunities afforded discretionary shares, the Canada Revenue Agency (“CRA”) has done some sabre-rattling with respect to the valuation of the shares when they are issued as part of an estate freeze. It is important in these cases that the fair market value (“FMV”) of the property is accurately determined.

Discretionary shares are a valuable tool in the income splitting toolbox. However, in order to ensure you handle that “tool” with care, you must obtain income tax advice before implementing any structure with discretionary shares.

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 Ontario Retirement Pension Plan - Who is Self-employed?

The consultation paper on the Ontario Retirement Pension Plan (ORPP) has been released. You can read it here.

One of the most significant groups excluded from the ORPP are self-employed people. In the initial announcement it was unclear who was considered self-employed. Was it a sole proprietor? Was it a corporation with sole shareholder or was it a professional corporation, or was it all of the above?

These questions have been addressed in the consultation paper and essentially, you are considered self-employed if you operate an unincorporated business or are the shareholder of a corporation and

only receive dividends as remuneration.

Who Are the Self-Employed?

 

For purposes of the ORPP, the paper states that self-employed individuals not eligible to participate in the ORPP would refer only to individuals who either:

1. own and operate unincorporated businesses (i.e., sole proprietors, partnerships and some independent contractors); or

2. own and operate incorporated businesses but are not employees and do not receive a salary or wages as compensation (e.g., an individual who receives distributions from the corporation that are not considered salary or wages, such as dividends).

“By contrast, an individual who owns and operates an incorporated business and earns a salary or wages as an employee of the business would not be considered self-employed for the purposes of ORPP eligibility. As a result, these incorporated owner-operators would be required to participate in the ORPP, to the extent that they are considered eligible employees.”

The report states that according to Statistics Canada, “On average, incorporated owner-operators receive two-thirds of their annual income from wages and salaries. In the event that these individuals receive other types of income (e.g., dividends), they would not make contributions to the ORPP on this other income.”

Unique Status of the Self-Employed

 

The report notes that the self-employed occupy a unique position in the labour market, in that their income can fluctuate year to year, and that self-employed individuals may feel that it is more prudent to invest in their business, rather than contribute to a mandatory savings plan.

Notwithstanding the above, the report notes that “evidence suggests that self-employed individuals may also be undersaving for retirement. In fact, research indicates that self-employed individuals are less likely to be financially prepared for retirement when compared with paid employees.”

Submissions

 

The report states that “although the self-employed under current ITA rules would not be able to enrol in and make contributions to the ORPP, there may be interest among self-employed individuals in participating in the ORPP, as they do in the CPP. Ontario could engage in discussions with the Government of Canada to amend the relevant ITA rules to allow individuals who are not in an employment relationship and who do not report income from salary and wages to participate in the ORPP, as is the case with the CPP.”

As someone who operates through a professional corporation, I am not that keen to make an employee and employer contribution to the plan; however, other self-employed individuals may feel the ORPP would help supplement their retirement income and would welcome the opportunity to have the option to be part of the plan.

If you are self-employed and wish to make a submission or comment, you can do so at: ORPP@ontario.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.

The Costly TFSA Blunder & Playing With Matches - The 20% Matching Penalty

In general, I understand the policy reasoning behind many of the income tax legislative changes made by the Department of Finance (that does not mean I agree with all these policy changes). I also typically understand the rationale behind most of the CRA's administrative polices. However, there are four tax rules and administrative policies I cannot comprehend and are major pet peeves of mine. They are:

1. You can be penalized for re-contributing to your TFSA in the same year you withdrew funds. This rule may make administrative sense for the CRA, but when 75,000-100,000 people over-contribute/incur penalties each year, there is a problem with the rule in my opinion.
2. You can be penalized 20% of the income you did not report on a T-slip, even though the CRA has that information on hand.
3. The necessity to file a T1135 Foreign Income Verification Form to report specific foreign stocks that do not pay a dividend, even if they are held at a Canadian Institution (rule on hold for 2013, to be effective 2014, see last weeks post).
4. The fact the CRA has an April 30th personal filing deadline, yet many slips (T3, T5013) are not issued until the 2nd week of April (even though the deadline for those slips is March 31st). IMHO, the deadline to file all these tax slips should be moved up 15 days.

I was fortunate enough to be interviewed by Rob Carrick of the Globe and Mail on my first two pet peeves and was thus able to vent on a medium other than my BBC soap box.

The Costly TFSA Blunder 

Many Canadians continue to over-contribute to their TFSAs. Most of these over-contributions result because you take money out of your TFSA and then re-contribute those funds back in the same year. However, unless you have additional contribution room, you are not allowed to re-contribute those funds until January 1st of the next year.

As TFSAs have been promoted by the CRA and financial institutions as a savings account, where you can take money out and put money back in; the re-contribution rule is counter intuitive and a trap for many Canadians.

I discuss this issue and other TFSA related issues in this interview with Rob.

Playing With Matches- The 20% Matching Penalty

The CRA’s matching program catches the non-reporting of income every fall. Each year the CRA checks the T-slip information in its database against Canadian taxpayer’s income tax returns to ensure the income you reported matches the CRA's database records. Where the income filed by a taxpayer does not match, an income tax reassessment is mailed to the taxpayer asking for the income tax due. If the taxpayer is a first time offender, they are just assessed the actual income tax owing and possibly some interest. If this is the second occurrence in the last four years, a 20% penalty of the unreported income is assessed.

Under Subsection 163(1) of the Income Tax Act, where a taxpayer has failed to report income twice within a four-year period, he/she will be subject to a penalty. The penalty is calculated as 10% of the amount you failed to report the second time. A corresponding provincial penalty is also applied, so the total penalty is 20% of the unreported income. This penalty can apply even if you owe no tax!

To avoid the chance of this penalty, I strongly suggest you make a checklist of any T-slips you expect to receive and follow-up with any missing slips. You may also want to call the CRA in June or July and confirm with them all the slips their system is showing. You can do this with your "My Account"; however, not all slips are reflected online.

I discuss this insidious penalty and other income matching issues in this interview with Rob. 

Tax Tips for Dividend Investors

 

Rob interviewed me on a third, less controversial topic, that being tax tips for dividend investors. Please keep in mind the three points I discussed in the interview. When you prepare your tax return, you should have dividend income from the same companies as you reported last year, unless:

1. The company stopped paying dividends;
2. You are missing a T3/T5 slip - if so, please follow-up or you may be subject to the 20% penalty discussed;
3. You sold the stock - if so, you must report a capital gain.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.