Ways to avoid tax on split income(tosi)
It is the taxation of individuals, as opposed to a family unit, which gets considered as a taxable unit in Canada. Hence, a family with a single income earner earning $90,000 will pay a higher tax than a family where two spouses each make $45,000 respectively. This fact coupled with a top marginal tax rate fuels the existing drive towards income splitting. Income splitting involves shifting income from one family member to another member in a lower tax bracket, thereby reducing the overall tax bill payable to the Canada Revenue Agency. The planning was disarmingly simple and considered standard practice for incorporated small businesses.
The Government’s Original Proposal
The Government’s Original Proposal on July 18, 2017, aimed to restrict “Income Sprinkling” by extending the existing rules for Tax on Split Income (TOSI).Fundamentally, the government proposed to determine the legitimacy of the contributions made by each family member towards the results of the business. Any dividends or capital gains from that business over a “reasonable” return on labour and capital will invite tax at the highest marginal rate (In some cases as high as 53.53%) in the hands of the recipient of income.
The Revised Proposal
The revised proposals released on December 13, 2017, include a series of so-called “bright line” tests to remove certain individuals from the TOSI rules. These modifications have kept the reasonableness tests but narrowed the scope by adding safe harbours, where TOSI would not apply.
The Flowchart summarizes these new rules and the applicability of TOSI to the various situations. Please zoom(if required) for better readability. The definitions for relevant items on the flowchart are listed below :
Excluded Shares
Shares of a corporation owned by an individual are “Excluded Shares” where:
• Less than 90% of the corporation’s business income for the last taxation year was by providing services;
• The corporation is not a professional corporation (A PC is defined (S.248(1)) as a corporation carrying on the practice of an accountant, dentist, doctor, lawyers and others);
• The individual owns shares that represent 10% or more of the voting and the value of the corporation; and
• All or substantially all of the income of the corporation is not derived from another Related Business in respect of the individual.
Based on the votes and value condition, individuals holding shares via a trust will not be covered under this exclusion, as it appears that a direct holding of shares is a requirement. In certain situations, a rollout of shares to trust beneficiaries could allow for directly holding excluded shares to avoid TOSI.
The tax authorities have stated that over 75 percent of Canadian small businesses are service providers; hence, they might not qualify for this exemption.
Example of excluded shares :
Sandy Augustine, a Canadian Resident, is the owner of Tasty Foods Inc., a Canadian private corporation. The company sells packaged food. One of his children is now 25 years old and has recently graduated from school and is actively searching for a job. Provided this child holds shares which have 10% or more of the votes and equity in Tasty Foods Inc, the child can receive dividends at graduated income tax rates. Additionally, the child will also be entitled to the non-refundable tax credits for the basic personal exemption and tuition fees.
Where dividend payments would be split income if paid to a shareholder under age 25, but would not be split income if they were at least 25 years of age, consider delaying the payments until the shareholder reaches 25 years of age.
Tax Planning
It may be necessary for business owners to review the existing business structures to determine if a reorganization should be considered to fit into the excluded share exemption ( increase the stake of the family members in the family business in order to be excluded from the new rules). As a transitional measure, the Federal Government of Canada has provided business owners to the end of 2018 to revise business ownership to meet the excluded share requirements.
If an individual holds excluded shares in a private company at the end of 2018, then he/she will be considered to have owned excluded shares for all of 2018. Therefore, dividends received from the company in 2018 will be exempt from the TOSI rules.
Excluded Business
The business of a specified individual for a taxation year, if he/she is actively engaged on a regular, continuous and substantial basis in the activities of the business in either the taxation year or any five prior taxation years.
CRA guidance: An individual will be deemed to be ‘Actively Engaged’ if the individual works in the business at least an average of 20 hours per week during the portion of the taxation year of the individual that the business operates or meets that requirement for any five prior years. The five taxation years need not be consecutive.
For example, if an individual had met the actively engaged criteria in the years 2010, 2011, 2012, 2014 and 2016, but has since retired and no longer actively participating in the business, that individual still passes the actively engaged test. Hence, the excluded business exclusion will apply, and any income received by that individual from the corporation will not be subject to TOSI. There is still some ambiguity as to what type of supporting papers is the Canada Revenue Agency looking for the past years, where records may be difficult to obtain. We advise business owners to keep a timesheets log and work description for each family member receiving income from the corporation (other than salary).
Example of excluded business: Mr Bean, who is Bob’s 19-year-old son, works 20 hours per week at Tasty Foods Inc as a server. Servers get paid on average $1,400 per month, for part-time work. Mr Bean receives a monthly dividend from Tasty Foods Inc for $1,400 per month. In this scenario, Mr Bean would be exempt from the TOSI rules, as he works at least 20 hours per week in a related business and gets reasonable dividends.
It appears that Finance has directly targeted “income sprinkling” with children between the ages of 18 and 24. This period majorly falls in the years in which children attend post-secondary education, which under the old rules, allowed income sprinkling to provide significant tax savings.
Tax Planning
You might want to increase the participation of family members(work more hours) in the family business to pass the 20 hour test to get covered under the exception.
You might want to consider funding your children’s’ education with Registered Education Savings Plans (RESP). By saving for post-secondary education using an RESP account, parents can benefit from matching contribution grants from Government as well as other programs to help low-income families and provincial programs.
Where a shareholder under the age of 25 works in a related business, but does not meet the 20 hours per week test, it should be made sure that the shareholder is compensated only through reasonable salary.
Reasonable Return
If you don’t meet the first two exemptions (bright-line tests), there is another exception based on a “reasonable return” that can apply for adult family members who are 25 years of age and older.
Reasonable Return includes those payments that represent a reasonable return based on the following criteria (the “Reasonableness Criteria”):
- The work performed in support of the Related business;
- The property contributed directly or indirectly in support of the Related business;
- The risks assumed by the individual in respect of the Related Business;
- The total amounts already paid to or for the benefit of the individual in respect of the Related Business; and
- Any other factors that may be relevant.
It is vital to remember that each exemption is standalone in nature. For example- A Professional Corporation signifies that the “excluded shares” exception is out of the question. However, this professional corporation can still be covered under other exclusions as long as it meets the exclusion criteria (“reasonable return”; “Excluded Business, spouse age 64+, etc.).
Other Exclusions
In particular, the TOSI rules will not apply to income received by an individual from a related business if the individual’s spouse made the contributions to the business and attained the age of 65 years in or before the year the amounts are received.
“Excluded Amount”- Income/gain of the specified individual is derived from:
- Property received as a result of the death of the parents (for individuals under 25)
- Property received as a result of the death of any person, and the specified individual is enrolled as a full-time post-secondary student or is entitled to disability tax credit (for individuals under 25)
- Property transferred to the individual in respect of a separation agreement
- A taxable capital gain as a result of a deemed disposition on death or disposition of qualified farm/fishing property or a qualified small business corporation shares (regardless of age)
Other Definitions:
Safe Harbour Capital Return
A return up to a prescribed rate (highest prescribed rate in effect for a quarter in the year) based upon the fair market value of property contributed by the specified individual in support of a related business (pro-rated according to the number of days in the year that the property substituted therefore is used to support the related business).
For example, Donny contributes $50,000 in the property to the family business and the property and uses it for the entire year. He receives $1000 in dividends. The prescribed rate at present is 2%. One must then calculate $50,000 x 2% x 365 days/365 days = $1000. In this scenario, Donny falls outside the ambit of the new TOSI rules which would have taxed the dividends at the highest marginal rate.
Arm’s Length Capital
Property of the specified individual, if the property or property for which it is a substitute, was not:
- Acquired by the individual as income (i.e., as a dividend) from another property or as a gain from the disposition of another property where the income or gain was derived directly or indirectly from a related business in respect of the individual;
- Borrowed (including from arm’s length sources); or
- Transferred to the individual by a person who was related to the individual (other than as a consequence of the death of a person).
Related Business
A related business in the context of TOSI means:
A Related Business in respect of an individual includes any business of a corporation where another individual related to the former owns either
- shares of the corporation or
- property the value of which is derived from shares of the corporation and their fair market value is not less than 10% of the fair market value of all of the shares of the corporation.
- business of a sole proprietorship, corporation, partnership, or trust where another individual related to the former is actively engaged in the operation of the business.
Split Income
It can generally include:
- Dividends and shareholder benefits from private corporations;
- Certain partnership and rental income;
- Trust income derived from a) or b)
- Interest on loans to private corporations, partnerships or trusts; and,
- Capital gains on the sale of shares of private corporations.
If the TOSI rules have restricted your ability to do tax planning, you might want to look at other income splitting strategies which don’t fall under the ambit of TOSI rules or Attribution rules (that generally prevent us from income splitting by attributing the income back to the splitter), these are as follows:
Prescribed rate investment loans:
If your spouse or partner has lower income than you, it might be beneficial to deploy a prescribed rate loan strategy whereby you give a loan to your spouse or partner at a fixed prescribed-rate, currently 1%, who can invest the funds in a portfolio of dividend-paying stocks. Any income or gains earned over and above the interest expense will be taxed in the hands of the spouse, regardless of age.
Example:
Andrew, is in the top tax bracket, and his partner, Deena, is in the lowest bracket. Let’s say Andrew loans Deena $200,000 at the current prescribed rate of one percent secured by a promissory note. Deena invests the money in a portfolio of Canadian dividend-paying stocks with a current yield of four percent. Each year, she takes $2,000 of the $8,000 in dividends she receives to pay the prescribed rate interest (on loan to Andrew).
The net tax savings for the couple would be having the dividends taxed in Deena’s hands at the lowest rate instead of in Andrew’s hands at the highest rate. This benefit would be slightly offset by having the $2,000 of interest on the promissory note taxable to Mark, but the interest paid would be tax deductible to Deena, since the interest cost was incurred to earn income.
Pension Income Splitting
The TOSI proposals do not cover the splitting of pension income. Eligible pension income can be split among married and common-law couples to a maximum of 50%.
Spousal RRSP
If you are married or in a common-law relationship, you may choose to direct some or all of your RRSP contribution to a spousal plan to split income in retirement. RRSPs were designed to provide for the long-term goal of retirement. Spousal RRSP is like an investment account for your spouse’s retirement that allows you to contribute and get a tax deduction for contributing. Your spouse will see a tax-free return on that money as well until the spouse withdraws the money. This planning works best if you think that, upon retirement, you will have a higher income or have accumulated more retirement assets than your spouse.
Note that with a spousal RRSP, you can effectively have all of your RRSP/RRIF withdrawals taxed in your spouse’s or partner’s name, whereas with pension-income splitting, can be done only up to 50 percent of RRIF withdrawals.
Income splitting with kids
You can gift capital assets to a minor child by setting up an in-trust account for him or her. Any capital gains (but not interest or dividends) earned in the trust account will not be subject to attribution rules and will attract tax in the hands of your child. Mostly, minor children will have little or no other income and thus pay no tax on the trust income distributed to them.
It is most likely that owners of CCPCs who are not in the top bracket would stop paying dividends to family members who would be subject to the new TOSI rules.
As per PBO it is estimated that the new TOSI rules will bring about $356 million in new federal revenue (2018-19) and will impact about 32,900 families (90 % of these families fall within the income group of $150,000 and $1-million), which works out to an average of $10,820 per family. However, various exclusions and subjectivity in assessing things such as reasonableness will create additional difficulty for multiple stakeholders such as CRA and tax courts in enforcing the rules; and for the taxpayers in applying the rules. This vagueness has created fertile grounds for disagreements between taxpayers and the CRA, with taxpayers seeking to limit the scope of the term. Moreover, small business compliance costs to review all payments going to related parties will significantly increase the red tape burden on small business owners. The new measures do not promote entrepreneurial spirit and might cause flight of capital from Canada– we might feel the consequences in the future years.
If you are an owner-manager, ensure that you are discussing your case with your CPA to take proactive planning steps and avoid any unwarranted surprises come tax time.
Works Cited
Guidance On The Application Of The Split Income Rules For Adults. (n.d.). Retrieved from www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/guidance-split-income-rules-adults
Income Sprinkling using Private Corporations (n.d). Retrieved from http://www.pbo-dpb.gc.ca/web/default/files/Documents/Reports/2018/Income%20Sprinkling/Income-sprinkling%20Using%20Private%20Corporations%20_EN_Updated.pdf
This article is being provided as general information only and is not meant as legal opinion or advice. Cloudiverse CPAs Inc cannot accept any liability for the tax consequences that may result from acting based on the information contained therein. Each situation is unique and should be reviewed on its own with the proper attention and care it deserves.Please contact any member of our team if we can be of further assistance in this regard.