Overview of the Tax on Split Income (TOSI)
Income splitting (also known as income sprinkling) is a strategy that can be used by high-income owners of private corporations to divert their income to family members with lower personal tax rates, thereby decreasing the family's tax burden overall.
The federal government issued draft legislative proposals designed to limit income splitting on July 18, 2017. Prior to these changes, legislation imposed a tax on split income in order to disincentivize income-splitting arrangements with minor children who were residents of Canada.
The tax on split income, as outlined in section 120.4 of the Income Tax Act, took effect on January 1, 2018. The new legislation expands the category of individuals subject to the TOSI to include children who are over 18 and other related adult individuals who are residents of Canada, as well as adding several exclusions.
Income Exempt from the TOSI: A Brief Summary
Split income is defined in s. 120.4 as income from a nonpublic corporation, a partnership or a trust. It also includes the income or gain from the disposition of property that took place after 2017, where the income from that property would be subject to TOSI.
The following is a summary of each condition and, if available, information on the subjective tests involved in determining eligibility. In the following list, the "individual" refers to the person who is receiving the split income. Income is considered exempt from TOSI if:
- The individual is over 18 and is not related to anyone who owns, is actively engaged in, or has an interest in the business
- The individual has a spouse or common law partner over the age of 65, and if the income would be excluded in the hands of the individual's spouse or common law partner
- The individual has a deceased spouse or common law partner, and if the income would be excluded in the hands of the individual's spouse or common law partner
- The individual is 18 or older, and is actively engaged on a regular, continuous and substantial basis in the business in either the current year or any five previous but not necessarily consecutive years. An individual is deemed to be actively engaged on a "regular, continuous and substantial basis" if they work in the business at least an average of 20 hours a week during the part of the year in which the business operates.
- The individual is 25 or older, directly owns at least 10% of the shares of the non-public corporation and if the shares meet the requirements for excluded shares. Shares are considered excluded under the TOSI if the corporation earns no more than 90% of its business income from the provision of services, is not a professional corporation, and if at least 90% of the corporation's income is not derived from one or more related businesses.
- The income received or gain realized is inherited property, if the individual is 25 or younger, and if the individual is either a full-time student enrolled during the year at a post-secondary educational institution or qualifies for the disability tax credit
- The individual is either realizing
taxable capital gains on the arm's length disposition of
qualified small business corporation shares or qualified farm or
fishing property or realizing taxable capital gains on the deemed
disposition of property on their death
- These exclusions apply to minor children except for actual dispositions to non-arm's length parties
- The individual is receiving income derived from the property acquired as a result of a breakdown of a marriage or common-law partnership
- The individual is 25 or older and receives split income that is considered a "reasonable return". This test is based on the extent of their contribution of labour and capital to the business, the risks taken, and other payments already received from the business. The TOSI will apply to split income to the extent that it is unreasonable.
- The individual is 18 or older, and is receiving income or taxable capital gains from the disposition of inherited property where the deceased would have met the active engagement threshold under the excluded business test, the excluded shares provisions, or the reasonable return provisions.
Complexities of the Legislation
The sheer volume of exclusions outlined in section 120.4 makes the rules complicated to navigate, even for experts of the TOSI. The new regulations raise significant challenges for tax planning as they may have unexpected consequences for taxpayers, particularly if family businesses are carried out through holding or investment companies, or where shares are held by a family trust.
Tax planning with the TOSI requires familiarity with the complete set of exclusions. Without familiarity with the numerous provisions, an income that falls under an exclusion could be improperly taxed. The consequences of not understanding whether income is taxable under the new rules are clear: split income is taxed at 33%, the highest marginal federal tax rate for 2019.
The complexity and novelty of the TOSI, in combination with its tax consequences affecting a wide range of private business structures, present several challenges for tax professionals. The first, and most obvious, is the potential of taking a narrow view of the TOSI exclusions and missing potential applications in tax planning. Second, the process of checking novel tax situations against a complicated set of rules requires significant time and resources to ensure accuracy and compliance. Inefficiencies arising from navigating complicated legislation reduce the time available for other tasks that require more creative applications of expertise.
The TOSI Navigator
Developed in partnership with leading tax advisory firm Moodys, Tax Foresight's new TOSI Navigator allows tax professionals to circumvent those issues. This dynamic tool was designed to be an interactive and user-friendly version of the Moodys integral flowchart, which has been adopted as the industry standard for financial professionals across Canada.
The TOSI Navigator takes the user step-by-step through the regulations, addressing the inclusion and exclusion criteria and customizing its subsequent queries to the user's particular tax situation as more questions are answered. The process eliminates potentially confusing factors that are inapplicable in each unique tax situation and only asks questions that are relevant to clarifying whether the relevant income is subject to the TOSI.
Using the navigator provides many benefits for tax practitioners. It eliminates inefficiencies in the process of determining whether exclusions apply, allowing users to work more efficiently and accurately. No longer overtasked with inefficient navigation of legislation, professionals can turn their attention to applying more of their expertise to clients' situations. The navigator also incorporates CRA interpretations for better comprehensibility and quality assurance, allowing professionals to increase their mastery of the legislation and ensure efficient, accurate client advice.
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.