In Canada, taxpayers are taxed at a marginal rate. In general, the higher the income, the higher the tax rate. Accordingly, the motivation to redirect (split) income to another person, in the hopes of lowering the respective tax rate, is common. Canada Revenue Agency works to thwart such efforts with the tax on split income ("TOSI") rules, starting with subsection 120.4(1) of the Income Tax Act.
The scope of "split income" in the current version of the TOSI rules is widely encompassing. This includes, but is not limited to, dividends, income from a partnership, rental property income, amounts in respect of a debt obligation, benefits, income of a trust beneficiary and capital gains. However, the legislation also delineates some forms of income as exempt from the TOSI legislation, referred to as "excluded amounts". Income from wages or salaries and publicly traded investments are also TOSI exempt.
Pursuant to subsection 120.4(2) of the Income Tax Act, split income belonging to a "specified individual" is taxed at the highest marginal rate except for an "excluded amount". Per subsection 120.4(5) of the Income Tax Act, capital gains representing split income are deemed to be dividends at twice the amount of the gain.
In 2018, the TOSI amendments were intended, in part, to prevent the use of private corporations to split income with adults, common law partners and spouses. The modifications to the "Definitions" found in subsection 120.4(1) of the Income Tax Act resulted in additions to the meanings of excluded amount, specified individual and split income. Further definitions were added to subsection 120.4(1) including excluded business, source individual, reasonable return, arm's length capital, related business, safe harbor capital return and excluded shares.
From its inception, the application of the TOSI rules was triggered by reference to a "specified individual", initially a resident Canadian under the age of 18. The current rules are broader in scope and apply to Canadian resident individuals including adults (other than a trust) as well as minors with a Canadian resident parent.
Income in contravention of the TOSI rules is linked to the "source individual" and transferred to the specified individual. A source individual is defined as a resident Canadian individual in the respective year who is related to the specified individual. The definition of "related" can be found in subsection 251(2) of the Income Tax Act and includes "individuals connected by blood relationship, marriage or common-law partnership or adoption...", a corporation and the person who controls it or a related group in control. "Blood relationship..." is defined at subsection 251(6) of the Income Tax Act and includes children, marriage, common law and adoption.
Excluded amounts are not considered split income. Examples are an inheritance per paragraph 70(5)(a) of the Income Tax Act. Also, capital gains or income not within the excluded amount definition, such as from a non-related business or "excluded business". The excluded business exception applies if the specified individual is involved in the activities of the business.
In addition, an excluded amount includes "excluded shares." Excluded shares are owned by the
specified individual pursuant to certain conditions. For one, less than 90% of the corporation's business income for the respective tax year was from the provision of services and it is not a professional corporation. Also, the income of the corporation cannot be from a related business.
Finally, the specified individual must own 10% or more of voting shares which also represent 10% or more of the fair market value of the shares of the corporation. Accordingly, the capital gain from the sale of excluded shares, excluded business and a non-related business are excluded amounts. Additional excluded amounts include employment income, amounts related to the breakdown of relationships including married and common law couples, the retirement of a founder of a business, older than 65 years, and death.
A "related business" is carried on by a source individual. As mentioned, a source individual is a Canadian resident related to the specified individual. A "related business" refers to a business carried on by a source individual including a business carried on through a partnership, trust or corporation as long as the source individual is actively and regularly engaged in respective income producing activities. Also included in the definition of a related business is a source individual's partnership interest in the business of a partnership and the business of a corporation. However, the source individual must own as much as or greater than 10% of the corporation's shares.
The current incarnation of the TOSI legislation is comprehensive and further restricts income splitting methods by Canadian taxpayers. The definitions in section 120.4 of the Income Tax Act have been significantly broadened in order to impede splitting income with persons other than just minors. The rules target adults as well and contain precise definitions of source and specified individuals which are used to link entities such as private corporations, partnerships, trusts and the respective transfer of income.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
