Private Corporation TOSI Rules
“Episode III: Revenge of the Fisc”
Note to readers: As noted in the lead-in to our July/August 2018 tax article, “Holding Passive Investments in a Private Corporation—Impact on the Small Business Deduction,” by Maninder Dhadda, CPA, CGA, the proposed legislation described in this article generated considerable concern among many in the profession in the summer and fall of 2017. You can review CPA Canada’s response to the proposed legislation by visiting the Members’ Area of the cpacanada.ca website and choosing “Taxation of private corporations” under News from the profession.
Star Wars fans might be able to draw some parallels between the famed franchise and the federal government’s recent advances against private companies.
Episode I: The saga begins on July 18, 2017, when the government releases a number of proposed amendments to the Income Tax Act (ITA), including amendments to create the tax on split income (TOSI) regime.
Episode II: Almost immediately after the release of the draft legislation, there’s an uprising of interested parties who rebel against the proposals as originally drafted. Now on the defensive, the federal government releases a revamped version of the TOSI regime on December 13, 2017, by way of amendments to the original proposals. While Episode II of this saga is an improvement over Episode I, the “rebels” are still not satisfied.
Episode III: The federal government’s latest response to the backlash comes out with little fanfare by way of a notice of ways and means motion dated March 22, 2018. It receives royal assent on June 21, 2018.
All of these changes to the original proposals have made it difficult for taxpayers to follow the plot—specifically, with regard to the potential implications for their businesses and the income-splitting opportunities (if any) that still exist.
The balance of this article will attempt to address some of these issues, and without further allusion to Star Wars.
At a macro level, the expressed purpose of the TOSI regime is to improve the fairness of the Canadian tax system and ensure that all Canadians pay their “fair share” of taxes. At a micro level, the purpose is to expand the scope of the “kiddie tax” regime to apply to all related individuals, so that a private company business owner cannot split income with low-income, related family members who have not made significant contributions to the business (something not possible for salaried employees, as noted by the government).
The first and, to a lesser extent, second versions of the TOSI rules were seen by many business owners and their advisors as highly ambiguous and open to subjective interpretation; additionally, in certain instances, both were seen to put business owners at a disadvantage to salaried employees with regard to income-splitting opportunities.
The third version of the TOSI rules was intended to respond to these criticisms and remedy the noted problems. Although it achieved this objective in some instances, it did not address a number of concerns expressed by taxpayers, and these areas of concern continue to create potential traps for the unwary.
Discussed below are some of the improvements made since the original legislation was drafted and some of the issues that remain problematic.
What Has Improved?
It appears that the TOSI rules cease to apply once business activities stop.
Based on the revised TOSI rules, it appears that in cases where an adult individual receives income that is not derived directly or indirectly from a related business for the year,1 such income will be an excluded amount, and, therefore, it will not be subject to TOSI. This suggests that even if an individual is subject to TOSI on income that is received from a corporation and derived from a related business, once this related business ceases to exist, any future income paid by the corporation to the individual will not be subject to TOSI.
The possible practical application of this change to the TOSI rules is that it may make sense to continue having low-income, related family members retain an equity interest in a corporation, even if the TOSI rules apply to income received by these individuals, on the off chance that the related business ceases to exist in the future, since future income allocations paid to such individuals will not be subject to TOSI.
A business owner might also consider having their low-income, related spouse retain an equity interest in a corporation even if the TOSI rules apply, because when a business owner reaches the age of 65, their spouse will have income from a corporation treated as an excluded amount in cases where this same amount would constitute an excluded amount if received by the business owner themselves. This means that business owners will be able to split income from a related business with their spouse once they reach the age of 65, regardless of the spouse’s investment in said business.
- With the addition of “for the year,” the legislation now makes it an annual test. If there is no business for the year, the rules won’t apply.
The criteria for the “excluded share” exemption from TOSI is easier to meet.
Earlier versions of the rules exempted individuals from TOSI on income received on “excluded shares” as long as this income met several conditions. One condition was that the shares on which the income was paid had to represent 10% or more of the corporation’s voting rights and 10% or more of the fair market value (FMV) of all issued and outstanding shares.
The third version of the TOSI rules simplified this requirement, making it so that the shares will be considered excluded shares in regard to a particular individual if the shares represent 10% or more of the corporation’s voting rights and FMV, but the individual in question need not meet this test entirely through the particular class of shares to which the income relates.
These particular changes to the TOSI rules will make it easier for taxpayers to meet the excluded share exemption test in situations where multiple classes of a corporation’s shares are issued—in many cases, multiple classes are issued for non-income-tax purposes. One example of such a case is where voting rights are retained in a voting non-participating share, separate from other classes of participating shares.
Photo: Max2611/iStock/Getty Images Plus
The TOSI rules are less likely to apply after a marital breakdown.
The third version of the TOSI rules includes an additional paragraph, which states that an individual will not be deemed to be related to their spouse or common-law partner at any time in the year if, at the end of said year, the individual is living separate from their spouse because of the breakdown of the marriage.
These changes should reduce the number of instances in which TOSI will apply to income that is: a) paid to individuals and b) directly or indirectly related to corporate businesses that are transferred necessarily between former spouses pursuant to their family-law commitments.
What Hasn’t Improved?
TOSI cannot be avoided in multi-tier structures.
One of the perceived flaws in the first two versions of the TOSI legislation was that the definition of excluded shares never seemed to apply in cases where a business was carried on in an operating entity (“Opco”) and the shares of Opco were held indirectly by an individual through a holding company (“Holdco”). Unfortunately, the third version of the TOSI rules did nothing to resolve this issue.
As a result, individuals who want to rely on the excluded share exemption in the TOSI rules will not be able to receive dividends from a Holdco that indirectly owns shares of an Opco. Where such structures currently exist, taxpayers should consider the non-tax implications of merging their Opco and Holdco in order to be eligible for the excluded share exemption.
The definition of “provision of services” remains ambiguous.
One of the other conditions of the excluded share definition in the TOSI rules is that less than 90% of the corporation’s business income can be from the “provision of services.” What constitutes the provision of services is not defined in the original draft legislation, leaving the term subject to interpretation. Unfortunately, the third version of the TOSI rules did nothing to clarify this definition. What this means for the many businesses that provide their customers with a bundle of goods and services is that, in some instances, the apportionment of “income” between these goods and services is going to be somewhat arbitrary and/or challenging.
It’s important to note that in cases where a related group carries on multiple businesses that include the provision of services and the sale of goods, the overall corporate structure associated with these businesses may need to be reorganized to ensure that certain shares meet the definition of excluded shares for TOSI purposes.
Opportunity Amid Uncertainty
As illustrated in the examples above, the new TOSI regime is incredibly complicated. The recent changes made in version III of the rules improved the rules to an extent, but these rules could still have many unexpected ramifications.
However, despite its complexity, the TOSI regime still offers opportunities to accomplish income splitting between related family members in a tax-efficient manner. As the TOSI rules have now been finalized (at least, for the moment), now is the time for advisors to review the circumstances of their private company clients and help these clients determine the implications for their businesses.