Tax On Split Income (TOSI) – Round Two
In another act of blatant cowardice, Finance Minister Morneau has finally introduced his next attempt at the TOSI rules. As I suggested in a post yesterday, the man has no shame. After promising in October that the TOSI rules would be introduced “later in the fall”, he waiting until December 13th at the end of the current Parliamentary session to introduce rules that are supposed to come into force on January 1st, 2018. Morneau is simply following the Liberal tradition of cowardice shown by Liberal Finance Minister Paul Martin when he first introduced the TOSI (a.k.a. “Kiddie Tax”) in his 1999 Budget. I will post about that in a separate opinion piece in the coming days.
A cynic might suggest, that the introduction of rules that turn our corporate tax system on its head without giving businesses and their advisors to make necessary changes was designed to allow Morneau to avoid having to face questions in the House.
Again, one must question the ability of the Department of Finance to have adequately “considered” over 21,000 written submissions, some in excess of 100 pages, since October 2nd in order to produce a substantial re-draft of the legislation.
The TOSI rules were accompanied by guidelines from the Canada Revenue Agency (CRA) as to how they will administer the new rules.
Senate Standing Committee on National Finance (SSCNF)
It should also be noted that, earlier today, the Standing Senate Committee on National Finance has tabled its report, based upon hearings held across the country.
Without going into detail, the Committee has 3 strong recommendations, which I have discussed in a separate posting.
What is the TOSI?
The TOSI, generally referred to as the “kiddie tax” was introduced by Liberal Finance Minister Paul Martin in 1999. The rules apply to income from private businesses, such as dividends on unlisted shares, or income in the form of a trust or partnership distribution derived from a business or rental activity of a related individual. The TOSI also denies access to the Lifetime Capital Gains Exemption (LCGE) in respect of the disposition of shares as part of a non-arm's-length transaction. In cases where the TOSI applies, the income is subject to top flat-rate personal tax in the hands of the minor, and personal tax credits (with the exception of the dividend tax credit and foreign tax credit) are denied with respect to the amounts.
Although there has been some change to the July proposals, the government still proposes the following:
to extend the tax on split income (TOSI) to apply to certain adult individuals who will have amounts included in split income, but generally only to cases where the amount is unreasonable under the circumstances. The measures will expand the circumstances in which the TOSI applies, including the types of income that are considered to be split income.
To introduce a “reasonableness” test for dividends. It is clear from decades of decided cases, that there is no such test regarding dividends. The reasonableness test is still proposed to apply differently based on the age of the adult specified individual (i.e., whether the individual is between 18 and 24 or is 25 or older).
The rules being introduced today are somewhat clearer than the earlier version, but they will still leave too much room for subjectivity on the part of the Canada Revenue Agency in the application of the rules.
The revised draft legislative proposals also make the following changes to the July 2017 proposals:
The TOSI will not apply to compound income (i.e., income earned from the investment of an initial amount of income that is subject to the TOSI or attribution rules).
The July 2017 proposals had included amendments to extend the application of subsections 120.4(4) and (5) of the Income Tax Act (which currently apply to minors and effectively deem twice the amount of a taxable capital gain to be a dividend in certain circumstances) to specified adult individuals. These amendments will not move forward.
The existing provision will be modified so that it will not apply to a minor in circumstances in which a capital gain arises as a consequence of that person’s death.
The class of related individuals for the purposes of the TOSI rules will not be extended to aunts, uncles, nieces and nephews.
Income derived from property acquired as a result of the breakdown of marriage or common-law partnership will be exempted from the application of the TOSI rules.
Individuals aged 18 to 24 will be permitted a prescribed rate of return on capital contributed to a related business. In certain cases, however, such as where the individual earned the capital contributed from an unrelated business, the individual will be permitted a reasonable return on the contribution.
The proposed extension of the TOSI to taxable capital gains from the disposition of property will not apply to the types of property that can qualify for the LCGE (i.e., qualified small business corporation shares and qualified farm or fishing property). This exemption from the application of the TOSI will apply regardless of whether the LCGE is claimed in respect of the taxable capital gain arising from the disposition.
Perhaps the most welcome change is that the TOSI rules will allow spouses to split income from a family business even if only one spouse was active in the business, once that individual has reached age 65. This will put some small business families on an equal footing with families who are already able to split pension income.
Special rules will apply in respect of a deceased individual, so that the surviving spouse continues to benefit from the contributions made by the deceased individual. New rules for inherited property will apply to people who have attained the age of 18 and not just those whose spouses have attained the age of 65. For the purpose of applying the exclusions from the TOSI in respect of income from inherited property, the person inheriting the property will generally not face a less favourable treatment than the deceased.
Along with the draft legislation the Government tabled the CRA guidelines for the implementation of the new TOSI rules.
"Split income" will generally include dividends or interest paid by a private corporation or received from a partnership directly or indirectly (i.e. through a family trust) to an individual from a related business ("Related Business") unless the amount falls within a specific exclusion (the "Excluded Amount" or "Excluded Amounts").
Under the Proposals, the following will be Excluded Amounts from split income:
For adult individuals – amounts received from an excluded business, which is a business where the individual was 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.
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. The five taxation years need not be consecutive. In any other case, whether an individual is Actively Engaged will depend on the facts and circumstances of that case.
For individuals between the age of 18 and 24 – return on property contributed in support of a Related Business that is a safe harbour capital return ("Safe Harbour Capital Return") or a Reasonable Return having regard only to contributions of arm's length capital to the business ("Arm's Length Capital"):
Safe Harbour Capital Return: return on property contributed by the individual in support of the Related Business provided that such return does not exceed a prescribed capital return determined by formula, and
Arm's Length Capital: property of an individual, other than property that is derived from property income in respect of a Related Business, that is borrowed under a loan (even an arm’s length loan), or that is transferred from a related person (other than inherited property).
For individuals age 25 or over – income from or taxable capital gain from the disposition of excluded shares ("Excluded Shares") or a payment that qualifies as a reasonable return ("Reasonable Return"):
Excluded Shares: shares of a corporation owned by an individual are excluded shares where:
less than 90% of the corporation's business income was from the provision of services and the corporation is not a professional corporation;
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.
Payments that represent a reasonable return based on the following criteria (the "Reasonableness Criteria"):
the work performed in support of the Related Business;
the property contributed directly or indirectly in support of the Related Business;
the risks assumed in respect of the Related Business;
the total amounts paid or payable by any person or partnership to or for the benefit of the individual in respect of the Related Business; and
such other factors that may be relevant.
For any individual – taxable capital gains realized on death or from the disposition of qualified farm or fishing property and qualified small business corporation shares.
Where the individual acquired a property as a consequence of the death of another individual, special rules will apply for determining whether a payment from property is derived from an Excluded Business in respect of an individual, is a Reasonable Return on contributions made to a Related Business or is income from, or a taxable capital gain from the disposition of, Excluded Shares.
What does it mean?
The payment of dividends to family members, and particularly the payment of capital dividends, as discussed in my year end planning newsletter really hasn’t changed. The thought that the payment of a dividend by promissory note might qualify as a contribution of capital to the company will still apply, but only for shareholders older than 25.
All of the problems discussed since the summer concerning the proving of one’s contribution to a related business are still present. The current and previous Chief Justices of the Tax Court of Canada have stated that the Court, already overburdened, will be swamped by the litigation that will arise as a result of the new TOSI rules.
Capital gains that qualify for the LCGE, whether realized directly or allocated from a family trust, will continue to qualify and will not be part of “split income”.
If a taxpayer is 25 or older, dividends or capital gains in respect of Excluded Shares will not be split income. To be excluded from TOSI, the following conditions must be met:
the individual has attained the age of 25 years in or before the year;
the individual owns at least ten per cent of the outstanding shares of a corporation in terms of votes and value; and
the corporation meets the following conditions:
it earns less than 90 per cent of its income from the provision of services;
it is not a professional corporation (i.e., a corporation that carries on the professional practice of an accountant, dentist, lawyer, medical doctor, veterinarian or chiropractor); and
all or substantially all of its income is not derived from a related business in respect of the specified individual. This will affect a number of legitimate pre-existing arrangements, such as a professional corporation paying rent for the building in which its business is carried on to a corporation owned by the adult children of the professional.
If a company does not meet this test, the shareholder must be able to show that a dividend represents a reasonable return based upon a number of criteria administered by the CRA.
Morneau claims that there will be a transitional provision to allow a family business to meet the 10% ownership provision referred to above. However, anyone who understands the implications of inter-family share transfers, estate freezes, etc. will readily see that the chances of taking advantage of this transitional rule is unlikely to be of any benefit to most businesses
A word about capital gains
As stated above, the capital gain on the disposition of shares or farm or fishing properties that qualify for the LCGE will not be subject to the TOSI rules.
BUT the capital gain in respect of shares that don’t qualify for the LCGE will be subject to the TOSI rules. The basic rule is that if the income from the property would be TOSI, then the gain on the disposition will be TOSI, unless the property qualifies for the LCGE.
If a capital gain is subject to TOSI, the treatment will depend on whether the taxpayer is older than 17. If the taxpayer is over 17, the taxable capital gain will be included in TOSI and taxed at the top personal rates. If the taxpayer is not over 17, rather than ½ of the gain being taxable at ordinary tax rates, the full amount of the gain will be treated as a dividend, taxable at top personal tax rates.
It is crucial to keep active business companies onside in terms of their assets, since being offside results in the shares being disqualified for the LCGE. The new TOSI rules make this even more important.
Because of the higher tax on non-exempt capital gains, it becomes even more important to keep your active business company onside for the purposes of the LCGE.
Given the SSCNF report, discussed above, one could hope that the Senate will fulfill its role as the House of Sober Second Thought. A CBC discussion about the Senate in July, 2010, made the following observation:
Both houses of Parliament can pass, amend, delay or defeat bills. Senators do not usually delay or defeat legislation already passed by MPs, but they can reject bills and they will.
If the Senate decides the government of the day does not have a mandate to do what it proposes, or a bill is not good legislation because it is misguided, based on wrong information or not in the public interest, it will bring the legislative process to a halt.
If the Senate defeats a bill, that usually means the government has to go back to the drawing board.
In 1988, the Senate made national news when it delayed Bill C-130, the bill that proposed to implement the free trade agreement between Canada and the United States. The government called an election on the issue,…
The Government will not allow a free vote on the tax proposals in the House, since a vote on a tax bill is considered a confidence vote and the Government would have to resign if they lost the vote. But, since Trudeau expelled all Liberal Senators from the Liberal caucus, one can only hope that the Senators will do what the Liberal Government is not prepared to do – put the interests of the people ahead of partisan politics.