With 2019 tax season right around the corner, we thought it might be beneficial to dust off the archives and take a second look at an often misunderstood concept. Last year we looked at Tax on Split Income or TOSI as it is commonly referred to.
In July of 2017, the federal government released proposals aimed at limiting opportunities for shareholders of privately held corporations to split income with family members. There was a significant backlash from both business communities and income tax professionals.
Due to this backlash, the federal government amended their proposal and released the revised proposal in December 2017. The federal budget meeting on February 27, 2018, confirmed that the government is planning on moving forward with the proposal. On March 22, 2018, the proposed legislation was released.
Since that proposed legislation was released, there have not been any updates.
The legislation significantly affected the distribution of income and dividends to both shareholders and family members. These rules have come to be known by the acronym TOSI (tax on split income).
The TOSI rules were officially implemented in the 2018 tax year and will continue in subsequent years. The objective of these rules is to eliminate income splitting with related individuals who have not contributed significantly to the business.
To keep it simple, individuals and family members that are significantly involved and making a meaningful contribution to an incorporated business are excluded from the new tax on split income rules.
The department of finance believes that about 3 percent of Canadian-controlled private corporations, and approximately 45,000 entities have been affected by these changes.
The TOSI rules apply in all circumstances where interest or dividends is paid, unless definitive and subjective exceptions apply.
Definitive exceptions are clear and easy to ascertain. Subjective exceptions are more difficult to ascertain and are based on an assessment of the facts associated with each individual circumstance.
All income that falls under the TOSI rules is removed from an individual’s net income and taxed separately at the top marginal tax bracket in the applicable province.
To see more information on your province’s tax brackets, click here.
An important term to clarify is “Related Business”. Related business in respect to an individual and a corporation refers to; if an individual is somehow related to “individual A” who owns shares of company Z that represent 10% or more of the fair market value of the company Z shares.
To put it another way, if Bob is related to Betty, and Betty is a 10% shareholder of “Z”, then “Z” is a “related business” to Bob.
There are several TOSI exceptions that we would like to outline:
1) Excluded Business Exception
Individuals that are 18 years of age or older, who contribute labor to a “Related Business” on a regular, continuous, and substantial basis are considered to be “Actively Engaged” and are not subject to TOSI.
To be Actively Engaged, the individual must have worked an average of 20 hours a week during the taxation year, or during the business’s season of operation. If an individual falls within this exception, they do not need to consider the TOSI rules with respect to whether the amounts received were reasonable.
2) Excluded Share Exception
Individuals aged 25 and over who own an “Excluded Share” of a corporation are not subject to TOSI. For a share to be considered “Excluded”, the following criteria must be met:
- Less than 90% of the corporation’s business income was from the provision of services;
- the corporation is not a professional corporation;
- the shares held by the individual represent 10% or more of the votes and value of the corporation; and,
- all or substantially all of the income of the corporation is not derived from another “Related Business” with respect to the individual.
3) Reasonable Return
Individuals age 25 and over who receive an amount that qualifies as a “Reasonable Return” are not subject to TOSI. Reasonableness criteria are as follows:
- Labour Contribution – the work performed by the individual in support of the Related Business before the amount became paid.
- Property Contribution – The property contributed directly or indirectly by the individual in support of the Related Business.
- Risk Incurred – the risks assumed by the individual in respect of the Related Business.
- Historical Payments – the total amount paid or payable by any person or partnership to or for the benefit of the individual in respect of the related business.
4) The greater of a safe harbor capital return and reasonable return based on the cost of arm’s length capital
Individuals over age 17 and less than age 24 before the year who receive a return on property contributed in support of the “Related Business” will not be subject to TOSI.
5) Other exceptions
There are other exceptions when TOSI rules generally will not apply. However, in the interest of keeping this post a reasonable length we chose to only include what we thought was the most beneficial. For information on other potential exceptions leave a comment or send us an email.
Assume the following facts:
- Company “A” carries on an active business of farming and is neither a service business nor a professional corporation. “A” is a seasonal business operating about six months per year.
- Spouses, Bob and Betty, own all of the fixed-value preferred shares that were the result of an estate freeze completed last year.
- A discretionary family trust owns all of the common shares of “A”. Beneficiaries of the trust include Bob & Betty’s children and grandchildren.
Grandchild #1 is 27-years-old and has recently completed an MBA. He has not worked on the farm in the past years; however, he was in need of cash flow and spent four months in the current year, working 40 hours per week.
Grandchild #2 is 24-years-old and has worked weekends on the farm for the last six years, clocking about 6 hours per weekend for a total of about 150 to 200 hours per season.
Grandchild #3 is 30-years-old and works in his own professional practice in a city very far away. When #3 finished high school at age 17, he worked with Bob on the farm, full-time for five years before returning to school.
The plan is to pay dividends from “Company A” to the trust and allocate the dividend amounts as one-third to each Grandchild.
For Grandchild #1, the dividend amounts meet the “Excluded Business”” exception because he worked at least an average of 20 hours per week during the farm’s current operating season.
For Grandchild #2, the dividend amount does not meet the “Excluded Business” exception because, while he has worked every year for 6 years, the work time is less than an average of 20 hours per week during the farm’s operating season. As such, the dividend paid to #2 will be taxed at the top marginal rate.
For Grandchild #3, the dividend amount meets the “Excluded Business” exception because he worked at least an average of 20 hours per week during the farms operating season in at least five prior years.
For more information or if you would like to set up a meeting and talk about your particular situation, contact us. Consult your finance experts and have them help you plan out your taxable situation.
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Disclaimer: This Forbes Wealth Blog is for informational purposes only and does not constitute financial, legal, or tax advice of any kind. Please consult your legal, accounting, tax, investment, banking, and life insurance professionals to get precise advice relating to your particular situation before acting upon any strategy.