The tax on split income is like an escape room: everyone is caught, and the exits aren’t clearly marked.
So said Cory Litzenberger, president and founder at CGL Strategic Business & Tax Advisors in Red Deer, Alta., in a podcast last year about the expanded rules for tax on split income (TOSI).
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 (see “Income subject to TOSI,” below), barring various exclusions. Generally, TOSI may apply when a client receives dividends or interest—or realizes a capital gain—from a private corporation, and a family member is actively engaged in the corporation’s business or holds at least 10% of its value.
The new rules were part of the Liberal government’s controversial 2017 tax changes, certain elements of which were finalized in the 2018 federal budget.
We asked experts how they help clients solve the TOSI puzzle, while remembering that the rules are complicated and each client’s situation is unique. Advisors don’t have to be TOSI experts, says Wilmot George, vice-president of tax, retirement and estate planning at CI Investments in Toronto; rather, they should be familiar with the rules so they can identify potential issues and have productive conversations with clients’ accountants.
Here are some client examples that highlight those issues.
Wait out age requirements
George says the typical situation targeted by the expanded rules is a business-owner client paying dividends to a university-age child. Consider the hypothetical case of Radical Roasters, an operating company in Ontario that roasts organic coffee beans. The owner is a single dad who has paid dividends to his 20-year-old daughter, a full-time student, since she was 18. The daughter owns at least 10% of the votes and value of the business, and has no other income. The dividends cover university and living costs, but now they’re subject to TOSI, meaning the dividends will be taxed at the top marginal rate instead of at lower graduated rates.
Options include having the daughter work an average of 20 hours per week (if she had worked that amount in any five previous years, it would also count) or contribute property to the business—options not likely viable for a university student.
Instead, the father can postpone paying dividends until the daughter turns 25, says George, when TOSI no longer applies where the business isn’t a professional corporation or services business, and doesn’t itself earn income from a related business. (It’s difficult to avoid TOSI when a family business is structured as a holding company connected to an operating company.)
He adds that if the daughter didn’t own 10% of the votes and value of the shares, the family could consult an accountant about restructuring the business.
For the dividend amounts no longer paid, the father might retain earnings in the business and invest, or might buy additional business assets to earn business income, George says. Or he could increase his salary so after-tax cash flow remains constant (see table below for options).
“TOSI has now taken away the opportunity to receive those dividends tax efficiently,” George says. As a result, the father pays more than $22,000 in additional total tax in 2018, compared to 2017, to maintain the same after-tax cash flow.
Once the daughter turns 25, no test applies for amounts received, so dividends could be increased at that time if desired.
|Details for Radical Roasters (Ontario)||2017 (adult child, no TOSI)||2018 (adult child, TOSI)||2018 (no dividends; increased salary to dad)||2018 (salary/dividend mix to dad)|
|Active business income||$500,000||$500,000||$500,000||$500,000|
|Less owner’s pre-tax salary||($306,330)||($306,330)||($369,835)||($306,330)|
|Taxable business income||$193,670||$193,670||$130,165||$193,670|
|A Corporate income tax (Ontario)||($29,051)1||($26,146)2||($17,572)2||($26,146)2|
|Less dividends to daughter||($30,000)||($55,314)||Nil||Nil|
|Less dividends to dad||Nil||Nil||Nil||($55,314)|
|Retained corporate earnings||$134,619||$112,210||$112,593||$112,210|
|12017 small business tax rate (federal/Ontario): 15%|
22018 small business tax rate (federal/Ontario): 13.5%
Current-year cash flow (before and after tax)
|Owner’s salary (pre-tax)||$306,330||$306,330||$369,835||$306,330|
|B Tax on salary1||($127,344)||($126,854)||($160,849)||($126,854)|
|C After-tax salary||$178,986||$179,476||$208,986||$179,476|
|D Daughter’s dividends||$30,000||$55,314||Nil||Nil|
|D Dad’s dividends||Nil||Nil||Nil||$55,314|
|E Tax on dividends||Nil||($25,804)2||Nil||($25,804)2|
|F After-tax dividends (D − E)||$30,000||$29,510||Nil||$29,510|
|G Total personal tax (current year [B + E])||($127,344)||($152,658)||($160,849)||($152,658)|
|Total tax (corporate and personal [A + G])||($156,395)||($178,804)||($178,421)||($178,804)|
|Current year after-tax cash flow (C + F)||$208,986||$208,986||$208,986||$208,986|
22018 top marginal rate for non-eligible dividends
Source: Wilmot George
Meet the labour test
Danielle Sideris, senior tax manager at BDO Canada in Toronto, describes a corporation in B.C. owned equally by spouses Piya and Bhidu (a hypothetical couple). Bhidu works full time in the consulting business and owns Class A shares. Piya owns Class B shares and provides graphic design services but isn’t on payroll. (Sideris notes that, where shareholders own shares of the same class and thus must be paid the same amount of dividends, corporate reorganization might be necessary.)
As a result of TOSI, she calculates that a non-eligible dividend of $100,000 paid to Piya in 2018 would result in more than $28,000 in additional personal tax (assuming Piya has no other income or deductions). How to solve the puzzle?
The excluded shares exemption for adults age 25 and older doesn’t apply for a services business (or professional corporation), but Piya might meet the 20-hour-per-week work requirement. If she’s close to that requirement, perhaps she can work more hours, Sideris says, adding that documentation, such as timesheets, is required.
If the spouse met the labour test in any five previous years, the business owner might not have documentation—something CRA understands, BDO says on its website, with the agency “generally widening” the factors it considers where pre-2018 records don’t exist.
Alternatively, the company could pay Piya a “reasonable” dividend based on work or capital provided, though some uncertainty remains about how CRA will interpret “reasonable,” Sideris says. Paying a salary, which would not be caught by the TOSI rules, might therefore be a better option for a spouse in a low tax bracket, she says—though the salary must also be reasonable to be deductible from the corporation (see “Pay an unreasonable salary?” below).
Sideris also notes that where the business owner is at least 65, a spouse can receive dividends and TOSI doesn’t apply.
Also, if Piya can’t meet the labour test and no longer receives dividends, any subsequent increase to retained and invested earnings should be considered in light of the rules for passive investment income going forward, says Sideris (see “Put deferral loss in perspective for Ontario business owners”).
Convert taxable dividends to capital gains
Business owners aiming to keep within the threshold for passive investment income and who require funds can remove amounts from their corporations without triggering TOSI—at least for now.
Consider another hypothetical case: Aashi operates various retail businesses through a private corporation, Market Group. She, her husband and 18-year-old daughter all hold company shares. Aashi wants to use Market Group’s significant retained earnings to buy vacation property. She also knows now is an ideal time to remove money from the company to reduce the impact of the rules for passive investment income.
For tax years after 2018, access to the small business deduction (SBD) drops by $5 for every $1 of passive investment income above $50,000, and is eliminated at $150,000 of investment income.
A TOSI exclusion applies to capital gains that qualify for the lifetime capital gains exemption (LCGE). To qualify, gains must derive from the sale of qualified farming or fishing property, or from the sale of shares from a qualified small business corporation, among other requirements.
The exclusion represents “an opportunity to draw out wealth from the corporation, without TOSI, at a very attractive rate,” says Kenneth Keung, director, Canadian tax advisory at Moodys Gartner Tax Law in Calgary. For example, the combined top marginal tax for Ontario taxpayers in 2018 for capital gains is about 27%, versus 39% and 47% for dividends (eligible and non-eligible, respectively).
Conversion occurs in the usual way. First, the family exchanges its existing shares for new ones in Market Group,* electing to realize a capital gain of the desired amount. Family members pay capital gains tax or shelter the gain with other capital losses. Either way, the new Market Group shares’ adjusted cost base (ACB) is equal to the elected amount. It is important to note that the LCGE must not be claimed in respect of the gains triggered on the exchange, Keung says.
Second, these new shares are transferred to a holding company, which issues to the family members promissory notes or share consideration with paid-up capital. The holdco repays the notes or returns the paid-up capital to the family with funds from Market Group, transferred via intercorporate dividends, an amalgamation or winding up.
Keung says the biggest risk with this planning is Section 84(2) of the Income Tax Act (ITA). If CRA finds that Market Group’s funds have been distributed to shareholders on the winding up, discontinuance or reorganization of the company’s business, “CRA then has the power to recharacterize that draw of money into a dividend, so that the whole planning would be moot,” he says.
Another warning: this planning might only be available for a limited time, Keung says, because the feds proposed to prevent conversion of dividends to capital gains in their original 2017 tax proposal before abandoning the measure. The government continues to assess efficient intergenerational business transfers and could potentially prohibit this type of planning where there’s no such transfer, Keung says.
Use prescribed rate loans
A common and CRA-permitted way to split income is using prescribed rate loans, Keung says.
Consider John and Jill, a hypothetical married couple with children ages 19 and 16. John is in a top tax bracket; Jill and the children aren’t, and Jill has received $2 million as a beneficiary of her deceased father’s estate.
A family trust is set up with family members as beneficiaries. (Keung notes several things to beware of when doing so, such as avoiding the trust reversionary rule under Section 75(2) of the ITA.) Jill can loan funds to the trust at an interest rate at least equal to CRA’s prescribed rate, currently 2%, and the trust must pay the interest within 30 days of year-end. With these requirements met, attribution rules won’t apply on trust income.
Assume the trust invests in publicly traded securities and earns dividends, capital gains and interest. CRA recently confirmed that the dividends and capital gains from publicly traded securities won’t be subject to TOSI when allocated to the beneficiaries, Keung says, regardless of their age.
In accordance with trust rules, the character of dividends and capital gains is preserved as they flow through the trust, he says. Thus, dividends and capital gains from publicly traded companies can be tax-efficiently allocated to all beneficiaries, including the 16-year-old, he says.
However, trust rules don’t similarly provide character preservation for interest, which will be subject to TOSI when allocated to beneficiaries. Thus, for tax purposes, clients should minimize interest income and maximize dividends and capital gains, Keung says.
Income subject to TOSI
TOSI potentially applies if a business-owner client or their family members earn these types of split income:
- Dividends and shareholder benefits from a private corporation
- Income received from a partnership or trust, where the income is derived from a related business or a rental where a related person is involved
- Income on certain debt from a private company, partnership or trust
- Income or gains from the disposition of private shares or other property with historical TOSI
Source: Moodys Gartner Tax Law and BDO Canada
Pay an unreasonable salary?
Under the TOSI rules, dividends from a family business paid to adult family members must be “reasonable” based on contributions to the business. However, “reasonable” isn’t defined in the Income Tax Act, says Cory Litzenberger, president and founder of CGL Strategic Business & Tax Advisors. Rather, the act specifies that unreasonable amounts can’t be deducted by the business for tax purposes. That provision doesn’t preclude unreasonable amounts being income for recipients, he says.
He offers the example of paying a $100,000 salary to a spouse who’s not active in an Alberta-based business and has no other income. The business wouldn’t benefit from the deducted salary, so the corporation would lose out on $11,000 of tax savings at the small business rate.
Since dividends would likewise be non-deductible, Litzenberger says the real difference to consider is TOSI on dividends versus income tax on salary. In that match, salary wins.
A $100,000 salary results in income tax of $24,394 (average tax rate) for the spouse, while the same amount in dividends would be caught by TOSI and result in tax of $42,470 (highest rate for non-eligible dividends)—a difference of $18,076.
The math tends to work in favour of a salary in all provinces when the active spouse is in a high tax bracket, Litzenberger says, though he notes that other factors affect the decision to pay a salary versus dividends, such as payroll taxes, CPP requirements and compliance costs.
Also, CRA uncertainty throws a wrench in the plan: the agency could potentially argue that an unreasonable salary presents a shareholder benefit or contravenes anti-avoidance rules, though such arguments wouldn’t be slam dunks, Litzenberger says. For example, the spouse pays more tax on an unreasonable salary than a reasonable one. Further, the corporation pays more tax without the deducted salary, so shareholder value has arguably decreased, he says.
Still, he’s not yet making such bold tax moves for business-owner clients. “We’re filing tax returns in real time, and [CRA is] auditing with hindsight,” he says. Further, potential guidance from jurisprudence could take several years, making this approach a wait-and-see one.
These types of property aren’t subject to TOSI but, as they involve death or divorce, you likely won’t be offering congratulations to your client:
- Capital gains that result from a death
- Income that results from a relationship breakdown
- For family members aged 18 to 24: amounts from inherited property from a parent—or from any person, if the 18- to 24-year-old is enrolled full time at a post-secondary institution or entitled to the disability tax credit
Source: Moodys Gartner Tax Law and BDO Canada
*Correction: A previous version of this story said that the exchange of existing shares for new ones resulted in a new operating company. In fact, it does not result in a new operating company. Return to the corrected sentence. This section has also been updated for clarity.