On December 13, 2017, the government released new rules designed to prevent income splitting using private corporations. Originally proposed as part of the July 18, 2017 private company consultation paper issued by the Department of Finance, the new rules simplify what was initially proposed 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.
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 adult individuals as well. The TOSI rules previously only applied to individuals who were under the age of 18 — any income taxed under these 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, dividends and capital gains received from a related business, known as “split income.” This generally includes the following:
However, the rules provide a number of exclusions, some of which are “bright-line” tests. If the conditions for the exclusions are met, the TOSI rules will not apply.
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, and safe harbour returns on capital that individuals between the ages of 18 to 24 actually contribute to a business.
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 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. 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 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 is also unclear what type of evidence the Canada Revenue Agency 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. If you intend to rely on this exclusion, be prepared to document the hours that family members are spending working in the business.
