Income Splitting Canada: New Income Splitting Rules (TOSI)
What Do The New Income Splitting Rules in Canada Mean For Me?
On December 13, 2017, the Federal Canadian government released new income splitting rules proposal designed to prevent income splitting using private corporations. These proposals were originally announced as part of the July 18, 2017 Private Company Consultation Paper issued by the Department of Finance.
The original income splitting rules proposals in July were met with significant criticism and opposition from business owners. In fact, the Federal Government of Canada received a whopping 21,000 submissions from the Canadian public outlining their concerns in respect of these new proposals.
The proposed new income splitting rules released in December 2017 simplify what was initially announced, and are to be effective January 1, 2018. The purpose of this article is to clarify the changes to the Tax on Split Income regime in Canada effective January 1, 2018 and to explain the ways in which you can continue to income split with your family.
What the New Income Splitting Rules Seek to Achieve
The government’s central 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. ‘Income Splitting’ refers to the ability of a business owner to ‘sprinkle’ bits of income to various members of his or her family including children, brothers, sisters and parents, so as to reduce that business owner’s overall tax obligation.
To illustrate, if Bob earned $100,000 in dividend income from his corporation in Ontario, he would pay approximately $17,067 in tax in that year.
However, if Bob distributed (sprinkled) $20,000 of income to his daughter, $20,000 to his son and $20,000 to his spouse, Bob would only pay tax on $40,000 (while his family members paid tax on their respective $20,000). On the $40,000 that Bob took as dividend income, he would only pay $1,497 in tax.
Each of his children and spouse would only pay $192 in tax on their $20,000 income. Multiply this by three, and the children/spouse pay only $576 in tax combined. When adding all of the tax obligations of the family together, Bob only pays $2,073 in tax ($1,497 + $192 + $192 + $192) on his $100,000 of dividend income (instead of $17,067 if he hadn’t used income sprinkling); thereby saving $14,994 in tax in that one year. This is a significant tax saving.
The Federal government was concerned that business owners were able to shift their income to achieve these tax advantages, but yet these tools were not available for mere employees of the same corporation. The employee had to pay tax on the entire amount of his or her salary and was unable to shift the income or tax liability to his or her family members.
For this reason, the Federal government announced its proposal to eliminate the use of income sprinkling where the family members do not contribute to, or work for, the family business.
The Previous Income Splitting Rules
Tax on Split Income (TOSI) is not a new concept. Previously the TOSI rules applied only to shifting income to a child who was under the age of 18. When this occurred, the child would be subject to tax at the highest marginal rate – essentially taxing the child as if the income was received by the parent in the high tax bracket. Known as the “Kiddie Tax”, this virtually eliminated the use of income sprinkling with children under the age of 18.
Essentially, the new rules extend the Kiddie Tax to individuals of all ages if they do not work for the family business.
The New Income Splitting Rules
The TOSI rules will potentially apply to any income amounts received from the family corporation including dividends and capital gains. However, notably, the rules do not apply to salary received by family members.
Salaries and wages have always been subject to a reasonableness test. The reasonableness test looks to the amount paid to the family member compared to the actual work performed. If the amount paid to the family member is well in excess of the going rate for that same type of work, a tax deduction will not be allowed to the business for amounts paid in excess of a reasonable amount as wages. However, the individual is still fully taxable on what they receive.
The new TOSI rules thus primarily affect dividends and capital gains.
How Does TOSI Work?
What TOSI does is apply Tax on Split Income at the highest marginal rate to the individual recipient (the family member). This virtually eliminates the entire advantage of income splitting thereby curbing the use of this tax planning technique. It also causes the taxpayer to pay a higher tax than he would have had he not attempted to income split.
To illustrate the effect of using the highest marginal rate on the income received using the example above, each of the three family members would be subject to the top marginal rate of 53.53%, meaning they would pay approximately $17,236.80 in tax on their $60,000 of ineligible dividends. Bob would pay $11,491.20 on his $40,000. As a result, Bob would pay a total of $28,728 in tax on his $100,000. If Bob had not attempted to income split, he would pay only $17,067 in tax on that same $100,000 of ineligible dividends. This punitive TOSI tax is meant to punish Bob for attempting to income split with his family members by requiring him to pay an additional $11,661 in tax in that year.
It Works Backwards
As always in law, politics and government, the legislation is unnecessarily overcomplicated. Rather than create a law that explicates the precise circumstances where Tax on Split Income would arise, the rules work backwards. Instead, the government chose to apply the punitive Tax on Split Income to ALL income (dividends and capital gains) received by individual family members from a corporation. Then, the government carved out exceptions where TOSI would NOT apply.
These exemptions, or exclusions are known as “bright-line” tests. If the conditions for the exclusions are met, the TOSI rules will NOT apply.
Rather than discussing all of the exclusions, we will discuss only the four most pertinent exclusions that allow individual family members to continue to income split using dividend or income sprinkling.
1. Exclusion #1 – The Excluded Business Exception (for individuals aged 18+)
The excluded business exception will 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.
This exclusion will also be met if, in a total of 5 previous taxation years, the 20-hour test per week has been satisfied. Note that this is true even if these 5 years occurred any time in the past, and the 5 years do not have to be in succession (so, it can be 5 out of the past 20 years). As a result, 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 not be subject to TOSI.
How do you Prove it?
The question then is how do you prove that the business is an excluded business for any individual? It is also unclear what type of evidence the Canada Revenue Agency will require, especially in the context of evidencing the contribution for past years where records may be difficult to obtain. As this is new law and the CRA has not yet put forth precise criteria required in order to meet this requirement, our advice is that the best evidence remains to be contemporaneously recorded books and records.
We advise to begin to keep a time log and work description for each family member receiving income from the corporation (other than salary). This log should be updated on a daily or weekly basis.
If your business is prompted to produce these records to the CRA to evidence that your business meets this exclusion, the CRA has the ability to access the documents’ meta data or test the paper’s age to determine when the workbook, record or ledger was created. If the record was indeed created contemporaneous with the work rendered, and updated each day or week, you will easily be able to establish that the records are true and accurate. We maintain that in the absence of contemporaneous records, it would be extremely difficult to demonstrate the hours works or work performed for each family members for the preceding number of years. Our advice – begin to keep a log today!
2. Exclusion #2 – The Excluded Shares Exception (for individuals aged 25 +)
An exclusion from TOSI applies for income or gains received on excluded shares held by individuals who are 25 years of age or older. ‘Excluded Shares’ means the shares represent at least 10% of the votes and value of the corporation.
In addition, the entire corporation must meet a threshold test. 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 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.
In plain English, this means that the corporation is in the business of selling goods or is otherwise not in the business of the provision of services.
As well, professional corporations do not qualify for the exclusion whatsoever. This means professional corporations will not be able to income split under this exemption whatsoever.
Regarding the votes and value condition, we note that the law requires that the shares held by the individual family members are held ‘directly’. This means individuals holding shares through a trust will not be able to rely on this exclusion. This can have a huge impact on tax planning techniques as it may no longer be advisable to institute a family trust to hold the shares of the family business, where each family member become a beneficiary of the trust to multiple the Lifetime Capital Gains Exemption (LCGE). For more information on the LCGE, read our article here.
As a last note, the 10% votes and value requirement of the shareholder generally applies at the time the income is received.
3. Exclusion #3 – The Reasonable Return Test (for individuals aged 25 +)
If you don’t meet the first two exemptions, there is another exception based on a reasonable return that can apply for adult family members who are 25 years of age and older. 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 or the safe harbor capital 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.
Safe Harbour Capital Return
A safe harbor capital return is determined as the return on property contributed by the specified individual to the related business. The formula to make this determination is the result of Y x Z, where:
- Y is the highest prescribed rate of interest in effect for a quarter in the year; and
- Z is the fair market value of the property contributed by the individual, then pro-rated for the number of days the property was used in the related business in the year.
To illustrate, say Johnny contributes $25,000 in property to the family business and the property was used during the entire year. The prescribed rate at present time is 2%. One must then calculate $25,000 x 2% x 365 days/365 days = $500. Johnny may be allowed to receive $500 in that year without the TOSI rules coming into effect.
4. Exclusion #4 – Taxpayers with Spouses Aged 65 or Older
The rules for this exclusion is simple: The TOSI rules will not apply on income received by the spouse if the spouse is at least 65 years old in the particular year. This exemption allows a business owner aged 65 or older to income split with his or her spouse without having to worry about the punitive Tax on Split Income rules.
Summary of New Income Splitting Canada Rules
In summary, an individual will NOT be subject to the punitive Tax on Split Income where:
- The individual is over the age of 18, and he or she worked for the business for an average of 20 hours per week, in the present year, or in 5 non-cumulative preceding years.
- The individual is over the age of 25 and owns more than 10% of the votes and value of the shares of corporation directly (not through a trust) and the business is not in the provision of services, and the corporation is not a professional corporation.
- The individual is over the age of 25 and the income represents a reasonable return or safe harbor capital return on his or her investment.
- The individual is over the age of 65.
Income Splitting Still Available in Canada
Good news – This means income splitting is still available in Canada. It is extremely important however to structure your corporation so that your family members meet the tests outlined above. You have until the end of 2018 to ensure this structure is established, or the income received by your family member through traditional income splitting methods will be subject to the highest marginal tax rate (53.53%). Contact us today for how we can structure your small business corporation to avoid the new punitive Tax on Split Income rules.
Prior to January 2018, a business owner could lower his tax bracket by income splitting to family members who were more than 18 years of age. Under the old regime, the CRA would penalize income splitting to family members under the age of 18 by taxing any dividends, interest, and capital gains transferred to the child at the highest marginal tax rate, currently at 53.53%. Under the current TOSI regime, this punitive measure extends to children who are older than 18 years of age, unless the exclusionary rules apply.
Exclusion Rule #1: The family member is 18 years of age or older and has a “regular, continuous, and substantial” stake in the business. This standard is based on working at least 20 hours per week in the business in any previous 5 years of the business (even if not consecutive). In order to prove this, it is advisable to keep records or logs of the number of hours that family members work in your business contemporaneously to their work.
Exclusion Rule #2: The family member is 25 years of age or older and owns at least 10% of the corporation’s shares and votes directly (i.e. not through a trust), and where the corporation is a private corporation (ie. not a professional corporation) that derives its income primarily from the sale of goods (i.e. where less than 10% of its income comes from the provision of services) and where the corporation does not earn income directly or indirectly from another business owned by the corporation.
Exclusion Rule #3: The family member is 25 years or age of older and is receiving dividends of the family corporation based on a “reasonable return” on his work or “safe harbor capital return” on the contribution of property.
Exclusion Rule #4: The owner of the corporation who wishes to income split with a lower income earning spouse is at least 65 years of age or older.
–Shira Kalfa, Founder, BA, JD
© Kalfa Law, 2020
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.