Mastering TOSI: Unlocking Tax Savings for Your Family-Owned Business

Are you looking to optimize your family’s tax planning strategies? Understanding the Tax on Split Income (TOSI) and how trusts can be used effectively is crucial for family-owned businesses in Canada.

The Tax on Split Income (TOSI) rules were implemented to prevent high-income earners from reducing their tax burden by shifting income to family members in lower tax brackets. These rules ensure that income distribution reflects true economic contributions, promoting fairness within the Canadian tax system. For family-owned businesses, navigating TOSI is essential to avoid unintended tax consequences and optimize tax efficiency.

Trusts offer a powerful and versatile tool for income splitting, allowing for strategic distribution of income among family members. By leveraging trusts, families can achieve tax savings and protect their assets, while complying with TOSI regulations.

With extensive experience and expertise in Canadian tax law, I am well-equipped to guide you through the complexities of TOSI and trusts. As a Chartered Professional Accountant (CPA, CA) with advanced degrees in tax law and business administration, I have a deep understanding of the nuances involved in tax planning for family-owned enterprises. Let’s delve into the strategies that can help you effectively manage your tax obligations and secure your financial future.

 

Section 1: Understanding Tax on Split Income (TOSI)

Defining TOSI and Its Role in the Tax Landscape

The Tax on Split Income (TOSI) is a regulatory measure implemented within the Canadian tax system aimed at limiting the ability of high-income earners to reduce their tax burden by shifting income to family members who are taxed at lower rates. The TOSI rules apply a higher tax rate, essentially the highest marginal rate, to certain types of income that are distributed or allocated to specified individuals, which primarily include family members. The goal of TOSI is to ensure that income derived through certain advantageous tax strategies is taxed in a way that reflects its true economic substance, rather than merely its form, thereby upholding the principles of tax equity and fairness within the Canadian tax system.

Historical Context: Rationale for Implementing TOSI

The need for TOSI arose from longstanding concerns about the fairness of the tax system, particularly as it pertained to the distribution of income within families for tax purposes. Historically, income splitting was a prevalent practice, used to exploit lower tax brackets within a family unit, thereby reducing the overall tax liability. This practice was especially common in family-run businesses where it was relatively easy to distribute dividends or income to family members who contributed little to the actual business operations but were nonetheless able to receive substantial income at a lower tax rate.

This strategic income distribution posed a significant challenge to the integrity of the Canadian tax system, prompting the government to introduce rules to counter what it viewed as aggressive tax planning. The initial version of TOSI, often referred to as the “kiddie tax,” was introduced in 1999 and targeted at preventing adults from shifting part of their income to minor children. However, as tax planning strategies evolved and continued to exploit gaps in the legislation, the scope of TOSI rules needed to be broadened. This led to the significant amendments in 2018, aimed at tightening the rules and expanding their reach to include adult family members under certain conditions.

Overview of the Types of Income Covered by TOSI

TOSI applies to various types of income that can be shifted within a family through dividends, capital gains, or other means. The types of income that typically fall under the scope of TOSI include:

• Dividends from Private Corporations: This is one of the most common types of income affected by TOSI. Dividends paid by private corporations to family members who do not actively contribute to the business are generally subject to TOSI.
• Shareholder Benefits: Benefits that a shareholder receives from a corporation, which are not tied to active business involvement, can also be subjected to TOSI.
• Certain Capital Gains: Capital gains from the sale of shares of a private corporation that are not listed on a designated stock exchange and where the recipient does not actively contribute to the business.
• Income from Trusts and Partnerships: Income derived from trusts or partnerships where the recipient is a family member with little to no active involvement in the business operations can also fall under TOSI.

Key Criteria that Trigger TOSI Implications

TOSI is not universally applied to all income received by family members. Instead, its application depends on several criteria designed to assess the recipient’s involvement and contribution to the business, among other factors. The key criteria include:

• Age and Relationship: The age of the recipient and their relationship to the individual or entity generating the income are critical factors. TOSI rules initially targeted minors but have been expanded to include adults in certain contexts, particularly where there is little evidence of active business involvement.
• Nature of Work: For income not to be subject to TOSI, the recipient must be actively engaged in the business. This is typically quantified as working at least 20 hours per week during the part of the year the business operates, which must be consistent and verifiable.
• Source of Income: The source of the income (e.g., dividends from private corporations, capital gains from the sale of shares) plays a crucial role in determining whether TOSI applies.
• Contribution to the Business: Income subject to TOSI includes payments that do not reflect a reasonable return for the work performed, capital invested, or risks assumed by the family member.

These criteria are designed to ensure that TOSI applies to income that does not genuinely reflect an economic contribution to a business’s operations, thus maintaining fairness in the tax system by taxing such income at the top marginal rate. This approach underscores the Canadian government’s commitment to a more equitable tax system, where income distribution strategies align more closely with actual economic activities and contributions.

 

Section 2: The Role of Trusts in Income Splitting

Introduction to Trusts: Types and Basic Mechanics

In Canadian financial planning and tax strategies, trusts serve as a versatile and powerful tool. A trust is a legal entity created by a settlor, who transfers property to a trustee to manage on behalf of one or more beneficiaries. The fundamental characteristic of a trust is the separation of legal ownership (held by the trustee) and beneficial enjoyment (held by the beneficiaries). Trusts are often used for estate planning, protecting assets, and tax planning, including income splitting.

There are several types of trusts utilized in Canada, each with specific purposes and benefits:

• Family Trusts: Often used to allocate income to family members, especially for managing and protecting family assets.
• Testamentary Trusts: Created as part of a will and come into effect upon the settlor’s death.
• Inter Vivos Trusts: Established by the settlor during their lifetime, often for asset protection and tax planning.
• Alter Ego and Joint Partner Trusts: Used by individuals aged 65 and older for estate planning without losing control over their assets.

Each trust type follows the basic mechanics of trust operation, where the trustee legally owns and manages the trust assets, making decisions about when and how to distribute income or capital to the beneficiaries according to the trust agreement.

How Trusts Can Be Used for Income Splitting

Trusts can be an effective vehicle for income splitting, which involves distributing income among several family members to utilize lower tax brackets and reduce the overall tax burden. This strategy can be particularly beneficial when dealing with high-income earners looking to redistribute income to family members in lower tax brackets.

The strategic use of trusts in income splitting often involves complex arrangements like owning shares of a holding company (Holdco) that itself owns an operating company (Opco). Here’s how it can work:

• Operating Company (Opco): This is typically the family business generating active business income. If this income is retained within Opco, it may be subject to high corporate tax rates or individual tax rates if distributed to high-income family members directly.
• Holding Company (Holdco): Opco can pay dividends up to Holdco, where these funds can be reinvested. The dividends received by Holdco from Opco are generally not subject to additional corporate tax due to the dividend refund mechanism.
• Trust Ownership: A family trust can own shares of Holdco. This structure allows for income earned by Holdco, whether from Opco dividends or other investments (like income from publicly traded stocks), to be distributed flexibly to beneficiaries of the trust.

Legal Structure of a Trust and Its Tax Treatment under Canadian Law

A trust is considered a taxpayer under Canadian tax law, and its structure must comply with specific legal and tax requirements. The legal structure of a trust involves the settlor, who creates the trust; the trustee, who manages the trust’s assets; and the beneficiaries, who receive benefits from the trust. Trusts must be created with a clear intention, evidenced in writing, and involve a genuine transfer of property to the trustee.

From a tax perspective, trusts are subject to taxation at the highest marginal tax rate on any income retained within the trust that is not distributed to beneficiaries. However, income distributed to beneficiaries is taxed in the hands of those beneficiaries, often at lower rates if they have little other income.

Trusts, TOSI, and Income Splitting Scenarios

• Dividend Sprinkling: Income from Opco can be paid as dividends to Holdco and then from Holdco to the trust. The trust can distribute these dividends to adult beneficiaries who might be subject to lower personal tax rates, assuming they do not trigger TOSI rules due to lack of involvement in the business.
• Capital Gains: If Holdco or the trust sells shares of Opco, the capital gains might be distributed to beneficiaries. Provided the beneficiaries are adults and the gains do not constitute a prohibited business investment income, this might not attract TOSI.
• Investment Income through Trusts: Income from investments held by Holdco, like dividends from publicly traded companies, does not typically trigger TOSI when distributed through a trust. This makes trusts an attractive option for income splitting through investment income.

Trusts provide a flexible, legal means for income splitting among family members, allowing for tax efficiency and strategic financial planning. While TOSI rules impose limitations to curb aggressive income sprinkling practices, with proper structuring and compliance, trusts can still be used effectively to achieve financial goals and minimize tax liabilities within the bounds of Canadian tax law.

 

Section 3: Combining Trusts with TOSI – Opportunities and Pitfalls

The Tax on Split Income (TOSI) rules and the strategic use of trusts for income splitting form a complex landscape that requires careful navigation. Trusts can offer significant advantages for tax planning within families, but they must be managed with an understanding of TOSI to avoid unintended tax consequences.

How Trusts Interact with TOSI Rules

The interaction between trusts and TOSI rules hinges largely on the nature of the income received and the beneficiaries’ involvement in the underlying business. TOSI was designed to prevent income splitting as a method to reduce tax liabilities through the transfer of income to family members who are taxed at lower rates without a substantive contribution to the earning of that income.

For trusts, TOSI specifically considers the type of income distributed to the beneficiaries:

• Dividends from private companies and capital gains from the disposition of shares are typical examples where TOSI could apply if the beneficiaries are considered to have not contributed to the business.
• Income from a trust that arises from a business where the beneficiaries do not actively engage can also attract TOSI.

Scenarios Where Trusts Can Safely Be Used to Split Income

1. Active Business Engagement: Income distributed to beneficiaries who are actively engaged in the business (typically at least 20 hours per week during the business’s operational period) is generally exempt from TOSI. For example, if a discretionary trust distributes dividends from an Opco to a beneficiary who works in the business, this income may not trigger TOSI.
2. Excluded Shares: If a trust holds shares that qualify as excluded shares (shares of a corporation where the holder owns at least 10% of the votes and value, and less than 90% of the business income of the corporation comes from services), and the trust distributes dividends from these shares to beneficiaries, the income is generally exempt from TOSI. However, this can be complex to apply through a trust structure and often requires careful planning.
3. Reasonable Returns: Income attributed to beneficiaries that represents a reasonable return based on their labor, capital contributions, or assumed risks relative to the family business generally does not attract TOSI. This could involve documenting and justifying the amount distributed from the trust based on the beneficiary’s involvement or investment in the business.

Focus on Discretionary Family Trusts

Discretionary family trusts are particularly favored in tax planning for their flexibility in income distribution decisions. The trustee has the discretion to decide how much income each beneficiary should receive, which can optimize tax efficiency by allocating income to beneficiaries with lower personal tax rates.

However, when dealing with TOSI, the discretionary nature of these trusts does not inherently protect the income from being taxed at the highest rates if the beneficiaries do not meet the criteria for exclusion from TOSI. Effective use of a discretionary trust in the context of TOSI involves ensuring that distributions align with legitimate business contributions by beneficiaries or fall under other TOSI exemptions.

Common Pitfalls and Mistakes to Avoid

1. Inadequate Documentation: One of the most common pitfalls is the failure to adequately document the active involvement of beneficiaries in the business operations. Without clear records demonstrating involvement, distributions from trusts may inadvertently attract TOSI.
2. Misunderstanding TOSI Exemptions: Misinterpreting which types of income and which beneficiaries qualify for exemptions under TOSI can lead to unexpected tax liabilities. For example, assuming that all dividends paid to a trust are exempt without considering the nature of the underlying shares can be a costly error.
3. Ignoring Attribution Rules: While trusts can be effective for income splitting, ignoring the attribution rules related to the transfer of assets into the trust can lead to TOSI implications. Particularly, transfers that are done as a means to split income without proper consideration of tax rules can attract scrutiny and penalties.
4. Overlooking Corporate Compliance: Trusts that hold shares in a corporation must comply with corporate law requirements, including maintaining appropriate records and adhering to legal standards for shareholder decisions. Failure to do so can not only create legal issues but also affect the tax status of the income distributed to beneficiaries.

In conclusion, while trusts offer a versatile and strategic tool for income splitting, they must be used with a thorough understanding of TOSI to ensure tax efficiency and compliance. Balancing the flexibility of discretionary trusts with the rigorous requirements of TOSI requires careful planning, accurate documentation, and a proactive approach to tax management. Avoiding common pitfalls and engaging in informed strategies will help in leveraging trusts effectively under the TOSI framework, enhancing tax planning for family-owned businesses in Canada.

Section 4: Strategic Planning and Compliance

When leveraging trusts for income splitting in the context of the Tax on Split Income (TOSI) rules, strategic planning and rigorous compliance are paramount. This section outlines effective strategies for structuring trusts, the critical legal considerations, and documentation practices necessary to support the income splitting strategy, along with case studies demonstrating successful implementations.

Strategies for Structuring Trusts to Comply with TOSI

1. Design Trusts with Clear Contribution Criteria: Structure the trust so that distributions to beneficiaries are aligned with their actual contributions in terms of labor, capital, or assumed risks. This ensures that distributions can be justified as reasonable returns, exempting them from TOSI.
2. Utilize Excluded Shares: For trusts that hold corporate shares, ensure that the corporations qualify as small business corporations and that the shares meet the criteria for excluded shares—where the beneficiary owns at least 10% of the votes and value of the corporation. This requires careful planning to ensure that both the trust and the beneficiaries meet the necessary conditions.
3. Active Engagement Documentation: Establish and maintain meticulous records of the active involvement of beneficiaries in the business, documenting hours worked, roles performed, and decisions made. This documentation is crucial for proving the necessary engagement levels to exempt income distributions from TOSI.
4. Diversify Trust Investments: Where possible, diversify the investments held by the trust to include non-business income-generating assets. Income from these assets, such as dividends from publicly traded companies, typically does not attract TOSI and can provide more flexibility in income distribution.
5. Regular Trust Reviews and Adjustments: Regularly review and adjust the trust’s strategy and structure in response to changes in tax laws and family circumstances. This proactive approach ensures ongoing compliance and optimization of tax benefits.

Legal Considerations and Documentation

1. Trust Deed Specifications: The trust deed should clearly specify the terms, including the powers of the trustee, the rights of the beneficiaries, and the conditions under which distributions can be made. This legal document is foundational in governing the operation of the trust and must be drafted to accommodate TOSI considerations.
2. Documenting Contributions and Distributions: Keep detailed records of all contributions by beneficiaries to the business and corresponding distributions from the trust. This includes financial contributions, time sheets, job descriptions, and records of decisions influenced by beneficiaries in their capacity related to the business.
3. Compliance with Corporate and Trust Law: Ensure that the trust and any corporations involved comply with relevant corporate and trust laws, including maintaining proper corporate governance and meeting all filing requirements. This compliance is crucial for maintaining the trust’s and corporation’s legal standing and tax treatment.
4. Legal Review and Consultation: Regularly consult with legal and tax professionals to review the trust’s activities and structures. This practice helps in navigating complex regulatory environments and ensuring that the trust operations are compliant with current laws and effective in achieving tax planning goals.

Case Studies: Successful Trust Structures Navigating TOSI Rules

Case Study 1: The Family Development Corp

Background: A family-owned real estate development corporation used a family trust to hold shares in a holding company that owned various subsidiaries. The family members actively participated in the business.

Strategy: The trust distributed dividends from the holding company to adult family members involved in the business, documenting their contributions and ensuring the shares qualified as excluded shares.

Outcome: The distributions were not subject to TOSI due to the active involvement of the beneficiaries and compliance with the excluded shares criteria, resulting in optimized tax benefits and successful income splitting.

Case Study 2: Tech Innovations Trust

Background: A trust was established to hold shares in a tech start-up for the benefit of the founder’s children, who were not initially active in the business.

Strategy: As the children grew older, they took on significant roles within the company. The trust was structured to allow for income distribution based on their active engagement and contributions.

Outcome: By documenting the children’s involvement and ensuring that their employment was substantial, dividends paid to the trust and then distributed to the children avoided TOSI, aligning tax efficiency with genuine business involvement.

Case Study 3: The Investment Trust

Background: A discretionary trust was set up to manage the investment portfolio of a family, including investments in public and private companies.

Strategy: The trust distributed income from public investments, which do not attract TOSI, to beneficiaries in lower tax brackets, while carefully planning private company investments to align with TOSI exemptions.

Outcome: The trust effectively split income among family members, utilizing lower tax brackets without triggering TOSI, thanks to strategic investment choices and distribution planning.

These case studies demonstrate the effectiveness of well-planned trust structures in navigating the complexities of TOSI, highlighting the importance of strategic planning, legal compliance, and thorough documentation in successful tax planning and income splitting through trusts.

Section 5: Recent Developments

Navigating the intricacies of the Tax on Split Income (TOSI) and the strategic use of trusts for income splitting requires staying abreast of recent legislative changes and case law. This section discusses recent developments in legislation, provides analysis of relevant case law, and offers predictions for future trends in tax regulation concerning TOSI and trusts.

Recent Legislative Changes Affecting TOSI and Trusts

Expansion of TOSI Rules in 2018

The most significant legislative change affecting TOSI and trusts occurred in 2018, when the scope of TOSI rules was broadened significantly. The amendments aimed to close loopholes that allowed high-income earners to shift income to family members taxed at lower rates. Key changes included:

• Extending TOSI rules to adult family members in certain conditions.
• Introducing specific criteria to determine when TOSI applies, such as reasonable returns based on contributions to the business.
• Defining “excluded shares” and setting criteria for active engagement in the business to exempt income from TOSI.

Clarifications and Guidance from the Canada Revenue Agency (CRA)

Since the 2018 amendments, the CRA has issued several guidance documents to clarify the application of TOSI rules. This includes detailed explanations on what constitutes “reasonable returns,” how to determine active engagement in a business, and specific scenarios where TOSI would or would not apply.

Introduction of Anti-Avoidance Rules

In response to sophisticated tax planning strategies that sought to circumvent TOSI rules, the government has introduced anti-avoidance rules aimed at preventing abusive practices. These rules target schemes designed to artificially manipulate income distribution without reflecting actual economic contributions.

Predictions for Future Trends in Tax Regulation Regarding TOSI and Trusts

Further Tightening of Anti-Avoidance Rules

As taxpayers continue to seek ways to minimize tax liabilities through income splitting, it is likely that the government will introduce more stringent anti-avoidance rules. These rules will aim to close any remaining loopholes and ensure that income distribution reflects actual economic activity.

Increased Scrutiny and Audits by the CRA

The CRA is expected to increase its scrutiny of income splitting arrangements involving trusts. This heightened focus will likely result in more frequent audits and stricter enforcement of TOSI rules. Taxpayers should be prepared for rigorous examinations of their income splitting practices and ensure they have robust documentation to support their claims.

Legislative Amendments to Address Emerging Tax Planning Strategies

As tax planning strategies evolve, legislative amendments will be necessary to keep pace with new developments. Future changes may include more precise definitions of active engagement and reasonable returns, as well as updated criteria for excluded shares. These amendments will aim to provide clearer guidance and reduce ambiguity in the application of TOSI rules.

Advancements in Tax Technology and Data Analytics

The CRA is increasingly leveraging advanced technology and data analytics to identify and assess potential TOSI non-compliance. This trend will continue, enabling the CRA to more efficiently detect patterns of abuse and enforce compliance. Taxpayers should anticipate a more data-driven approach to audits and investigations.

In conclusion, staying informed about recent legislative changes, relevant case law, and emerging trends is crucial for effectively navigating the TOSI landscape and utilizing trusts for income splitting. As a trusted tax professional, it is essential to provide clients with up-to-date advice and proactive strategies to ensure compliance and optimize tax efficiency. Engaging with legal and tax experts, maintaining thorough documentation, and adopting a proactive approach to tax planning will help safeguard against unintended tax consequences and enhance financial planning for family-owned businesses in Canada.

Conclusion

Navigating the complexities of TOSI and trusts for effective income splitting requires a thorough understanding of the tax landscape, strategic planning, and rigorous compliance. Here’s a recap of the key points covered:

• Understanding TOSI: We explored the definition, historical context, types of income affected, and the key criteria triggering TOSI implications. The TOSI rules are designed to ensure fairness and tax equity by applying the highest marginal tax rate to income shifted within families without substantial business involvement.
• The Role of Trusts in Income Splitting: Trusts offer a versatile tool for income splitting, allowing for tax-efficient distribution of income among family members. Different types of trusts, such as family trusts, testamentary trusts, and inter vivos trusts, play specific roles in estate planning and tax optimization.
• Combining Trusts with TOSI: Trusts can be used effectively for income splitting by adhering to TOSI rules. Strategies include documenting active business engagement, utilizing excluded shares, and ensuring reasonable returns on contributions. Proper structuring and compliance are essential to avoid unintended tax consequences.
• Strategic Planning and Compliance: Effective trust structuring involves clear contribution criteria, active engagement documentation, diversified investments, and regular reviews. Legal considerations, such as trust deed specifications and compliance with corporate law, are crucial for maintaining the trust’s tax treatment and legal standing.
• Recent Developments and Case Law: Staying updated with legislative changes, CRA guidance, anti-avoidance rules, and relevant case law is vital for effective tax planning. Future trends indicate further tightening of anti-avoidance rules, increased CRA scrutiny, legislative amendments, and advancements in tax technology.

Given the intricate nature of TOSI and trusts, it is highly advisable to engage with a tax professional to explore these strategies tailored to your specific circumstances. A proactive approach to tax planning, combined with expert guidance, can help optimize your tax efficiency and achieve your financial goals.

Call to Action

For personalized advice and to explore effective income-splitting strategies using trusts, we invite you to consult with Shajani CPA. Our team of experienced tax professionals are dedicated to providing up-to-date advice and proactive solutions to meet your needs.

For a consultation, please contact us and discover how Shajani CPA can support your tax planning needs. Stay informed, stay proactive, and ensure your family-owned business thrives with optimal tax strategies.

 

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