Individuals in Canada are subject to tax at marginal rates. Our tax rates increase in accordance with our taxable income. As a result, it is common for high income individuals to pursue strategies which allow them to shift income from their tax return to the return of a lower income family member, such as their spouse, child, or parent. These strategies may trigger the tax on split income (TOSI) rules which cause the split income to be taxable to the family member at the highest marginal tax rate.
TOSI has existed for many years on certain income received by children who are under 18 years of age. This tax is commonly referred to as the “kiddie tax”. These rules apply to split income from private corporations, such as dividends paid or shareholder benefits. The rules may also apply to income from a trust or partnership if the trust or partnership earns income from a business in which the parent is actively involved. Capital gains are generally not subject to this tax. The income paid to the child will be taxable at the highest tax rate rather than the child’s marginal tax rate if the kiddie tax applies.
Beginning in the 2018 taxation year, the scope of TOSI was greatly expanded. This tax can now apply to any individual that receives income from a related business regardless of age. There are many exclusions available which prevent application of this tax if certain conditions are met. These exclusions must be fully analyzed before implementing any income splitting strategies.
TOSI may apply when a “specified individual” receives income from a “related business” in which a “source individual” is actively engaged or a significant equity owner, and the specified individual has not made a significant contribution to the related business. A specified individual is a Canadian resident individual, or a non-resident individual with a Canadian resident parent if the non-resident individual is under 18 years of age. A source individual is any individual related to the specified individual. Individuals are related by either blood or marriage, such as a spouse or common-law partner, parent, grandparent, in-laws, or a child. Aunts, uncles, nieces, nephews, and cousins are not related for tax purposes. A related business is a business from which the specified individual receives income, in which the source individual is actively engaged or a significant equity owner, or a trust or partnership that receives income from a business in which the source individual is actively engaged or has an interest in.
As an example of the above, a common planning strategy used in the past involved issuing non-voting shares in a privately held corporation to lower income family members, such as a spouse, child, or parent. Dividends could be declared on these shares to utilize the lower tax brackets of the family members. Rather than the individual running the company paying tax at the highest marginal tax rate, the family members could pay little to no tax on the dividends received. Under the current rules, TOSI may apply to the family member, the specified individual, as they are receiving income from a related business run by the source individual.
TOSI does not apply if the income received meets the conditions of an “excluded amount”. Many amounts may meet the conditions of an excluded amount. These conditions vary depending on the age of the taxpayer. Common examples of excluded amounts include:
Amounts from property received by individuals under 25 years of age due to the death of their parent.
Amounts from property received by individuals under 25 years of age due to the death of any person, and the recipient is enrolled in full-time post-secondary studies or eligible for the disability tax credit.
Amounts received from property transferred to an individual due to the breakdown of a marriage or common-law partnership.
Taxable capital gains resulting from a deemed disposition upon death.
Taxable capital gains resulting from the disposition of qualified farm or fishing property, or qualified small business corporation shares.
For individuals under 65 years of age with a spouse older than 65 years of age, or a deceased spouse, amounts received that would be excluded amounts had they been received by the spouse.
For individuals that are at least 18 years of age, amounts received that are not from a related business or an “excluded business”.
For individuals that are between 18 and 24 years of age, amounts that meet the definition of a “reasonable return” or “safe harbour capital return”.
For individuals that are at least 25 years of age, taxable capital gains received from “excluded shares”, or a reasonable return in respect of the individual.
An excluded business is one of the most common avenues to avoid application of TOSI. An excluded business is a business in which the specified individual is actively engaged on a regular and continuous basis during the taxation year, or any of the five preceding taxation years. Therefore, if a child is actively working in the business of their parent or actively worked in any five preceding years, they can receive income from the business without TOSI applying. The commonly accepted test for this purpose is if they worked an average of at least 20 hours per week during the period. However, this is not a definitive test as it can vary depending on time commitment required to run the specific business.
The safe harbour capital return is based on the specified individual’s capital contributions to the business. A safe harbour capital return is calculated as the fair market value of capital contributed to the business by the specified individual multiplied by the prescribed interest rate. For example, an individual may contribute cash or other property to the business and therefore are entitled to a return on this contribution. Any amounts in excess of the calculated safe harbour capital return will be subject to TOSI.
A reasonable return is based on contributions to the business, whether capital contributions, contributions from work performed, or risks assumed such as guaranteeing a loan. A reasonable return is also based on relative contributions of the specified and source individuals and must be assessed on a case-by-case basis. There is not one single factor that indicates if a return is reasonable, so this area requires careful analysis and documentation to support the reasonableness.
Income or gains will be considered to be from excluded shares if the following conditions are met:
Less than 90% of the corporation’s business income was earned from the provision of services (i.e. businesses earning income primarily from the sale of goods would be excluded).
The corporation is not a professional corporation.
The specified individuals own shares representing at least 10% of the voting rights and 10% of the fair market value of all shares of the corporation.
Less than 10% of the income of the corporation was received from a related business.
TOSI is one of the most complex areas of the Income Tax Act. As you can see from the above, there are many different definitions and exclusions that must be carefully analyzed to understand application of these rules. Income splitting can still be beneficial to you and your family, but we must work together to ensure the benefits of these strategies are attained.
For more information, please contact firstname.lastname@example.org or 1 844-GYTD-CPA