Your client may have embraced the risk of opening a business, but an entrepreneurial spirit alone won’t help anyone escape the tax on split income (TOSI). Accomplishing that feat requires expert tax advice and planning, because the TOSI rules are complicated.
The challenges are laid out in a paper from RSM Canada, which discusses various CRA tax interpretations of TOSI over the last year, summarizes the various exceptions to the rules and provides planning insights. At the 2019 Ontario Tax Conference in October, the paper’s authors highlighted some of these interpretations and also discussed “related business” in the context of the excluded shares exception.
TOSI and the excluded shares exception
TOSI, whereby certain dividends paid to minor children are taxed at the highest marginal rate, was extended in 2018 to adults and more types of income, barring certain exceptions (this TOSI flowchart from Moodys Gartner Tax Law provides an overview of the rules).
A typical situation where TOSI might apply is when your business-owner client splits income by paying dividends from their corporation to family-member shareholders. Such income would be from a related business. The Income Tax Act defines a “related business,” which is generally a business in which a Canadian-resident family member is actively involved or has a significant capital interest at any time during the year.
One way to avoid TOSI is to qualify for the excluded shares exception: for family members age 25 or older, TOSI doesn’t apply if they can meet all these requirements:
- Less than 10% of the corporation’s income in the previous tax year was derived from a related business.
- The family member personally owns 10% or more of the votes and value of the corporation.
- The corporation isn’t a professional corporation.
- Less than 90% of the corporation’s gross business income in the previous tax year was from providing services.
At the 2019 Ontario Tax Conference, Sunny Jaggi, senior manager at RSM Canada and one of the paper’s authors, highlighted the first requirement above — that most or all of the corporation’s income can’t be derived from a related business in the last taxation year.
“Typically, this test becomes relevant in [holding company–operating company] structures,” Jaggi said, “where holdco will generally fail this test because it’s deriving most or all of its income from an opco, which is a related business.”
Holdco sells its opco shares and invests the proceeds
Jaggi outlined a CRA technical interpretation in which an investment holding company, Investco, owns all the shares of an operating company, Opco. Opco’s income isn’t from services, and Opco isn’t a professional corporation. Investco’s only income comes from Opco dividends that are distributed annually.
Spouses Mrs. and Mr. A are equal shareholders of Investco and over age 25. Mr. A is actively involved in Opco’s business and Mrs. A isn’t. As a result, for Mrs. A, Investco income is derived from a related business, Opco.
In year three, Investco sells its Opco shares and uses the net proceeds to invest in a portfolio of publicly traded securities. As a result, in year five, Mrs. A could benefit from the excluded shares exception.
If Investco paid dividends to Mrs. A in year five, the previous tax year — year four — would be the first year that Investco would have no income derived from a related business in respect of Mrs. A. That’s because no dividends would be paid to Investco from Opco in that year — the year after the sale of the business.
Once a holdco severs the connection to its related business, opco, by either selling opco or liquidating the business (which could take two or three years), the holdco may fit into the excluded shares exception, the RSM Canada paper says.
Opco converts to an investment corporation
Jaggi highlighted another CRA technical interpretation involving the excluded shares exception and income from a related business. This time, shares were held directly, not through a holding company.
In this scenario, spouses Mrs. and Mr. A are over age 25 and each own a 50% interest in ACo, which carried on a business until two years ago. ACo isn’t a professional corporation, and the old business was a non-services business. Only Mrs. A was actively engaged in the old business.
Since ACo disposed of its old business two years ago, its sole activity has been investing in public securities using the proceeds from the sale and ACo retained earnings.
In considering whether dividends paid in the current year to the inactive spouse (Mr. A) would meet the excluded shares exception, “CRA first considered whether the activities of ACo would be considered to be a business,” Jaggi said at the conference. “Without [a] related business, TOSI should not apply.”
The CRA took the position that the dividends wouldn’t be split income. ACo met the requirements for the excluded shares exception, in part because ACo’s income for the last taxation year was from earning property income, not from a related business for the year. (Recall that ACo sold its business two years ago.)
The takeaway: “Historical retained earnings and proceeds of disposition of sale of a business and an asset sale can be used to income split with an inactive shareholder,” Jaggi said.
Carrying on a business
When applying the TOSI rules, income characterization is important, specifically the distinction between income from business versus property, which has important implications for corporations, partnerships and trusts that hold passive investments.
In general, TOSI shouldn’t apply to income derived from a property so long as the earning of that income doesn’t rise to the level of carrying on a business. CRA technical interpretations have indicated that where a corporation doesn’t carry on a business, the activities of the corporation can’t be a “related business,” and TOSI wouldn’t apply, said Rishma Jessa, senior director at RSM Canada and one of the paper’s authors, at the conference.
Caution is warranted, however, because determining an income’s character is fact-specific to each case; there’s no bright-line test. The CRA definition is broad, and, in common law, a corporation’s activities are presumed to be business activities unless the presumption is rebutted, Jessa said. Factors considered in jurisprudence include number, volume and frequency of transactions; and type and turnover of investments.
CRA comments have indicated that the threshold is low as to whether a corporation’s investment activities constitute a business for TOSI purposes. “A holding company that owns a portfolio of marketable securities in addition to the shares of an operating company may be considered to be carrying on an investment business,” the paper said.
To avoid being considered to carry on a business, a holding company would likely have to hold only subsidiary shares, cash or near cash, Jessa said.
The authors suggested in the paper that a reasonable approach is to first assume that a corporation is carrying on a business for TOSI purposes, and to then ascertain whether the corporation can rely on one of the exceptions under excluded amounts.
How a services business could meet the excluded shares exception
In certain situations, it’s actually useful to presume that a corporation is carrying on a business.
For example, a services business (and non-professional corporation) could potentially meet the excluded shares exception — and thus split income with inactive shareholders — by ensuring that less than 90% of the corporation’s gross business income in the previous tax year came from providing services. (While the business would have to meet all requirements for the excluded shares exception, the 90% test is the big hurdle for services businesses.)
To meet the gross business income test, an opco could earn a sufficient amount of investment income that would be considered income from business. For example, the shareholders could lend sufficient funds to the opco (at the prescribed rate, to avoid corporate attribution rules) to generate investment income annually of over 10% of total gross business income, Jaggi explained at the conference.
To help support the characterization of income as business income, the opco should consider actively investing instead of buying and holding.
Jaggi noted that business owners should consider various factors when undertaking this type of planning (for example, the investment income could be taxed as specified investment business income, he said). Further, investment income over $50,000 annually will grind down the small business deduction.
For more details on CRA technical interpretations regarding TOSI, read the paper from RSM Canada.