On December 13, 2017, the government released new proposals designed to prevent income splitting using private corporations. Originally included as part of the July 18, 2017 private company consultation paper issued by the Department of Finance, the proposed new rules simplify what was initially announced. The new rules were passed into law on June 21, 2018, with only a few minor modifications to the December proposals, and are effective January 1, 2018.
The purpose of this article is to address some questions that have come up since the new rules were released.
How do the new rules work?
The government's objective is to eliminate the tax benefits of income splitting where the recipient of the income (a related family member) has not made a sufficient contribution to the family business. To accomplish this, they are extending the Tax on Split Income (TOSI) rules to apply to certain income received by Canadian resident adult individuals as well. The TOSI rules previously only applied to individuals who were under the age of 18. Any income taxed under the TOSI rules is subject to tax at the highest personal marginal tax rates, eliminating any advantage achieved from income splitting.
The TOSI rules will potentially apply to essentially any income amounts, dividends and capital gains that are considered "split income." This generally includes the following:
- Dividends and shareholder benefits from a private company;
- Income received from a partnership or trust where the income was derived from a related business, or the rental of property in certain cases;
- Income on certain debt obligations (e.g., interest); and
- Income or gains from the disposition of certain property disposed of after 2017.
However, the rules provide a number of exclusions, some of which are "bright-line" tests. If the conditions for one of the exclusions are met, the TOSI rules should not apply. Note that for adult individuals, amounts will generally only be captured in split income if they are derived from a related business.
In this article, we will not go through all of the exclusions — rather, we will focus on three main exclusions and also how the TOSI rules impact the taxation of capital gains. This will provide further insight on how these exclusions are intended to work, as well as highlight some issues and uncertainties. Notable exclusions not addressed in this article include: the ability to split income with a spouse — once a business owner reaches 65 years of age, income and gains on inherited property (where certain conditions are met), and deemed taxable capital gains realized on death.
Exclusion from TOSI for "excluded businesses"
We have had a number of questions in this area. The exception for excluded businesses focuses on the contribution of an individual to the business. The first thing to keep in mind is that the new rules do not apply to wages paid for work performed. Salaries and wages have always been subject to a reasonableness test — generally, a tax deduction will not be allowed to the business for amounts paid in excess of a reasonable amount as wages, while the recipient is still fully taxable on what they receive. Let's consider dividends received from the family business by adult family members, which will be subject to the new rules.
The excluded business exception can apply to any family member who is 18 years of age or older. To qualify for this exclusion, the family member must be engaged on a regular, continuous and substantial basis in the business. This can be proven on a factual basis or by meeting a threshold of having worked on average at least 20 hours a week in the business in the current year, during the part of the year in which the business operates. This exclusion will also be met if in a total of 5 previous taxation years of the individual the 20 hour per week test has been satisfied. Note that this is true even if these 5 years occurred any time in the past. The 5 years do not have to be in succession. Therefore, if the family member has worked at least 20 hours a week on average in 5 years at any time in the past, any dividends they receive now or in the future from the family business will generally not be subject to TOSI.
The question then is how do you prove that the business is an excluded business for any individual. To meet this exclusion, likely the best way is to have evidence that the average of 20 hours a week test was met. Time records would be ideal, but this is often not available in a family business context. It has been unclear what type of evidence the Canada Revenue Agency (CRA) will require for past years, where records may be difficult to obtain, if you are relying on the fact that the test was met in 5 previous taxation years. The CRA recently commented that they understand the challenge of providing historical documentation for years prior to 2018. As a result, they have indicated they will consider all information that can be made available about the history of the business and involvement of family members, and are generally widening the factors they will consider where pre-2018 historical time records do not exist. If you intend to rely on this exclusion going forward, be prepared to document the hours that family members are spending working in the business.
Exclusion from TOSI for "excluded shares"
An exclusion from TOSI applies for income from, or capital gains from the disposition of, excluded shares held by individuals who are 25 years of age or older. In order for shares to be considered excluded shares, the following conditions must be met. The individual must hold shares that represent at least 10% of the votes and value of the company (these shares can be separate from the excluded shares of the company). In addition to this requirement, the exclusion only applies to shares of corporations where less than 90% of the business income of the corporation is from the provision of services, and where 90% or more of all the income of the corporation is not derived directly or indirectly from one or more other related businesses of the individual (outside of the corporation). Excluded shares also do not include shares of a professional corporation.
Based on the votes and value condition, individuals holding shares through a trust will not be able to rely on this exclusion, as it appears that a direct holding of shares is a requirement. Where planning makes sense and is available, a rollout of shares to trust beneficiaries could allow for directly holding excluded shares to avoid TOSI.
This exclusion will not apply to shares held in service businesses due to the 90% condition requiring a look at business income from services. This 90% condition raises some uncertainties in terms of the breadth of businesses that could be captured as a service business since "the provision of services" is not specifically defined in the tax rules. This condition will also result in additional compliance for some service businesses which earn business income from sources other than services as well, as tracking of service income will be necessary.
In addition, this exclusion requires a look at whether the corporation is earning income derived from another related business. According to the government papers, this particular condition is meant to prevent splitting a service business into services and non-services parts using holding companies or sister companies (known as "side-car" structures). However, holding companies are often used in family planning structures for other purposes. It may be the case that the 10% votes and value requirement is met in terms of individuals holding shares of a holding company. However, to meet the exclusion, less than 10% of the income of the corporation can be from another related business outside of the corporation. Therefore, for a holding company, it will be necessary to consider all income, including dividend income received by a holding company from an operating company, to determine whether or not the exclusion will apply. The CRA has confirmed that it will be difficult for shares of a holding company to be excluded shares where the income of the holding company is dividend income received from a subsidiary operating company that is a related business.
As a last note, the 10% votes and value requirement of the shareholder generally applies at the time the income is received. However, for 2018 only, a special transitional rule applies for the purposes of this condition. The transitional rule will allow this condition to be applied at the end of the year. For example, if an amount is received in 2018, and at the time of receipt the taxpayer does not own 10% of the votes and value of the company, the amount received could be excluded from split income (so that TOSI doesn't apply) in 2018 if the taxpayer increases their votes and value ownership to 10% by the end of 2018.
Exclusion from TOSI for "reasonable returns"
If you don't meet the excluded business or excluded shares exceptions, there is another exception based on a reasonable return that can apply for adult family members who are 25 years of age and older. For example, a reasonable amount of dividends can be paid to these individuals and not be subject to TOSI if the amount paid represents a reasonable return on their contribution to the business. This reasonable return will take into account a number of factors including the work performed for the business. The other factors include the property contributed by the individual to the business, the risks assumed by the individual in respect of the business, the historical payments that have been made to the person in the past for their contributions, and other relevant factors.
Summary of the three exclusions above
When considering whether dividends on private company shares are effectively excluded from the TOSI rules, it may be easier to qualify for the excluded business exception as it provides a "bright-line" test. Prove you have worked an average of 20 hours a week in the business in the current year or in 5 previous taxation years and the TOSI rules do not apply. The excluded shares exception has also been provided as a bright-line test for individuals 25 or older. However, with multiple conditions to meet, it appears limited to non-service businesses earning income from third parties with simple direct shareholding structures. The excluded shares exception will be difficult or impossible to access by individuals in many family business structures that use holding companies and trusts, or that earn service income or income from a related business. If you can't meet one of these two exceptions and are 25 years of age or older, then your dividends can still be excluded and not subject to the TOSI rules, but it will require you to prove a reasonable return based on the above criteria — a much harder task.
Note that for adult family members aged 18 to 24, there are further restrictions on what exclusions may apply to avoid the TOSI rules. If a family member in this age group doesn't qualify for the excluded business exception (as discussed above), then it will be necessary to determine if they contributed capital to the business as this may allow for another exclusion to apply. These include an exclusion for a safe harbour capital return or an exclusion for a reasonable return in respect of contributions of arm's length capital made by the individual in support of the business. These are more limited exclusions, making it more difficult for this age group to avoid TOSI.
What is the impact of the TOSI rules on gains?
Under the new rules, split income has been expanded to capture capital gains (or profits) realized directly, or distributed through a trust, from the disposition after 2017 of certain property. For family businesses, this will include gains on the disposition of private company shares. If such gains are considered split income, an exclusion may be available so that TOSI does not apply.
Most importantly for family businesses, the changes to the TOSI rules will generally not limit access to the lifetime capital gains exemption (LCGE). This is a significant change from the first round of private company tax proposals released in July 2017. Under the changes now passed into law, there is a specific exclusion from the TOSI rules for taxable capital gains from the disposition of qualified farm or fishing property or qualified small business corporation shares. This will enable families to continue to plan using the LCGE. Although it is necessary for the property to qualify for the LCGE for the exclusion to apply, the LCGE doesn't need to be claimed, meaning all of these eligible capital gains are not subject to TOSI (with one exception for minors).
In circumstances where a gain is not eligible for the LCGE, it is possible that another one of the exclusions previously discussed may apply to avoid TOSI. Note that if the excluded business conditions are being considered — the individual must satisfy the 5 previous year test to meet that exclusion. This means that the individual needs to make a meaningful contribution to the business either factually, or by meeting the average 20 hour a week test in 5 previous taxation years. You cannot apply the test for just the current year for gains.
For minors, there is another rule to keep in mind when it comes to the LCGE. The pre-2018 TOSI rules re-characterize certain capital gains realized by minors on non-arm's length transfers into taxable dividends. This rule will continue to apply to minors (only) post-2017, and as a result, the LCGE will not be available in these circumstances, as these gains will instead be treated as ineligible dividends.
The proposed new rules to prevent income splitting, while simplified from the initial July 2017 proposals, continue to have many issues and uncertainties.
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.
