In the past, you are able to pay an unlimited amount of dividends to family members who are shareholders of the company. On January 1, 2018, a law was made effective to eliminate the tax benefits of income splitting where the recipient of the income (e.g. a related family member) has not made sufficient contribution to the business. This rule is known as Tax on Split Income, or commonly referred to as TOSI.
Let’s go through how TOSI works, the impact it has on income splitting, and how you can avoid TOSI.
How does TOSI work?
Tax on Split Income (TOSI) is a tax applicable to Canadian resident adults who receive income that are considered “split income”. Any income taxed under the TOSI rules is subject to tax at the highest personal marginal tax rates, thus eliminating any advantage achieved from income splitting. Two common scenario subject to TOSI are dividend received from a private company and capital gain received from the sale of privately held shares, because the person receiving the income is related to the business.
Fortunately, the rules provide a number of exclusions. If the conditions for one of the exclusions are met, then TOSI would not apply. This blog is not intended to cover all exclusions, but rather the 3 main exclusions that you should be aware of.
Exclusion #1 – Excluded businesses
The exception from TOSI for excluded businesses focuses on the individual’s contribution to the business. It’s important to keep in mind that the rules do not apply to amounts paid to employees for work performed, even if the employee is a family member. Salaries and wages are subject to a separate reasonableness test, where a business tax deduction is disallowed for amounts paid in excess of a reasonable amount, while the recipient is still fully taxable on what they receive. However, dividends received from the business by an adult family member will be subject to the TOSI 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 in the business on a regular, continuous and substantial basis. 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. Therefore, if the family member has worked at least 20 hours a week on average, any dividends they received from the business will generally not be subject to TOSI.
Time records would be ideal, but this is often not practical to track in a family business context. As a result, the CRA has indicated they will consider all information that can be made available about the history of the business and involvement of family members. Having said that, if you intend to rely on this exclusion going forward, be prepared to document the hours that family members are working in the business.
Exclusion #2 – Excluded shares
An exclusion from TOSI applies to capital gains from the disposition of excluded shares held by individuals who are 25 years of age or older. To qualify for this exclusion, there are several conditions that must be met. The individual must hold shares that represent at least 10% of the votes and value of the company. In addition, the exclusion only applies to shares of corporations where less than 90% of the business income is from the provision of services, and where 90% or more of all income is not derived from directly or indirectly from related businesses.
With the votes and value conditions, a person holding shares through a trust will not be able to rely on this exclusion, as direct holding of shares is a requirement. Where tax planning makes sense and is available, a roll-out of shares to trust beneficiaries could allow for directly holding excluded shares to avoid TOSI.
The exclusion will not be applicable to shares held in a service business due to the 90% condition requiring a review of business income from services. This 90% condition raises some uncertainties in terms of what is considered a service business since the “provision of services” is not specifically defined. This condition will also require tracking of service income for businesses which earn income from sources other than services.
Furthermore, the exclusion requires a review of whether the business is earning income derived from another related business. This particular condition is intended to prevent splitting a service business into services and non-services parts using holding companies or sister companies. It may be the case that the 10% votes and value requirements are met in terms of individuals holding shares of a holding company. However, to meet the exclusion, less than 10% of the income can be from another related business outside of the corporation. Therefore, for a holding company, it will be necessary to consider all income, including dividend income received by a holding company from an operating company, to determine whether or not the exclusion will apply. The CRA has confirmed that it will be difficult for shares of a holding company to be excluded shares where the income of the holding company is dividend income received from a subsidiary operating company that is a related business.
Exclusion #3 – Reasonable returns
Another exception from TOSI is based on a reasonable return that can be applied to adult family members who are 25 years of age and older. For example, a reasonable amount of dividends can be paid and not be subject to TOSI if the amount represents a reasonable return on their contribution to the business. This reasonable return will take into account a number of factors – including the work performed, money contributed to the business, and the risks assumed by the individual in respect of the business.
Putting it all together
When considering whether dividends on private company shares can effectively be excluded from TOSI, it may be easier to qualify for the excluded business exception. You simply need to prove that you have worked an average of 20 hours a week in the business in the current year.
The excluded shares exception can also be used but multiple conditions must be met. It is also limited to non-service businesses earning income from third parties with simple direct shareholding structures. The excluded shares exception will be difficult or impossible to access by individuals in many family business structures that use holding companies and trusts, or that earn service income or income from a related business.
If you can’t meet one of these two exceptions and are 25 years of age or older, then your dividends can still be excluded and not subject to the TOSI income splitting rules. This will require you to prove a reasonable return based on the above criteria, which can be difficult to accomplish.