By Nizam Shajani, CPA, CA, MBA
This document is extracted from a paper originally written for York University Faculty of Law by Nizam Shajani.
TOSI or tax on split income must be considered when receiving certain types of income from a corporation. The 2018 amendments to section 120.4 of the Canadian Income Tax Act have brought to the forefront the question of if income splitting between family members who own a small business is still acceptable in tax planning. Where TOSI is applied, the recipient is taxed at the highest marginal tax rate.
I recently completed a research paper that provides a critical analysis of the interpretation and application of the tax on split income (TOSI) rules contained in section 120.4 of the Act regarding tax planning for years after 2017. The paper concludes with two findings:
- Clarification on instances when property may be transferred to family members for purposes that are not considered evading tax.
- Types of income from transferred property that are not subject to TOSI for adults.
The paper also resulted in the below TOSI Flow Chart (tool) that details acceptable forms of income splitting between family members who own a small business and allows a professional tax planner to navigate towards acceptable forms of income splitting and tax savings for these family units. I have included the research paper below the TOSI Flow Chart.
TOSI Flow Chart
Chapter 3 – The revised tax on split income rules and section 120.4 of the Act
This chapter provides a critical analysis of the interpretation and application of TOSI through a review of section 120.4 of the Act subsequent to the 2018 amendments. The research considers the historical context of the section to provide insight into the revised legislation and the related excluded amounts from TOSI noted in the section. The detailed explanation is targeted towards tax planners who will require an in-depth understanding of the new rules and related exemptions for planning purposes. The chapter concludes with a TOSI Flow Chart to assist tax planners in their work.
TOSI for adults
On July 18, 2017 the Canadian Department of Finance released a consultation paper entitled Tax Planning Using Private Corporations with an aim to close loopholes used by the very wealthy or the highest income earners via their private corporations. The paper was highly controversial and was met with significant opposition from the business community and tax professionals due to the accusatory tone of the paper underlining business owners were not paying their fair share of tax. One of the controversial amendments proposed by the government included the use of sprinkling income using private corporations (Department of Finance, 2017), a proposal that was eventually adopted and received royal assent on June 21, 2018 and is effective January 1, 2018 with legislation found in section 120.4 of the Act.
Income sprinkling was defined in that paper as “sprinkling income using private corporations, which can reduce income taxes by causing income that would otherwise be realized by a high-income individual facing a higher personal income tax rate to instead be realized by family members who are subject to lower personal tax rates or who may not be taxable at all” (Department of Finance, 2017). The definition was revised when adopted into the Act in section 120.4(2) within the definition of tax on split income. That section states:
“There shall be added to a specified individual’s tax payable under this Part for a taxation year the highest individual percentage for the year multiplied by the individual’s split income for the year.”
The Department of Finance consultation paper and the resulting legislation received considerable attention from the small business community as they were the target of these new rules. Media and tax advisory groups portrayed the legislation as an afront to a tool used in the past fifty years of tax planning. The revised legislation resulted in dividends or interest allocated to spouses or common law partners and adult children who are shareholders of private corporations to be subject to tax at the highest personal tax rates, with some exemptions. The historical context of income splitting rules provided in the previous chapter provide insight to the new legislation. The new TOSI rules expand the kiddie tax legislation’ introduced in 2000 to include additional family members. Closer examination of the legislation will also highlight the government’s response to court rulings and orbiter from past cases centred around income splitting.
Income subject to TOSI
Section 120.4(1) provides definitions that apply to the section. Split income is broadly defined in this section. Some of the forms of income that are subject to TOSI include taxable dividends, interest income, gains from the dispositions of unlisted shares, trust income, partnership income, rental income and income inclusion benefits from section 15 of the act. These forms of income need to be assessed against specific exemptions from TOSI to be taxed at the recipient’s marginal tax rate. Where an exemption is not met, the income from these forms will be taxed at the highest marginal tax rate as noted in section 120.4(2) of the act.
Income that is not subject to TOSI includes wages or salaries and earnings from publicly traded investments.
This definition of split income is broader that the original definition provided in the 2000 kiddie tax rules. Those rules, summarized in Gwartz v. The Queen, 2013, in which Justice Hogan quoted the 1999 Department of Finance budget plan commentary. “In order to improve the fairness and integrity of the Canadian tax system, this budget proposes a targeted measure to discourage income splitting with minor children. The new measure constitutes a special tax, at the top marginal tax rate instead of the normal graduated rates, to be imposed on certain income of individuals age 17 or under.
Income that is not received as dividend income, partnership income or trust income is not subject to the new measure. Accordingly, income from employment or personal services of the minor will not be subject to this measure. Dividends received on any listed shares will not be subject to these rules, since the income flow is less susceptible to manipulation. Further, income from property acquired on the death of a parent of the individual will be exempt from the measure, as will income from any property inherited by individuals with disabilities who are eligible to claim the disability tax credit or by individuals who are in full time attendance at a post-secondary institution. Individuals who have no parent resident in Canada for tax purposes in the year will also be exempted from the application of the new tax.
The scope of this new measure is narrow; it targets those structures that are primarily put in place to facilitate income splitting with minors. The government will monitor the effectiveness of this targeted measure and may take appropriate action if new income-splitting techniques develop.”
It would seem the new legislation is the government taking action to address new income splitting techniques that have developed in which they take offence to. However, in doing so there are clearly income splitting measure that continue to be acceptable. Those details are found in the excluded amount definitions in section 120.4.
Exclusions from TOSI
While TOSI continues for individuals under the age of 18 as has been since the introduction of the rules in 2000, the 2018 expansion of the TOSI rules allows for excluded amounts for taxpayers over the age of 18. These excluded amounts include split income from related businesses, reasonable returns and excluded business. In additions, excluded shares from split income are available as an exemption for individuals aged 25 and older.
Exemptions for unrelated business
An amount is excluded from TOSI if an individual has attained the age of 17 in the previous year and the amount is not directly or indirectly from a related business. Split income received from an unrelated business is excluded from TOSI. Split income must therefore be from a related business for TOSI to apply.
A new definition of related business was added to this section in 2018. Related business is defined in section 120.4(1) to include a business carried on by a source individual; or a business carried on by a partnership, corporation or trust in which a source individual is actively engaged. The definition also includes a business of a partnership in which a source individual has an interest or a business of a corporation in which a source individual has ownership.
The related business definition necessitates the understanding of source individual. Source individual is a new term and defined in section 120.4(1) to include an individual that is resident in Canada and related to the specified individual. A specified individual is also defined in the same section to include an individual (that is not a trust) who is resident in Canada. Related persons are defined in section 251(2) of the Act.
Exemptions for reasonable return for contributions made
TOSI will not apply where a reasonable return is paid to a specified individual who is over the age of 17. Section 120.4(1) added a definition of reasonable return in 2018 that specifically applies to this section. That section defines reasonable return from a related business as an amount that is reasonable based on the contributions of the individual receiving the amounts. For individuals under the age of 24, this is limited to the prescribed rate of interest on any capital contributed.
For individuals over the age of 24, there are additional considerations as to what would be reasonable. The considerations around reasonableness include the work performed in support of the business, property contributed to the business, risks assumed, amounts paid for the benefit of the business, and other factors that may be relevant.
The notion of contribution not impacting the rules on attribution (or TOSI) can be found in the McClurg decision in which CJ Dickson recognized that if a distinction were to be made between non arms length shareholders, the distinction should consider shareholders from which a shareholder has made no contribution to the company verse a shareholder that has made significant contributions. That orbiter has clearly been considered by the drafters of this legislation. While that case centred around attribution, it is interesting to note CJ Dickson recognized Mrs. McClurg’s contribution to the family business in his obiter. In the Neuman case Justice Iacobucci recognized a case of attribution in which the shareholder had not contributed, nor had they participated in the closely held family corporation. While attribution did not apply to either the McClurg or the Neuman cases, the new TOSI rules applied to these cases today would not see uniform results.
On a release dated December 13, 2017, CRA provided guidance for income sprinkling in a paper titled Guidance on the application of the split income rules for adults. The paper included CRA’s interpretation of contributions under the heading of reasonableness criteria. The guidance considers labour contributions, property contributions and risk assumptions.
CRA noted work performed in support of the business as labour contribution will have the remuneration compared a reasonable amount based on the following:
- “The nature of the tasks performed;
- Hours required to complete the tasks;
- A competitive salary/wage for the tasks in relation to businesses of similar size and industry;
- Education, training and experience;
- Degree of activities and nature of activities in relation to those of a business of a comparable nature and size;
- Time spent on the activity in comparison to time spent in other activities or undertakings;
- Particular knowledge, skills or know-how that the individual possessed;
- Business acumen; and
- Past performance of functions.”
Property contributed to the business are noted in the CRA guidance to include the following:
- “The amount of capital contributed to the business;
- The amount of loans to the business;
- The fair market value of property (both tangible and intangible property) transferred to the business, including technical knowledge, experience, skill, or know-how;
- Whether the individual has provided property as collateral for loans or other undertakings;
- Whether other sources of capital or loans are readily available;
- Whether comparable property are readily available;
- Whether property are unique or personal to the individual;
- Opportunity costs; and
- Past property contributions.”
Risks assumptions are noted in the CRA guidance to include the following:
- “Whether the individual is exposed to the financial liabilities of the business, whether through guarantees of mortgages, loans or lines of credit or otherwise;
- Whether the individual is exposed to statutory liabilities related to the business;
- Extent of the risk that contributions made by the individual to the business may be lost, whether in whole or part;
- Whether any risk is indemnified or otherwise limited in the circumstances, whether by agreement or otherwise;
- Whether the individual’s reputation or personal goodwill is at risk; and
- Past or ongoing risk assumption.”
The definition of reasonable return includes in subclause (iv) amounts that were paid. CRA’s guidance on this interpretation includes considering amounts that were previously paid to the individual, including payment of any kind. The inclusion of this subclause allows for a historical consideration of split income payments. Where payments have been made in the past, this may be enough to allow such payments to continue under the reasonable return exemption.
Additional consideration needs to be given to this subclause. The intent of this legislation has been to limit split income between related parties that have had minimal contributions to the business. The legislated definition of reasonable return includes a historical exemption in subclause (iv). A question arises for the situations in which one spouse had no contributions other then their initial share capital and had been historically splitting the dividends with the specified person. The defined term seems to allow this even splitting to continue under the reasonable return exemption.
The reasonable return definition also allows consideration in subclause (v) for other factors that may be relevant. This subclause leaves significant room for interpretation of relevant contributions and what would be considered reasonable as a return on such contributions.
The excluded business exemption is available to individuals who receive split income that are over the age of 17. A definition of excluded business is provided in section 120.4(1) to include a business in which the specified individual is actively engaged on a regular, continuous and substantial basis in the taxation year or in any five prior taxation years. Section 120.4(1.1) (a) allows an individual to be considered actively engaged in a business if they work at least an average of 20 hours per week during the portion of the year in which the business operates. This allows a person who works the minimum weekly hours in the current year or throughout any five previous years to consider any remuneration received to be exempt from TOSI. While the 20 hours per week is a bright line test, this is not the only consideration in determining if the individual is actively engaged in the business on a regular, continuous and substantial basis.
The terms actively engaged on a ‘regular, continuous and substantial basis’ are also mentioned in section 248 of the Act within the definition of a specified member of a partnership. These terms are considered in the case of McKeown v. The Queen, 2001. In that case McKeown appealed the reassessment that disallowed partnership losses and investment tax credits claims. McKeown claimed subsection 37(1) allowed him to claim the scientific research and experimental development deductions from his share of two partnerships. He provided detailed explanations of the partnership activities and documents for is position that he was actively engaged on a regular, continuous and substantial basis within a partnership. Chief Justice Garon stated that it can be concluded that an individual is not actively engaged on a regular, continuous and substantial basis throughout the year “where he or she does not monitor the research work, inquire about the work’s progress and advancement and any fairly important administrative problems that may arise in carrying out the research, or participate in any way in decisions concerning those matters. That is indeed the case of the appellant here. His participation in the activities of the two alleged partnerships was purely symbolic and artificial.” The ruling sets a high bar to meeting the definition of being actively engaged on a regular, continuous and substantial basis.
Similarly, in the case of Maslanka v. The Queen, 2004 justice Archambault notes the Maslankas were not engaged on a regular, continuous and substantial basis of the activities of the partnership because they only attended two meetings and completed a questionnaire that was not even recognized by one of the appellants. Their participation was also found to be symbolic and artificial.
In Simard v. The Queen, 2007 we are provided with some requirements to be considered actively engaged on a regular, continuous and substantial basis. Justice Tardif’s orbiter states that “a partner may be actively engaged in the activities of the business of the partnership of which he or she is a member only if he or she has a certain role to play in terms of the partnership’s decisions. In a business, there is usually a division between administration and operations. One partner may be confined to administration and another to operations. However, they participate in the decisions and keep each other mutually informed.”
The three partnership cases noted here necessitate more than symbolic meetings and artificial documentation or correspondence to meet the standard for being engaged on a regular, continuous and substantial basis throughout the year. At minimum, the standard requires a role in decision making. This standard is likely to be adopted where the bright line test for the TOSI exemption of excluded business is not met.
Where previous court definitions are adopted for being actively engaged on a regular, continuous and substantial basis, there would seem to be a gap between that definition and the definition of a source individual.
The rules allow a grandfathering from TOSI where they have met the five years of active engagement on a regular, continuous and substantial basis. An individual who works as such for any five years would therefore be grandfathered to receive split income from that business in future years without being subject to TOSI.
Excluded shares exempt split income from TOSI for individuals who are 25 year of age or older. Excluded shares are defined in subsection 120.4(1). Excluded shares include capital stock where:
- Less than 90% of the business income of the corporation was from the provision of services and the corporation is not a professional corporation;
- The specified individual owns shares of the corporation include 10% of the votes and value of the corporation; and
- All or substantially all the income of the corporation is not derived from a related business of the specified individual other than a business of the corporation.
The excluded shares exemption clearly leaves TOSI limited to the provision of services and specifically targets any income received from a professional corporation. The understanding of what constitutes a service then becomes important in determining the application of TOSI. The provision of services is not defined in the Act. CRA provides some insight into their understanding of what is a service. In their technical interpretation (Chong H, 2018), they use general business terminology to differentiate goods from services, underling the physical objects of goods verses the lack of a physical substance for a service.
In the case of Ogden Palladium Services (Canada) Inc. v. The Queen, 2001, the tax court of Canada weight into the definition of service. The case investigates the withholding requirements in a failure to withhold tax amounts from payments to a non-resident. The appellant believed the non-resident did not provide a service and therefore as the payor, the appellant did not have a requirement to withhold taxes.
Justice Lamarre refers to the 1980 case of Xerox of Canada Ltd. V. Ontario Regional Assessment Commissioner that looks to define services with a definition borrowed from The Assessment Act. He notes that Act deals with the assessment of businesses and it therefore follows that “the words “goods” and “services” are used in their ordinary commercial sense. . .. As distinguished from “goods”, “services” are intangibles; they are the work of the hand or the brain, valuable to the purchaser or user but not in themselves articles of trade or commerce.” Using this definition would require more than 10% of income to be derived from the provision of tangible objects to be considered for the excluded shares exemption.
The new TOSI rules include split income between spouses. Interestingly, a campaign promise by the Conservative Party of Canada includes an exemption for spouses from the recently introduced TOSI rules (Conservative Party of Canada, 2018). That party did not win the closely contested election, however this is worth mentioning as a future potential amendment to these rules.
Excluded amounts include within that definition amounts from property acquired under a matrimonial property settlement under section 160(4). This allows for an exemption from TOSI where property is transferred during a separation or divorce.
Subsection 120.4(1.1)(c)(i) allows an exemption from TOSI between spouses where the spouse or common law partner has reached the age of 65.
Subsection 120.4(1.1)(c)(ii) allows an exemption from TOSI where a spouse becomes deceased during the year.
The above allow for TOSI exemptions for property transfers between spouses in cases of divorce, retirement or death.
Inheritance and death
Property inherited will generally follow the attributes of that property from the person whom bequeathed the property.
Subsection 120.4(1)(a)(i) notes that where property is inherited from a parent by an individual under the age of 24, TOSI will not apply to income earned from that property.
Subsection 120.4(1)(a)(ii) notes that where property is inherited by a full time post secondary student under the age of 24 or a person eligible for the disability tax credit who is under the age of 24, TOSI will not apply to income earned from that property.
Disposition of QSBC or QFFP shares
Subsection 120.4(1)(d) excludes from TOSI the taxable capital gain from the disposition of qualified small business corporation shares or the disposition of qualified farm or fishing property. This exemption is regardless of age.
The sale of QSBC shares and the application of section 120.4 was tested against GAAR in Gwartz v. The Queen, 2013. In that case the Minister of National Revenue reassessed the appellant by recharacterizing capital gains claimed by a trust as dividends by citing GAAR. The recharacterization would have resulted in split income under the new kiddie tax rules. Justice Hogan found that the transactions resulting in the capital gains did not circumvent section 120.4.
TOSI flow chart
The subsequent page provides a flow chart in determining if an exemption is available for TOSI. The intended simplification of the flow chart necessitates reading the flow chart in conjunction with this chapter. The flow chart provides necessary guidance to tax practitioners to assist in determining if exemptions are available from TOSI.
What does this mean for you?
While courts have given little weight to the legislature’s comments, these comments do provide insight into the purpose of the legislation introduced and would facilitate a further understanding of the objective of the new rules on splitting income. Connecting the historical legislation to the court cases that followed and considering the orbiter provided by the judiciary provides an understanding of the intended legislation of section 120.4 that was introduced for 2018 and subsequent years.
There are clearly types of income splitting within family units that the government finds offensive. These are centred around service-based businesses where they believe manipulation of income earnings is more prevalent.
There are also clearly types of income splitting within family units that the government finds acceptable. These are centred around contributions made by individuals, either through active involvement, funding assets, assuming risks and other contributions.
An understanding of the excluded amounts in section 120.4 of the Act allows a tax planner the skillset to understand the new TOSI legislation. These exclusions have been formulated from past cases and related obiter from the judiciary. The TOSI flow chart provides an important tool in navigating the new legislation. The implications to a tax planner’s practice would be to identify exemptions to TOSI using these tools or decipher intent from the legislations more ambiguous rules as part of the design of a tax plan.
Tax planning will require the identification of property that is acceptable to transfer between family members and the documentation of the specific exclusion from TOSI. This should be considered at the onset of any tax plan and prior to taking steps in a reorganization of an entity.
Tax planners often fall in the trap of overlooking the purpose of rules within the Act. Understanding the purpose of those rules play an important role in assisting tax planners in providing a more comprehensive consultation to our clients.
The new rules in section 120.4 continue to allow for acceptable forms of income splitting within family units, however there is now a requirement to find specific exemptions from TOSI.
Income splitting between family members who own a small business continues to be an acceptable form of tax planning, however an acceptable form should be documented under the excluded amounts in section 120.4 of the Act.
The professional tax can assist in decision making when navigating the exemptions for the TOSI rules to the small business owner in their effort to reduce the amount of tax a Canadian family will pay each year. A professional tax planner that can identify the excluded amount in section 120.4 of the Act that is relevant to their client will facilitate significant tax saving opportunities for you.
This information is for discussion purposes only and should not be considered professional advice. There is no guarantee or warrant of information on this site and it should be noted that rules and laws change regularly. You should consult a professional before considering implementing or taking any action based on information on this site. Call our team for a consultation before taking any action. © 2021 Shajani LLP