In recent Tax Alerts we discussed the tax on split income (TOSI), which limits income-splitting techniques involving private corporations by taxing amounts received at the highest marginal tax rate. The rules are complex and, to date, the Canada Revenue Agency (CRA) has provided only limited guidance on their application.
In a recent Technical Interpretation (2018-0761601E5), the CRA considered a situation in which a corporation operates two separate and distinct lines of business. The spouse of the business owner works 25 hours per week in the corporation's property management business, but does not work at all in the corporation's construction business. The CRA was asked to clarify how the "excluded business" exception to the TOSI rules would apply to payments made to the spouse.
To meet the excluded business exception to TOSI, an individual must be actively engaged in a business on a regular, continuous and substantial basis either in the current year or in any five previous years. There is a deeming rule (a so-called "bright-line" test) whereby this exception is met if the individual worked, on average, 20 hours per week during the portion of the year the business operated. If this exception applies, the individual will not be subject to tax at the highest marginal rate on income received from the business.
In the interpretation, the CRA adopted the view that any income received by the spouse that is derived directly or indirectly from the property management business, being the line of business in which the spouse is actively involved, will be income from an excluded business and will therefore not be subject to TOSI. Any income of the spouse that is derived from the construction business will not meet the excluded business exception and will be subject to TOSI unless another exception to TOSI applies. The CRA indicated that separate accounting for each business will be required in order to properly trace the source of the income.
While any guidance from the CRA on the application of the TOSI rules is welcome, the requirement to maintain separate accounting for each business will add to the already high tax compliance burden that all owners of incorporated businesses face. Owners of corporations with more than one business who want to rely on the excluded business exception to TOSI must carefully consider how overhead costs and other expenses are to be allocated among each line of business, being mindful that the CRA could challenge that allocation. This requirement is in addition to maintaining adequate records to prove that the excluded business exception is met, including timesheets, schedules or logbooks sufficient to establish the number of hours an individual worked in a given year.
Even with this guidance, business owners continue to face uncertainty. The CRA's interpretation is in the context of a single corporation operating two separate businesses. On the question of whether a taxpayer is operating more than one business, the CRA's archived Interpretation Bulletin IT-206R states that "Whether the carrying on of two or more simultaneous business operations by a taxpayer is the same business is dependent upon the degree of interconnection, interlacing or interdependence and the extent of the unity embracing the business operations." There appears to be no bright-line test in determining whether one or more businesses exist.
Furthermore, the CRA has not fully clarified exactly how TOSI would or could apply to a dividend to the spouse in these circumstances. Once a separate accounting is completed for each business, does the annual income from the property management business contribute to a "pool" that accumulates and can be drawn from at any time, such that TOSI will not apply to any dividends to the spouse so long as they do not exceed this pool? Or alternatively, are payments to the spouse pro-rated based on the corporation's earnings of each business, such that part of each dividend is not subject to TOSI while the remainder is? While it is reasonable to argue that the former is the fair and correct answer, some confirmation from the CRA would be appreciated.
Finally, it remains unclear how the CRA's position would apply where these businesses are in separate corporations with a common holding company. Assume, for example, that the property management business is carried on through one corporation, the construction business through another corporation, and these two corporations are 100 per cent owned by a holding company. If the spouse is a shareholder of the holding company only, would a dividend to the spouse meet the excluded business exception to TOSI so long as it does not exceed the underlying earnings of the property management company? Must a dividend first be paid from the property management company to the holding company? Until the CRA provides some guidance, owners of incorporated businesses will continue to face more uncertainty than ever before.
The TOSI rules can present challenges to business owners. Contact your Collins Barrow tax advisor for guidance and to discuss other possible exceptions to these complex rules.
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