New tax rules are often accompanied by uncertainty until they’ve been tested, and the expanded rules for tax on split income (TOSI), effective for 2018, are no exception.
To provide clarity on TOSI and other tax topics, the CRA answered questions posed by members of the Canadian branch of the Society of Trust and Estate Practitioners (STEP Canada) at the society’s national conference in Toronto on June 6 and 7.
The annual CRA roundtable featured manager Steve Fron and industry sector specialist Marina Panourgias from the Trust Section II, Income Tax Rulings Directorate. Asking the questions were perennial panellists Michael Cadesky of Cadesky Tax and Kim Moody of Moodys Gartner Tax Law.
At the event, Fron stressed that his and Panourgias’s comments were conversational, and full written responses would be submitted to STEP Canada later this year. Both CRA reps stressed that each case is fact-dependent.
Under the expanded rules, TOSI may apply when a client receives dividends or interest, or realizes a capital gain, from a private corporation, and a family member is actively engaged in the corporation’s business or holds at least 10% of its value. A typical situation involves a business owner aiming to split income by paying dividends to family-member shareholders.
Here’s what the CRA had to say about TOSI exclusions in certain client situations.
Meeting the labour test where a business runs on less than 20 hours per week of labour
The rules say TOSI can be avoided where a business owner’s spouse or children (age 18 or older) are actively engaged in the business on a “regular, continuous and substantial basis,” with an average of 20 hours per week considered the threshold. This labour requirement is known as the excluded business exemption.
The CRA confirmed that a business that requires fewer than 20 hours of labour per week can still avoid TOSI. The example given at the roundtable was a business owned by a husband and wife that requires only 10 hours of work per week, with each spouse contributing five hours.
The possibility exists for both spouses to be considered actively engaged in the business even though the bright-line test isn’t met, Fron said. To make the determination for any particular year or subsequent year, “consideration has to be given to the ongoing nature and labour requirements of the corporation’s business,” he said.
Additional CRA comments accompany a similar situation described on the CRA’s website (Example 9).
Fron also said that assessing a family member’s labour contributions ultimately depends on circumstances, including “the nature of the individual’s involvement in the business — so, the work and energy that the individual devotes to the business — and the nature of the business itself. The more an individual’s involved in the management and/or current activities of the business, the more likely that the individual will be considered to participate in the business.”
Meeting the labour test to avoid TOSI on dividends
The next example provided by STEP Canada was a professional corporation where the business owner owns all the voting common shares and the spouse owns non-voting preferred shares. The spouse works in the corporation as a receptionist for at least 20 hours per week and receives dividends of $150,000 annually. A receptionist working similar hours would be paid an annual salary of $18,000, STEP Canada said. The society sought confirmation that the dividend income wouldn’t be subject to TOSI, because the corporation met the labour test.
Confirmation was received: Panourgias said the bright-line test was met, so the dividend would be TOSI-exempt.
Exclusion for a spouse age 65+ or deceased, and share ownership structure
The rules say TOSI doesn’t apply to split income received if your spouse (or common-law partner) is age 65 or older, or is deceased, and the amounts would be excluded from TOSI for your spouse under these same rules. (These requirements are from the deeming rule in 120.4 1.1(c) of the Income Tax Act.)
STEP Canada looked for confirmation of this TOSI exemption where the spouse age 65 or deceased qualifies for the excluded shares exemption because they hold company shares personally, while the other or surviving spouse holds the company shares indirectly through a trust. (Note that there are other requirements to qualify for the excluded shares exemption, but key for this discussion is the requirement of holding shares personally.)
Generally, the exemption holds, Panourgias said, assuming the corporation has a basic and common share ownership structure.
In the case of more complex structures, “it’s not clear whether the same approach would be applicable, so taxpayers should consider seeking confirmation of whether this general approach would apply to their specific fact situation,” she said.
She added a warning: “Where artificial transactions are undertaken to achieve a similar but inappropriate result, the GAAR [general anti-avoidance rule] could be applicable.”
Tracing ownership and attributes of shares after death
Next, consider a business owner who operates a services business. The owner and spouse own all the shares, and only the owner is actively engaged in the business. When the business owner dies, their company shares are gifted through their will to the spouse. The deeming rule provides that subsequent distributions from the corporation to the spouse wouldn’t be considered split income. The business would be deemed an excluded business in respect of the spouse, who would be deemed to be active in the business.
STEP Canada’s question was whether the shares would also be TOSI-exempt when the spouse dies and the shares are gifted to the children. Panourgias said they would be, with the children also deemed actively engaged in the business.
More generally, she said, “It is the CRA’s view that the effect of a previous application of the deeming rule in 120.4 1.1(b)(ii) could extend to a subsequent acquisition of property as a consequence of the death of another individual.” The section of the act she referenced refers to excluded businesses.
A related question was what happens where the business owner and spouse have each bequeathed one-half of their shares to each of two children, and the spouse dies first. Recall that only the business owner is active in the business.
The CRA responded that, while the shares that the children inherit from the spouse would be subject to TOSI, once the business owner dies, all the inherited shares would be exempt, starting in the tax year that the children inherit the business owner’s shares.
After the business owner’s death, “the deeming rule would apply such that each of the children would be deemed to be actively engaged in the business of [the operating company] throughout five previous tax years,” Panourgias said. “The result is that any income from [the operating company] that would otherwise be subject to tax on split income would be an excluded amount.”
Cadesky described the CRA’s response to the related question as “interesting” and “somewhat generous.”
Split income and preferred beneficiary elections
STEP Canada also sought confirmation concerning TOSI and the preferred beneficiary election.
This election allows a trust to allocate trust income to a preferred beneficiary, whereupon the trust can take a deduction and the amount is included in the preferred beneficiary’s income. The CRA confirmed that these amounts included in a beneficiary’s income aren’t split income.
That said, Panourgias noted that the definition of split income includes taxable dividends received in respect of corporate shares other than shares of a class listed on a designated stock exchange or shares of a mutual fund corporation. If such income allocated to a preferred beneficiary is also subject to a Subsection 104(19) designation, the amount designated is generally deemed a taxable dividend received by the preferred beneficiary and included in split income, she said, unless one of the TOSI exceptions applies.
Caution on avoiding passive income rules
The roundtable wouldn’t have been complete without a question on the new rules for passive investment income.
Effective for 2019 based on the previous year’s adjusted aggregate investment income, or AAII, the new rules call for a private corporation’s small business deduction to be reduced by $5 for every $1 of investment income above $50,000, and reduced to zero at $150,000 of investment income.
STEP Canada provided the example of a corporation (opco) owned by five other corporations (holdcos); the corporations are all related but not associated. Opco has a history of paying dividends equal to its annual income, with the holdcos building up large amounts of investment funds as a result. STEP asked if the anti-avoidance rule (Subsection 125 (5.2)) would apply if the opco continued this practice.
Fron said the rule might apply if it can be “reasonably considered” that one of the reasons for paying the dividends was to reduce opco’s AAII. The same would be true where transfers are made via trusts, he said.
The rule will be considered on a case-by-case basis, he said, and “caution here is warranted.”