Revised Income Sprinkling Rules

On December 13, 2017, the Department of Finance released the much-anticipated revised rules for the tax on split income, or TOSI.  The revised TOSI rules address income sprinkling between family members, and apply to the 2018 and subsequent taxation years.

The revised rules address some, but not all, of the issues with the July 18, 2017, version of the rules which provoked a huge outcry from the public and tax community.  The revised rules have brought some simplification and bright-line tests to the TOSI rules, but there remains considerable uncertainty if a taxpayer has not been excluded from the rules through one of the bright-line exclusions provided.  Concurrent with the release of the revised rules, the Canada Revenue Agency has taken the unusual step of issuing guidelines outlining how they intend to administer the revised rules.

Tax on Split Income

The TOSI rules taxes “split income” received by a “specified individual” at the highest marginal tax rate rather than at the individual’s marginal tax rate, and limits the tax credits the specified individual is entitled to claim in computing the individual’s tax liability, unless such income is an “excluded amount“.

A “specified individual” is any adult (18 or older) who is resident in Canada, or any minor who has a parent who is resident in Canada.

Under the revised rules, “split income” means:

1. dividends and shareholder benefits in respect of shares of a corporation (other than a class of shares listed on a designated stock exchange),
2. an amount included in a specified individual’s income from a partnership or trust that can reasonably be considered to be derived directly or indirectly from:
   1. a business carried on by:
      • a related individual resident in Canada,
      • a partnership, corporation or trust if a related individual resident in Canada is actively engaged on a regular basis in the activities related to the earning of income from the business,
      • a business of a particular partnership if a related individual resident in Canada has an interest in the partnership, or
      • a business of a corporation if a related individual resident in Canada owns shares of the corporation that comprise 10% or more of the fair market value of all of the issued and outstanding shares of the corporation.
   2. the rental of property by a particular partnership or trust if a related individual is actively engaged on a regular basis in the activities of the partnership or trust, or has an interest in the particular partnership,
3. income in respect of a debt obligation of a corporation (other than a corporation shares of a class of which are listed on a designated stock exchange), partnership or trust that is not listed or traded on a public market, or
4. a taxable capital gain or a profit from the disposition after 2017 of
   1. a share of a corporation (other than a class of shares listed on a designated stock exchange), or
   2. an interest in a partnership, an interest as a beneficiary of a trust, or a debt obligation where an amount was included in the individual split income or any part of the fair market value of the property is derived directly or indirectly from a share of a corporation (other than a class of shares listed on a designated stock exchange).

Exclusions from the Tax on Split Income

Under the revised rules the following income, profits and taxable capital gains are excluded from TOSI.

A. Income, Profit or Taxable Capital Gain from Inadvertent Transactions

Certain income, profits and taxable capital gains from property acquired inadvertently or from inadvertent transactions are excluded from tax.

1. For an individual less than 25 years of age, income from or taxable capital gain or profit from the disposition of property acquired by or for the benefit of the individual as a consequence of the death of a parent or of any person if the individual is enrolled as a full-time student at a post-secondary institution or is entitled to claim the disability tax credit.
2. Income from or taxable capital gain or profit from the disposition of property acquired as a result of separation because of a breakdown of marriage or common-law partnership.
3. Taxable capital gains from the deemed disposition as a result of death.

B. Exclusions Based on Reasonableness

Certain income from or taxable capital gain or profit from the disposition of property are excluded from TOSI if reasonable or below certain thresholds as follows:

For specified individuals from 18 to 24 years of age

4. An amount of income from or a taxable capital gain or profit from the disposition of a property for a taxation year up to a notional amount equal to the product of the fair market value of the property contributed by the specified individual in support of a related business and the highest prescribed interest rate for the year (which is currently 1%), referred to as a “Safe Harbor Capital Return”.
5. An amount of income from or a taxable capital gain or profit from the disposition of a property to the extent of a reasonable return having regard only to contributions of the individual’s property so long as the property was not acquired as income from or taxable capital gain or profit from the disposition of another property that was derived directly or indirectly from a related business, was not property borrowed by the specified individual, or was not property transferred directly or indirectly to the specified individual by a related person.

For specified individuals 25 years of age or older:

6. A particular amount derived directly or indirectly from a related business that would otherwise be split income and it is reasonable having regard to the following factors in respect of the relative contributions of the specified individual and related persons:
   • 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 amount paid or payable directly or indirectly to or for the benefit of the specified individual and related individuals in respect of the related business, and
   • “such as other factors as may be relevant”.

This reasonableness test is not determinable with respect to an arm’s length standard but is determinable based on the relative contributions of the specified individual and all other related persons. So a tally of all related persons contributions of labor, property, risks assumed and amounts paid in respect of the related business is required; a task requiring a considerable amount of record-keeping and consideration.

Please refer to the CRA Guidance below which sets out the factors the CRA will consider in determining whether an amount received by an individual exceeds a reasonable amount in regards to the labor contributed, property contributed, risks assumed and the total amount paid or payable to the specified individual in support of the related business.

C. Exclusion for being Actively Engaged in an “Excluded Business”

7. Income from or taxable capital gain or profit from the disposition of property to the extent derived directly or indirectly from an “Excluded Business“.

An Excluded Business is defined as a business if the specified individual is actively engaged on a regular, continuous and substantial basis in the activities of the business in the taxation year or in any five previous taxation years, whether or not concurrent.

To provide some certainty to this definition, an individual is deemed to be actively engaged on a regular, continuous and substantial basis if the individual worked in the business at least an average of 20 hours per week during the portion of the year in which the business operated. If an individual does not meet the hour worked threshold, it is still a question of fact whether or not the individual is actively engaged on a regular, continuous and substantial basis.

D. “Excluded Shares” for Individuals 25 or Older

8. The Department of Finance provided some level of income splitting for adults ages 25 or older by excluding income from or taxable capital gain or profit from the disposition of certain shares, if they meet the definition of “Excluded Shares”.

Excluded Shares are shares of a corporation that meet the following three conditions:

1. The shares are owned by the individual (note shares owned through a partnership or trust don’t meet this condition) and give the individual 10% or more of the votes and have a fair market value of 10% or more of the fair market value of all of the issued and outstanding shares of the corporation.
2. Less than 90% of the corporation’s business income for its last taxation year was from the provision of services and the corporation is not a Professional Corporation (such as the professional practice of an accountant, dentist, doctor, lawyer, veterinarian or chiropractor).
3. 90% or more of the corporation’s income for its last taxation year was not income derived directly or indirectly from one or more related businesses. Such income is for greater certainty deemed to include income derived from the provision of property or services to or in support of the related business, an amount that arises in connection with the ownership or disposition of an interest in the person carrying on the related business and an amount that is derived from an amount that is derived directly or indirectly from the related business.

Although the revised rules provide income sprinkling opportunities for family members, there is still considerable uncertainty in determining whether the 3 conditions for shares of a corporation to be Excluded Shares have been met; especially whether 90% or more of the corporation’s income for the relevant taxation year was not derived directly or indirectly from one or more related businesses.

Certainly, the provision of property or services to a related business and dividends received from or gains realized on the disposition of an interest in the entity carrying on the related business will throw the corporation offside so that it shares would not be considered Excluded Shares.  But what is meant by an amount derived from an amount derived directly or indirectly from a related business?

Will investment income earned on an investment portfolio by a holding company derived from a tax free inter-corporate dividend received from an operating company be considered an amount derived from an amount derived directly or indirectly from a related business?  In my view this is certainly the case.

But what if the major shareholder invests some of his or her proceeds received on the sale of a portion of the shares of an operating company into a new investment company (“Invesco”).  Will income earned by Invesco on its investment portfolio be considered an amount derived from an amount derived directly or indirectly from the related business of Opco?  Provided the major shareholder is still actively engaged on a regular basis in Opco’s business or owns 10% or more of the shares of Opco (based on fair market value) in the year, Opco’s business would be considered to be a related business and thus, the income earned by Invesco on its investment portfolio would in my view be considered to be derived from an amount derived directly or indirectly from the related business of Opco and thus subject to TOSI. Of course, it would be possible that dividends paid on Invesco shares held by a family member would be excluded based on some other exclusion such as the reasonableness exclusion.

This exception is much narrower than first meets the eye. The key is to ensure that the corporation’s income is not derived directly or indirectly (either on a primary or secondary basis) from the provision of property or services to a related business or arising in connection with the holding or disposition of an interest in a related business.

For instance, the shares of a corporation which the major shareholder capitalized with borrowed money, from inherited property, or from income or gains realized on the disposition of an unrelated business appear to possibly qualify as Excluded Shares.  Thus, the dividends paid on such shares to a related family member could possibly meet the definition of Excluded Shares such that dividends paid on such shares would be not subject to TOSI to the related individual provided the other conditions were met.

It would also appear that if the related business which taints the income of the corporation is no longer being carried on in the year and the related individual is not actively engaged on a regular basis in the related business, the shares of the corporation may possibly meet the condition for the amount not to be derived directly or indirectly from a related business, so that the shares of the corporation may be Excluded Shares.  Thus, dividends paid on such shares to related family members may not be caught under the TOSI rules.

Time will tell what is meant by the term “an amount derived from an amount derived directly or indirectly from a related business”.

E. Other Exclusions

9. Spouse is 65 Years of Age or Older or Who has Died
   In order to provide some income splitting on income from a private corporation for those age 65 or older, the rules provide that split income to a specified individual will be excluded from TOSI if such income would be an excluded amount to the individual’s spouse or common-law partner if included in the spouse or common law partner’s income and the spouse or common law partner is 65 years of age or older, or would be an excluded amount to the spouse or common law partner if included in the spouse’s income for the taxation year in which the spouse died.
10. Inherited Property
    If property is acquired by or for the benefit of a specified individual as a consequence of the death of another individual (either by bequest or inheritance) then the labor contributions, capital contributions, risks assumed and amounts paid or payable factors to the deceased individual are to be included for the purpose of applying the definition of a reasonable return to the specified individual.
11. Qualified Farm or Fishing Property / Qualified Small Business Corporation Shares
    Taxable capital gains from the disposition of property that is either a qualified farm or fishing property or qualified small business corporation shares are excluded from TOSI whether or not the enhanced capital gains exemption is claimed.

CRA Guidance

The CRA released guidance related to the revised rules on income sprinkling which clarifies how it intends to apply the new rules, including factors it will consider in determining whether a payment is a reasonable return. The guidance is helpful, however the CRA’s approach will certainly develop over time based on its experiences, the situations it reviews and based on court decisions. The CRA advises that taxpayers should be prepared to support their position that an amount is either excluded from TOSI based on one of the excluded positions or is a reasonable amount that is not subject to the TOSI rules.  Therefore, it would be prudent to properly document and support why amounts paid to family members are either excluded or reasonable.

According to the CRA guidance, the CRA will consider the following factors in determining whether an amount received by an individual exceeds a reasonable amount in regards to the labor contributed, property contributed, risks assumed and the total amount paid or payable to the specified individual in support of the related business:

Labour Contribution

• The nature of the tasks performed
• Hours required to complete the tasks
• A competitive salary/wage for the tasks in relation to businesses of similar size and industry
• Education, training and experience
• Degree of activities and nature of activities in relation to those of a business of a comparable nature and size
• Time spent on the activity in comparison to time spent on other activities or undertakings
• Particular knowledge, skills or know-how that the individual possessed
• Business acumen
• Past performance of functions.

Property Contribution

• The amount of capital contributed to the business
• The amount of loans to the business
• The fair market value of property (both tangible and intangible property) transferred to the business, including technical knowledge, experience, skill or know-how
• Whether the individual has provided property as collateral for loans or other undertakings
• Whether other sources of capital or loans are readily available
• Whether comparable property is readily available
• Whether property is unique or personal to the individual
• Opportunity costs
• Past property contributions.

Risk Assumption

• Whether the individual is exposed to the financial liabilities of the business, whether through guarantees of mortgages, loans or lines of credit or otherwise
• Whether the individual is exposed to statutory liabilities related to the business
• Extent of the risk that contributions made by the individual to the business may be lost, whether in whole or part
• Whether any risk is indemnified or otherwise limited in the circumstances, whether by agreement or otherwise
• Whether the individual’s reputation or personal goodwill is at risk
• Past or ongoing risk assumption

Total Amounts Paid

• Other amounts previously paid to the individual, (including salary or other remuneration or compensation, dividends, interest, proceeds, and fees), benefits and deemed payments (as may be reasonably required in the circumstances).

Please contact your DMCL advisor in regard to the interpretation of these new rules in your particular fact situation.