Navigating the thicket of tax-splitting rule exclusions

For business owners’ relatives, challenges linger in getting exempted from new TOSI rules

By Leo Almazora

Nov 13, 2018

For many families that own small businesses, new tax rules passed into law on June 21 have thrown the proverbial wrench in the works of their financial plans.

The new tax on split income (TOSI) rules expands on previous provisions by extending the tax regime not just to individuals under 18 years of age, but also to certain income received by Canadian resident adults. The rules provide a number of exclusions with set conditions — but as a recent article from BDO Canada notes, meeting those conditions could be challenging.

One major exemption is the excluded business exception, which can apply to family members that are “engaged on a regular, continuous and substantial basis in the business.” This can either be proven on a factual basis or by meeting a minimum threshold of hours spent working in the business. The threshold is an average of 20 hours of work a week contributed either in the current year, or over five past consecutive or non-consecutive taxation years.

“The CRA recently commented that they understand the challenge of providing historical documentation for years prior to 2018,” the experts from BDO Canada said. “[T]hey have indicated they will consider all information that can be made available about the history of the business and involvement of family members, and are generally widening the factors they will consider where pre-2018 historical time records do not exist.”

Another exemption applies from income or capital gains from the disposition of excluded shares held by individuals who are at least 25 years old. Shares are considered excluded when:

The individual holder owns at least 10% of the votes and value of the company
The corporation derives less than 90% of its income from the provision of services
90% or more of the corporation’s total income is not derived directly or indirectly from one or more businesses owned by the individual

The votes and value condition implies that shares considered under this exemption must be held directly, which means individuals holding shares through a trust cannot qualify. But the authors note that a rollout of shares to trust beneficiaries, when it makes sense and is possible from a planning perspective, could allow for direct holding of shares to avoid TOSI.

Since there’s no clear definition of “provision of services” under the tax rules, the 90% rule could result in additional income-tracking challenges for businesses that also earn income from non-service activities. Similarly, because of the third condition for excluded shares, qualifying for the exclusion will be challenging in cases where corporations are structured as holding companies that get income from a subsidiary operating company.

Adult family members who are at least 25 years old can also be exempted based on a reasonable return test. “[A] reasonable amount of dividends can be paid to these individuals and not be subject to TOSI if the amount paid represents a reasonable return on their contribution to the business,” the authors wrote.

However, qualifying for the reasonable-return exemption is much more difficult, as it considers many more factors such as the work the individual performed for the business, the value of property they contributed, the risks they assumed in respect of the business, and other relevant considerations.

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