27 Jul 2018
TOSI Rules - Tax on Split Income
Are Your Shares Excluded?
In July 2017 the Federal Government of Canada released its initial CRA income splitting draft legislation with new proposed TOSI rules. It targeted the splitting of income earned by private corporations with family members, usually through dividends. Where the family member receiving the dividend has not made a sufficient contribution to the business (either through effort, investment of capital or assumption of risks) the dividend would be considered split income and taxed at the highest marginal tax rate – the tax on split income (TOSI).
Following significant pushback from the business and tax communities, the Federal Government revised its TOSI proposals in December 2017. On June 21, 2018, the revised TOSI rules received Royal Assent and are now law.
Tax On Dividends 2018
The TOSI rules are very complex and apply to dividends received from private corporations in 2018 and later years. These TOSI rules are structured in such a way that virtually all dividends received from private corporations must pass through these rules.
The government has provided an array of exclusions that can exempt a dividend from the TOSI in which case the dividend will be taxed at the recipient’s marginal tax rate. However, if one of the TOSI exemptions does not apply, the dividend will be taxed at the highest personal tax rate (currently 34.2% on eligible dividends and 43.73% on non-eligible dividends).
While there are a number of TOSI exemptions, one exemption for family members who are not active in the business is the “excluded share” exemption. An individual will be considered to hold excluded shares in a corporation if:
- They are 25 years or older in the fiscal year
- In the last fiscal year of the corporation less than 90% of its business income was derived from the provision of services
- The corporation is not a professional corporation
- The individual owns shares that represent at least 10% of all issued voting shares and at least 10% of the value of the corporation’s issued shares
- In the last fiscal year of the corporation less than 10% of the corporation’s income was derived directly or indirectly from one or more related businesses other than a business of the corporation
It may be necessary for business owners to review and adjust existing business structures in order to fit into the excluded share exemption. As a transitional measure, the Federal Government of Canada has provided business owners to the end of 2018 to revise business ownership to meet the excluded share requirements.
If an individual holds excluded shares in a private company at the end of 2018, then they will be considered to have owned excluded shares for all of 2018. Therefore, dividends received from the company in 2018 will be excluded from the TOSI rules.
Our Manning Elliott tax team have summarized below some common business structures that will be impacted by the new TOSI rules. For the purpose of these examples we have assumed that X and Y are married. Both X and Y are older than age 25 and they have two young children ages 6 and 8. X works full time in the business of Opco and Y stays at home to care for their young family.
In our first example, X and Y own the shares of Opco directly. X owns voting common shares and Y owns non-voting common shares in Opco.
In this case, Y’s shares in Opco are not excluded shares as Y does not own shares that, in aggregate, represent at least 10% of the total votes and total value of Opco’s outstanding shares. If Y receives dividends from Opco, those dividends will be subject to the TOSI rules and the dividends will be taxed at the highest marginal tax rate, unless Y can rely on one of the other exceptions to the TOSI rules.
As long as Opco is not a professional corporation and earns less than 90% of its business income from the provision of services, it may be possible to restructure the shareholdings of Opco so Y holds at least 10% of the votes to fit within the excluded shares exemption. As long as this is done before the end of 2018, all dividends received by Y from Opco in 2018 will be excluded from the TOSI. However, business owners will want to consider the impact of putting votes in the hands of inactive family members.
In our second example, X and Y hold their shares in Opco through Holdco. X and Y both own voting common shares in Holdco.
If Holdco has received dividends from Opco, Holdco will be considered to have received income from a related business. If Holdco received a dividend of $100,000 from Opco in 2017, and that dividend represented 10% or more of Holdco’s total income for 2017, the shares of Holdco will not qualify as excluded shares to Y for 2018.
As a result, dividends received by Y from Holdco in 2018 would be subject to the TOSI rules and taxed at the highest marginal rate, unless Y can rely on another TOSI exemption.
Recently, the CRA commented that where Holdco has no business, its shares could not qualify as excluded shares. The basis for this position is that it would be impossible to determine if 90% or more of the company’s business income was from the provisions of services, as anything divided by zero cannot be computed. We note these comments may not be consistent with the CRA’s published position that shares of a company earning income from passive asset holdings could qualify as excluded shares.
In our third example, the shares of Opco are owned through a family trust. X and Y are beneficiaries of the family trust.
To rely on the excluded share exemption, the shares of Opco must be held personally. As the Opco shares are owned by the family trust, dividends received by Y through the family trust will not be received on excluded shares. As a result, dividends received by Y will be subject to the TOSI rules and taxed at the highest marginal tax rate, unless Y can rely on another TOSI exemption.
While it may be possible to distribute the shares of Opco to the trust beneficiaries in order to access the excluded share exemption from the TOSI, the consequences of putting shares in the hands of the trust beneficiaries need to carefully be considered. Issues to consider include loss of control over the shares, exposing the share value to creditors of the beneficiaries, and the difficulty and cost associated with retracting shares from beneficiaries that should no longer own the shares.
Manning Elliott LLP Can Help
The passing of the TOSI legislation into law is a game changer that will impact planning for almost all private corporations to varying degrees. Transitional TOSI rules provide business owners with the ability to adjust their corporate structures before the end of 2018. If this is done, dividends received by eligible shareholders in 2018 can be protected by the excluded share exemption.
To determine the impact of these new TOSI rules on you and your business, and for available planning options, please contact Manning Elliott tax advisor, Bryan Hubbell, CPA, CGA with any questions.
The above content is believed to be accurate as of the date of posting. Canadian and US Tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.