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.

_________________

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.

Confessions of a Tax Season Accountant — 2019 Edition

For the first four years of this blog, I wrote a series titled “Confessions of a Tax Accountant” during income tax season. Those posts would discuss interesting or contentious income tax and filing issues that arose as I prepared my clients’ tax returns. (One of my favourite of that series was this post that also included an ode to the Maple Leafs. I’ve since realized that I should stick to financial topics and leave the odes to professional writers. However, once a Leaf fan, always a Leaf fan. I wish them good luck with the Big Bad Bruins as they start another pursuit of the Cup on Thursday. Go Leafs Go.)

Today, I go old school and bring back the tradition with some new confessions to cleanse my tax soul.

I have only received the tax information for around 53% of my clients as of April 6th; as the remainder are waiting for their final T3 and T5013 slips to arrive and Easter is later this year. But I’ve still accumulated enough confessions to get off my chest. (By the way, the fact the T5013 essentially only has numerical boxes with no written descriptions continues to drive both clients and accountants mad.)

TOSI

This year marks the first year of implementation of the controversial tax on split income (“TOSI”) rules. If you have been a reader of this blog, you will know all about this issue. If you are a new reader or need a refresher, you can read this BDO publication on income splitting.

In general, TOSI has not been a huge issue for my clients this year (tax return wise) when considering their children, because many of them already stopped using their family trusts or private corporations to pay dividends to their children in 2018. This is because of the punitive TOSI rules for children (typically between age 18-24), which became effective January 1, 2018.

However, spouses are another story. Where spouses have received dividends, it must be determined whether the dividend is subject to TOSI or meets one of the exemptions. There is an excluded business exception for any family member who is at least 18 years of age and worked on average at least 20 hours a week in the business in the current year, during the part of the year in which the business operates. This exclusion will also be met if in a total of five previous taxation years of the individual the 20-hours-per-week test has been satisfied. Note that this is true even if the five years occurred at any time in the past. The years do not need to be in succession.

Many clients are still trying to determine whether their spouse's met/meet this test, and we cannot file their returns until that final determination is made.

U.S. capital gains reports

We continue to receive realized capital gains reports for clients for their U.S. brokerage accounts in U.S. dollars only. These reports are deceiving, as they have not converted the original purchase and sale into the Canadian-dollar equivalent at the time of the original purchase and at the sale dates. Thus, by missing the foreign exchange component, the reported gain is often way out of whack.

Donations and medical expenses

Several clients provide their donations and medical receipts in their own packages (i.e., each spouse provides me their own donations and medical receipts). I am not sure if this is done for simplicity or whether they do not realize that in almost all cases, we claim the donations and medical credits on only one spouse’s return to maximize the claim.

Missing T2202A for students

As per the recent blog post “The Top Tax Tips for Students,” students need to print out their T2202A tuition receipt from their student portal. I would say for 80% of the returns for which there is a student in the family, we have not received the receipt and I must request it be printed out. So, students and parents: ensure this form is retrieved.

RRSP withholdings

I had a couple of clients withdraw money from their RRSP this year for income smoothing purposes. The problem is the statutory withholding tax for RRSPs is only 10% for withdrawals up to $5,000, only 20% for withdrawals between $5,000 and $15,000 and 30% for withdrawals over $15,000. These withholding rates are often less than the actual marginal tax rate of the client and result in a surprise tax liability. For example, if you took out $15,000, the withholding rate is only 20%, but the actual tax rate when you file your return could be 42% — thus you would have a 22% shortfall.

That’s it for my confessions. I hope your tax return results in a refund or at least less tax than you anticipated.

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.

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.

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.