Navigating the New Landscape of Income Splitting for Family-Owned Businesses

Introduction: The Evolving Landscape of Income Splitting and Tax Planning in Canada

Income splitting has been a cornerstone of tax planning for Canadian family-owned businesses for decades. By allocating income among family members, businesses could significantly reduce their overall tax liability, benefiting from lower marginal tax rates across the family. This method not only facilitated a more efficient way of managing family wealth but also supported succession planning and wealth distribution among generations.

However, the landscape of income splitting underwent a significant transformation with the 2018 amendments to the Income Tax Act, particularly through the revision of section 120.4. These changes, often referred to as the enhanced Tax on Split Income (TOSI) rules, were introduced with the intent to tighten the use of income splitting as a tax reduction strategy. The legislation aimed to ensure that the benefits of income splitting are limited to those actively contributing to the business, thereby curbing what was perceived as an unfair advantage in tax planning.

The revised TOSI rules expanded the scope of income types and family members affected, applying higher tax rates to split income that doesn’t meet specific criteria of active engagement or direct contribution to the business. This shift has profound implications for tax planning within family-owned enterprises, necessitating a deeper understanding and strategic reevaluation of income distribution methods.

As these legislative changes redefine the boundaries and possibilities of tax planning for family businesses in Canada, it becomes imperative for stakeholders to grasp the nuances of these rules. The following sections will delve into the strategic implications of these changes, provide guidance on navigating the revised rules, and illustrate through case studies how family-owned enterprises can still leverage legal avenues for tax efficiency under the new regime.

 

Historical Context and the Evolution of TOSI

The Beginnings of Income Splitting

Income splitting has been a significant component of Canadian tax planning since the early 20th century. Initially introduced in the Income and War Tax Act of 1917, the original attribution rules aimed to regulate the transfer of income within families to ensure equitable tax distribution. Sir Thomas White, the then Minister of Finance, emphasized during the House of Commons debates that the rules were designed to prevent the evasion of taxes through the transfer of property among family members. Section 4(4) of the Act specifically targeted income-splitting strategies that were used to exploit individual tax exemptions, which at the time allowed the first $3,000 of income to be tax-free. By transferring property within a family, multiple members could potentially utilize their tax exemptions on the same income source, drastically reducing the family’s overall tax burden.

Challenges and Responses

Over the years, taxpayers and tax planners found creative ways to circumvent these rules, particularly through lending properties and forming corporate structures. A landmark case was Dunkelman v. MNR in 1959, where the court decided that a loan of property to family members did not constitute a transfer or assignment for attribution purposes. This ruling opened the door for income to be earned and reported by family members as if they were independent property owners, sidestepping the attribution rules.

In response to these strategies, legislative changes were made to strengthen the attribution rules. The 1952 Act revised the attribution provisions to include indirect transfers and loans of property. This was further tightened by introducing specific provisions under sections 74.1 to 74.5 of the Income Tax Act, which aimed to close loopholes that allowed income to be shifted within families through sophisticated lending and property transfer schemes.

The Introduction of TOSI

Despite these legislative efforts, the ability to split income within families continued to present challenges to the fairness and integrity of the tax system. This led to the introduction of the Tax on Split Income (TOSI) rules in 1999, initially targeted at income splitting with minors (often referred to as the “kiddie tax”). Section 120.4 of the Income Tax Act was crafted to apply the highest marginal tax rates to certain types of split income received by individuals under 18 years of age.

The rationale behind TOSI was clear: to deter high-income earners from shifting a portion of their income to family members in lower tax brackets, particularly minors, who had little to no other income. This was a direct response to the persistent use of income-splitting tactics that undermined the progressivity of the tax system. The TOSI rules were intended to ensure that similar amounts of income are taxed similarly, regardless of the techniques used to allocate that income within a family.

However, TOSI’s scope expanded significantly with the 2018 amendments, which brought adults into the fold under certain conditions. These changes were a culmination of ongoing observations that despite various reforms, income splitting remained a potent tax planning tool, particularly for family-owned businesses where control and ownership could be diffused among several family members. The 2018 amendments aimed to refine and extend the rules to prevent income splitting practices that did not correspond to genuine contributions to business activities, thereby reinforcing the principles of tax fairness and equity.

These historical shifts in the tax landscape reflect a continuous dialogue between tax planning strategies and legislative responses, where each adjustment in rules prompts a reevaluation of planning approaches. The evolution of TOSI is a testament to the complexity of balancing legitimate family business arrangements with the need to maintain a fair and equitable taxation system.

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Understanding the Revised Rules of Section 120.4 of the Income Tax Act

The Tax on Split Income (TOSI) has been a critical area of focus since its expansion in 2018, bringing comprehensive changes to how income sprinkling is treated within families, particularly involving private corporations. This expanded scope of TOSI targets strategies that were once commonplace in tax planning for family-owned businesses. Here is an in-depth look at the scope of TOSI, key exclusions and exemptions, and a practical tool to navigate these complex rules.

Scope of TOSI: Defining ‘Income Subject to TOSI’

The scope of TOSI under Section 120.4 of the Income Tax Act is expansive, capturing various income types that can be manipulated through income sprinkling strategies. Specifically, TOSI applies to:

• Taxable Dividends and Shareholder Benefits: This includes dividends from private companies where family members might be shareholders but not active in the business.
• Interest and Rental Income: Interest from loans to related parties and certain types of rental income derived from properties owned by a family business fall under TOSI.
• Capital Gains from the Disposition of Certain Shares: Profits from selling shares of private corporations not listed on a designated stock exchange are included.
• Trust and Partnership Income: Income derived from a trust or partnership where the family has significant control or influence is subject to TOSI.

These categories are purposefully broad, designed to capture not just direct income but also benefits that accrue through sophisticated family and corporate structures designed to shift income to lower-income family members.

Key Exclusions and Exemptions

Understanding the exclusions and exemptions under TOSI is essential for effective tax planning. The 2018 amendments introduced several vital provisions that allow families to navigate around TOSI under permissible scenarios:

1. Excluded Business: An important exemption exists for individuals who are actively engaged in the business. If a person works at least 20 hours per week on a regular, continuous, and substantial basis during the part of the year that the business operates, the income they receive from such business activities is exempt from TOSI. This exemption acknowledges the genuine contributions made by family members to business operations.
2. Excluded Shares: For individuals aged 25 and older, dividends or gains from shares that meet the “excluded shares” criteria are not subject to TOSI. To qualify, less than 90% of the business income of the corporation must come from the provision of services, and the individual must own at least 10% of the votes and value of the corporation.
3. Reasonable Returns: TOSI does not apply to income that represents a reasonable return based on the individual’s contributions (labor, capital, or risks) to the business. The law considers factors like the work performed, capital invested, risks undertaken, and payments previously made to the individual. For individuals under 24, the focus is more stringent, primarily looking at the prescribed rate of interest on capital contributed.
4. Spousal Exemptions: There are specific conditions under which income derived from property transferred between spouses due to matrimonial settlements, upon reaching the age of 65, or upon the death of a spouse, is exempt from TOSI. These exemptions acknowledge the social and economic partnership inherent in marriages, particularly in the context of family business planning.
5. Inheritance and Death: Exemptions also apply to inherited property. If a person under 24 inherits property from a parent, the income derived from that property is exempt from TOSI. This also applies to full-time post-secondary students under 24 and persons eligible for the disability tax credit.

Practical Tool: The TOSI Flow Chart

To aid tax planners and affected taxpayers, a TOSI Flow Chart has been developed as a practical tool to assess potential TOSI implications. This flow chart helps tax professionals determine whether specific income types are subject to TOSI and if any of the outlined exemptions apply. It serves as a step-by-step guide through the complexities of TOSI, offering visual assistance in identifying permissible income sprinkling opportunities and ensuring compliance with the law.

The flow chart begins by identifying the type of income and proceeds to question the relationship of the individuals involved, their level of engagement in the business, and whether any exceptions, like reasonable return or excluded shares, might apply. It simplifies decision-making, ensuring that tax planning remains within legal boundaries while optimizing tax outcomes.

The revised TOSI rules represent a significant shift in how family income is taxed in Canada, aiming to ensure tax equity and fairness across different income levels within families. Understanding these rules—particularly the scope of what income is covered, the exclusions available, and practical tools like the TOSI Flow Chart—is essential for tax professionals working with family-owned businesses. By navigating these rules effectively.

 

TOSI Flow Chart

Case Studies and Examples: Strategic Application of TOSI Rules in Family Business Arrangements

The complexities of the TOSI (Tax on Split Income) rules necessitate a clear understanding through real-world applications. Below, we explore three hypothetical case studies based on the types of scenarios that Shajani CPA often encounters. These examples illustrate how TOSI can apply to different income types and family business structures, and they demonstrate strategic approaches to income splitting that comply with the revised rules.

Case Study 1: The Tech Start-Up Transition

Scenario: A couple, John and Linda, own a successful tech start-up. As they plan for retirement, they want to transfer shares to their adult children, Emily and Mark, who have been actively involved in the business.

Application: Shajani CPA advised structuring the transfer of shares to qualify as “excluded shares” under TOSI rules. This involved ensuring that the shares represented more than 10% of the votes and value of the company. Both Emily and Mark had been actively engaged in the business, averaging more than 20 hours per week, satisfying the requirements to avoid TOSI on dividends received from these shares.

Analysis: This scenario is an ideal example of leveraging the “excluded shares” exemption. By carefully planning the share structure and documenting the active involvement of Emily and Mark, the family could effectively transfer wealth without triggering TOSI.

Case Study 2: Diversified Family Farm

Scenario: The Brown family owns a large farming operation that also generates substantial income from a side business of processing organic goods. The family wants to split income among the family members, including their children over 18 who are not actively involved in the business.

Application: Shajani CPA focused on the “reasonable return” principle for the children, who had previously contributed significantly to the capital investment in the processing business. The dividends distributed to the children were structured to reflect a reasonable return on their investment contributions, calculated based on a standard industry rate of return.

Analysis: This case shows the importance of the “reasonable return” exemption in TOSI, which allows income splitting where the income amounts are justifiable based on the individual’s contribution to the business. Detailed documentation of the initial capital contributions and a clear method for calculating returns were key to compliance.

Case Study 3: Real Estate Development Venture

Scenario: Sarah and Alex run a successful real estate development firm and wish to involve their adult son, Daniel, who has recently graduated from university. They plan to transfer property and shares to him but are concerned about TOSI implications.

Application: Shajani CPA helped them utilize a combination of strategies. First, they ensured Daniel was actively engaged in the business, documenting his contributions and role. Next, they structured his shareholdings to meet the criteria for “excluded shares” by ensuring he owned at least 10% of the voting rights and value. Finally, they planned for some of the income to be classified under “excluded business” by proving his direct involvement.

Analysis: This example highlights the effective use of multiple TOSI exemptions. It demonstrates that with proper planning and documentation, substantial compliance and tax optimization can be achieved even in complex business structures like real estate development.

Key Findings on Permissible Property Transfers

The revised TOSI rules have clarified several instances where property transfers within families are permissible without evading taxes:

• Transfers at Fair Market Value: If the property is transferred at fair market value and the family member receiving the property is actively involved in the business, it is generally permissible.
• Inheritances and Matrimonial Transfers: Property received through inheritance or as part of matrimonial settlements is not typically subject to TOSI, provided certain conditions are met, such as the inheritor being a student under 24 or disabled.
• Excluded Business and Excluded Shares: Proper structuring of business and share ownership can facilitate income splitting without triggering TOSI, as seen in the above cases.

These examples and analyses not only demonstrate the application of TOSI but also highlight the importance of strategic planning and documentation in navigating these rules effectively.

 

Strategic Tax Planning Under New TOSI Rules

The revised Tax on Split Income (TOSI) rules introduced significant changes to how income splitting is viewed and managed within family business structures. These changes aim to ensure fairness in taxation while still allowing legitimate family business and estate planning strategies. This section offers guidance for families and tax planners on how to navigate these changes effectively and avoid common pitfalls.

Recommendations for Families and Tax Planners

Identifying Legitimate Opportunities for Income Splitting

1. Utilize Excluded Business and Excluded Shares Exemptions: Understanding and applying these exemptions can significantly benefit families. If a family member is actively engaged in the business for at least 20 hours per week or owns at least 10% of the votes and value of the corporation (and the corporation meets certain income criteria), the dividends or gains from these shares are not subject to TOSI.
2. Document and Demonstrate Active Engagement: For those involved in family businesses, maintaining thorough documentation of their involvement is crucial. Timesheets, job descriptions, and records of decision-making roles can substantiate claims of substantial, continuous, and regular involvement.
3. Strategize Around Reasonable Returns: Especially for family members over the age of 24, ensure that any payments or distributions qualify as reasonable returns based on their contributions to the business. These can include labor, capital, or assumed risks. Document these contributions meticulously to justify the distributions as reasonable.
4. Optimize Use of Spousal and Inheritance Exemptions: Leverage spousal transfers during divorce or at the age of 65 and above, and be aware of the rules around inheritances, especially for transfers to individuals under the age of 24 who are students or disabled.

Planning for Effective Transfer of Property

1. Understand Property Transfer Norms: Recognize when transfers of property within family units are considered acceptable under TOSI rules. For instance, transfers at fair market value where the receiving party is significantly involved in the business can be structured to avoid TOSI.
2. Leverage Estate and Succession Planning: Use the rules surrounding inheritances to plan for the efficient transfer of business and personal assets. Understand how the attributes of inherited property affect TOSI implications.

Avoiding Common Pitfalls

Be Cautious with Income Attribution

1. Avoid Indirect Contributions Missteps: Be vigilant about indirect contributions where the income may inadvertently be subject to TOSI. This includes income or capital gains derived from property that was originally under the name of a high-income earner within the family and later transferred to a lower-income family member without sufficient compensation or justification.
2. Stay Informed on Service Income: With the focus on income from services in TOSI considerations, it’s essential to define whether the business primarily provides services or goods. Misclassification can lead to unexpected TOSI implications.

Regular Compliance and Documentation

1. Keep Detailed Records: Document all decisions and rationales for distributions and income allocations within the family business. This documentation should include meeting minutes, contribution records, and financial statements that justify the distributions.
2. Regularly Review Corporate Structures: Ensure that the business structure and share classifications adhere to the evolving interpretations of TOSI rules. This may involve adjusting share classes and ownership percentages or reevaluating who holds voting shares.
3. Consult With Tax Professionals Regularly: Given the complexity and the potential for significant tax implications, regular consultations with tax professionals who specialize in family business and estate planning are essential. They can provide updates on legislative changes and help in structuring your business and personal finances to comply with current tax laws while optimizing tax benefits.

Plan for Long-Term Implications

1. Consider Long-Term Tax Planning Over Short-Term Gains: Strategic decisions should not only focus on immediate tax savings but also consider the long-term growth and sustainability of the business. This includes planning for future generations and considering the potential changes in tax legislation.
2. Educate Family Members: As part of succession planning, educate the next generation on the implications of TOSI and the importance of compliance. This ensures that as leadership transitions occur, the new leaders are prepared to manage these aspects effectively.

By adhering to these strategies and remaining vigilant against common pitfalls, families and tax planners can navigate the complexities of the TOSI rules effectively, ensuring that their tax planning is both compliant and optimized for the family’s financial goals.

Conclusion: Navigating the Nuances of TOSI for Strategic Tax Planning

The landscape of tax planning in Canada has undergone significant changes with the revised Tax on Split Income (TOSI) rules. These changes not only alter how income is taxed when split among family members but also redefine the strategic approaches families and tax planners must consider. Here, we summarize the key points and encourage proactive steps to ensure compliance and optimization of tax benefits.

Summary of Key Points

1. Clarified Exemptions: The TOSI revisions have provided clearer guidelines on what constitutes permissible income splitting. This includes detailed exemptions such as excluded shares, excluded businesses, and reasonable returns based on active involvement or capital contribution.
2. Active Involvement: For families involved in business together, demonstrating active and substantial involvement in the business is crucial. This can exempt certain income types from being subject to TOSI, fostering a fair environment for family members who genuinely contribute to the business.
3. Fair Market Value Transactions: Property transfers within a family that are conducted at fair market value and for legitimate business purposes are generally outside the scope of TOSI. This helps maintain the integrity of familial transactions while allowing for legitimate tax planning.
4. Exemptions for Specific Circumstances: Specific exemptions such as those for young adults engaged in post-secondary education, disabilities, or inheritances, underscore the need for careful planning and documentation in family wealth transfers.

Call to Action

Understanding and applying the TOSI rules can be complex, especially given the nuances and specific exemptions that might apply to different family and business scenarios. It is crucial for taxpayers, particularly those involved in family-owned enterprises, to seek professional guidance to navigate these rules effectively. Consulting with a tax professional can provide tailored advice and strategic planning to ensure compliance while optimizing tax benefits.

At Shajani CPA, we specialize in navigating complex tax landscapes like these. Our experience and in-depth understanding of TOSI, combined with a personalized approach to each client’s unique circumstances, make us a trusted partner in your tax planning journey. We encourage you to reach out to explore how these changes might impact your family and business, ensuring you make informed decisions that align with both your financial goals and tax obligations.

In conclusion, as tax laws continue to evolve, staying informed and proactive in your tax planning strategies is more important than ever. Engaging with professionals like those at Shajani CPA can provide the expertise and peace of mind needed to navigate these changes effectively, ensuring that your family and business are positioned for optimal tax outcomes.

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. ©2024 Shajani CPA.

Shajani CPA is a CPA Calgary, Edmonton and Red Deer firm and provides Accountant, Bookkeeping, Tax Advice and Tax Planning service.

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