Canada: Finance Releases Updated Legislation To Limit Income Splitting

Last Updated: December 18 2017
Article by MaryAnne Loney and Mike Harris

On December 13, 2017, the Government released updated proposed legislation in respect of the tax on split income ("TOSI"). This legislation is a revision to the proposed changes introduced in July, 2017, and implements a number of changes that the Minister of Finance suggested in October would be forthcoming (for our October article see here).

Current TOSI

TOSI as currently drafted limits the ability to split income with minor children for the purpose of taking advantage of the child's lower marginal tax rates. Any "split income" of the child is taxed at the highest marginal rate, eliminating any benefit from splitting the income.

TOSI currently applies to income earned by children under 18 from certain sources, including dividends on shares (other than publicly listed securities), shareholder benefits, or income earned by a partnership or trust where the income can reasonably be considered to be derived from the provision of property or services of a related individual.

July 2017 Proposed Expansion to TOSI

In general, the July proposed legislation expanded TOSI to adults, and was proposed to apply to a number of sources, including dividend income earned from family businesses, unless the amount of the dividend paid was "reasonable". The proposed changes would also treat capital gains on shares of family businesses and income earned on previous TOSI as items to which TOSI would apply. Tax practitioners, including our tax lawyers at McLennan Ross LLP, had serious concerns as the proposed legislation was incredibly complex and added significant uncertainty to paying out dividends to related shareholders. (For a more detailed review of the July proposals, see our updates here).

Related July 2017 Concerns

In addition to the TOSI rules, the July proposed legislation introduced rules to greatly reduce the ability of family members who are not actively involved in the family business to use their lifetime capital gains exemption when the shares of the family business are sold. These proposed changes would also have greatly limited the ability to access multiple lifetime capital gains exemptions through the use of a family trust.

Our primary concerns with the July 2017 TOSI proposed legislation were:

  • It was not clear what the Canada Revenue Agency would consider to be "reasonable" in respect of dividends, interest income and capital gains. These concerns have been somewhat addressed as detailed below, though questions remain.
  • The complexity of the new rules would create a significant compliance burden. This has been largely addressed, though where TOSI could potentially be an issue, some additional analysis and record keeping will still be needed.
  • The proposed limitations on accessing the lifetime capital gains exemption would make transferring shares to the next generation more difficult. These proposed limitations have been eliminated.
  • As there is no grandfathering to protect gains already accrued prior to 2018 which will now be caught by TOSI, family owned corporations will have to consider what to do with shares already owned by shareholders which would be caught by the new TOSI rules. This is less of an issue under the most recent version of the legislation as fewer people will be caught by TOSI, but it is still potentially an issue for some people.

Excluded Amounts and Reasonableness

The new legislation provides some clear exclusions as to what is not caught by TOSI. These exclusions cover many of the circumstances tax practitioners were concerned about. In particular:

  • Income and gains on inherited property will generally be exempt from TOSI if the individual inheriting the property is 24 or younger and inherited the property from his or her parents. Inherited property will also generally be treated to more relaxed rules in other cases, with recipients being eligible for the same exclusions and reasonableness tests as the deceased.
  • Capital gains arising as the result of a death of an individual are not subject to TOSI.
  • Property acquired in a separation or divorce (by judgment or written agreement) will be exempt from the TOSI rules.
  • Capital gains on the shares of a qualified small business corporation share, qualified farm property, or qualified fishing property are not subject to TOSI and are instead treated as ordinary capital gains under the existing rules. Most importantly, these gains continue to be eligible for the lifetime capital gains exemption. A related rule ensures that planning through a family trust to access the lifetime capital gains exemption is also permitted.
  • Amounts derived from an "excluded business" are not subject to TOSI. Excluded businesses are those where the individual was at least 18 years of age and actively engaged on a regular, continuous and substantial basis ("Actively Engaged") in the activities of the business in the taxation year or in any five prior taxation years of the individual. Helpfully, the draft legislation provides a bright-line test that says that 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.
  • Amounts derived from "excluded shares" of a corporation owned by an individual over 25 are exempt from TOSI. A shareholder will own excluded shares of a corporation where:
  • the corporation is not a professional corporation, and less than 90% of the corporation's business income was from the provision of services (i.e. if the corporation has business income, at least 10% of that business income is from providing goods);
  • the shares 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 in respect of the individual.

Taxpayers will have until the end of 2018 to meet this qualification.

This exception only applies to income of an individual, where that individual owns the excluded shares. Finance guidance indicates that this definition will not be satisfied where a trust owns the shares and income is allocated to the beneficiaries of the trust. This means that even if the trust's ownership meets the excluded shares definition, any income allocated to beneficiaries will not be excluded because the beneficiaries do not themselves own 10% of the shares. This is likely to cause significant problems where there are non-tax reasons to have legal ownership of shares of a corporation separate from beneficial ownership (for example, disability trusts).

There is an exception for retired or deceased spouses. Where one spouse or common-law partner is 65 or older, and any income earned by that spouse would be an exempt amount (for example, if that spouse had at least five years of actively running the business), any income earned by the second spouse is exempt from the TOSI rules. This is intended to align with existing pension-splitting rules. A similar rule applies if the actively involved spouse has died.

Further, Finance has provided numerous examples that suggest the application of TOSI will end up being fairly limited.

What to do with existing shares caught by TOSI

One of our major concerns in 2017 was what should shareholders do with shares that are caught by TOSI, and more importantly, should they get rid of them prior to 2018.

This question was further complicated by the fact that gains on shares caught by the July TOSI rules that result from transfers to non-arm's length parties were going to be taxed as dividends, rather than capital gains. This gave a terrible tax result. As a result, our advice was that there may be an advantage in getting rid of the shares in 2017, although it would be impossible to know for sure until we knew more.

Luckily, this proposed dividend tax treatment of capital gains has been eliminated except for transfers from children under 18. As a result, the worst consequences of not having disposed of shares in 2017 are eliminated.

As the application of the TOSI rules appears to be quite limited, we do not believe that disposing of shares in 2017 will the best option in many circumstances. Instead, it may be preferable to consider many other planning techniques in 2018 to attempt to bring the share ownership outside of the TOSI Rules.

What to do in 2018

  1. Review ownership and shareholder contributions with your tax advisor to determine whether any shares will be caught by TOSI.
  2. Determine if the corporation should reorganize its share structure in order to be able to take advantage of the excluded shares provision. Note that for 2018 it is the share ownership at the end of the year that determines whether the shares are excluded shares, so there is an opportunity to reorganize in 2018 and avoid the TOSI rules.
  3. Review shares held in family trusts to determine what should be done with those shares. Potentially, shares should be rolled out to beneficiaries so they may take advantage of the excluded shares provision. Alternatively, the corporation may choose to not pay dividends on the shares to beneficiaries in the interim with the plan of potentially rolling them out to beneficiaries in the future.
  4. Stay tuned to our updates... While this legislation has answered many questions, further questions remain. We also anticipate the Government will be releasing their legislation on the taxation of passive investments in corporations with the 2018 budget.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
MaryAnne Loney
Mike Harris
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