A critical review of recent Canada Revenue Agency views on TOSI and how to use them to your advantage

Since coming into effect at the start of 2018, the new “tax on split income” or “TOSI” rules have been a source of anxiety for financial professionals advising private business owners due to its broad scope and complexity. The saga started on July 18, 2017 when the Department of Finance (“Finance”) introduced the first version of its TOSI proposals. The tax practitioner community reacted strongly to the ill-thought-out proposals, ultimately leading Finance to introduce a second version of the rules on December 13, 2017. Finally, further tweaks were made, and Finance released the the third and final version of the TOSI rules on March 22, 2018. You can read our firm’s blog about V3 of the TOSI rules here and view our flowchart here

Although V3 was greatly improved from the earlier versions, many grey areas of interpretations in the legislation remain. The uncertainty, combined with the complexity of the rules, have confounded financial professionals across Canada and, often, paralyze business owners from carrying on the most mundane business and remuneration transactions. Interestingly, some of the recently published Canada Revenue Agency (“CRA”) views on certain aspects of the TOSI rules have been extremely generous. In this article, we will walk through some of these and how they will shape TOSI planning going forward. Also, along the way, we will provide caution on placing too much faith on some of these interpretative views, as some of these appear to be inconsistent with the legislation and the CRA is known for revoking or deviating from its published positions where it sees fit. Be forewarned that this article is lengthy, technical and intended for people who are familiar with the TOSI rules but we promise it will be worth your time if you advise private family businesses. 

 

A. Recent CRA Views

1. Retired Business Owners

TOSI only applies to an amount to the extent it is “derived directly or indirectly from a related business in respect of the individual for the year”. Generally speaking, a related business means (a) a business in which a related person is actively engaged on a regular basis, (b) a business of a partnership in which a related person has any interest, and (c) a business of a corporation in which a related person directly or indirectly owns 10% or more of the value.

The draft version of the TOSI rules released on December 13, 2017 – V2 – did not have the phrase “for the year” as part of the related business test, but added the phrase in the final enacted version of the rules. In our previous blog, we have expressed our view that the change was as a result of The Joint Committee on Taxation of The Canadian Bar Association and Chartered Professional Accountants of Canada’s March 8, 2018 submission to the Department of Finance, with the result that a historical related business no longer taints funds or property after the business is disposed of. The CRA view from Q9 of the 2018 CTF Roundtable confirmed this interpretation.

The first situation that the CRA commented on was regarding a corporation that has historically carried on a related business but has since disposed of that business in a previous year. If the corporation pays out the historical retained earnings or sale proceeds relating to that historical related business as a dividend to its shareholders, the CRA confirmed that even though the dividend is derived directly or indirectly from that historical related business, it is not derived directly or indirectly from a related business “for the year”. Therefore, TOSI does not apply to that dividend income. Unsurprisingly, the CRA added that if transactions were undertaken primarily to frustrate the TOSI rules in this manner, the CRA would seek to apply the general anti-avoidance rule (“GAAR”) in the Act.

The CRA then commented on a different scenario where an individual wholly owns an Opco (which carries on a related business) and her inactive spouse wholly owns a ServiceCo. In Year 1, ServiceCo provides services to Opco for which Opco pays for, but ServiceCo does not pay a dividend to the inactive spouse. In Year 2, ServiceCo ceases all activities so it no longer has a business and it pays the after-tax retained earnings from Year 1 to the inactive spouse as a dividend. The CRA explains that since Opco continues to carry on its own related business during Year 2, and the inactive spouse’s dividend income from ServiceCo in Year 2 is derived directly or indirectly from Opco’s related business, that dividend income is derived from a related business “for the year”. Therefore, the inactive spouse cannot rely on the related business exception and TOSI potentially applies if no other TOSI exceptions are satisfied.

We agree with the CRA’s views in both of these scenarios.

 

Planning takeaway: 

These CRA interpretations provide certainty for retired business owners who have wound-up or disposed of their business to a purchaser outside the family in a previous year. Many of them still hold the historical retained earnings or proceeds from the sale of the business in their holding companies, and these interpretations confirm that those funds would no longer be tainted by the historical related business from which they arose. This, of course, is in addition to the age-65 rule contains in the TOSI rules. With respect to any investment income generated by the holding company from these funds, we will cover that in the Investment Corporation discussion below.

These interpretations should also serve as a warning to overly enthusiastic planners who attempt to plan into the related business exception through artificial means. An example of such plan is to move a business from one corporation to another every year, so that dividend declaration occurs in a year in which no business is conducted by the dividend payor corporation. Unless there is a bona fide commercial rationale for such arrangement, or the business has transformed into a new business distinctly different than the previous, such planning will likely fail due to either the application of the GAAR or the fact that the related business for the year still exists.

 

2. Gross versus net income for “excluded shares” test

The “excluded shares” exemption in the TOSI rules is a ‘get out of jail free’ card for shareholders who own shares representing at least 10% of votes and value in a corporation that carries on the ‘right’ type of business. Meeting the conditions for this exemption will allow the shareholder(s) to earn unlimited dividends and capital gains from these shares without TOSI ever applying. One of the required conditions is that less than 90% of the business income of the corporation for the last taxation year was from the provision of services (paragraph (a) of the “excluded shares” definition). In another words, the corporation meets this test as long as greater than 10% (for example, say 10.01%) of its business income is from, say, the selling of goods. The question then becomes: is it gross or net business income that is relevant for this test? The CRA‘s view from Q5 of the 2018 STEP Roundtable is that it is gross income that the definition refers to. The CRA uses the example of a plumber or contractor who provides services, but also sells replacement parts or construction materials. If 10% or more of gross income is from the sale of these parts or materials, then the shares of the corporation could potentially be excluded shares. However, the CRA cautions that income from the sale of goods could in some cases be considered income from provision of services where such income can reasonably be considered to be ‘necessary for or incidental to’ the provision of the services (to illustrate this, CRA uses the example of an office cleaning service that separately bills for cleaning supplies used).   

 

Planning takeaway: 

Using gross income to apply the 90%/10% test is a much more practical approach than requiring the taxpayers (and CRA field auditors) to figure out the net income from each activity. Business owners aiming to achieve excluded shares status should make sure 10.01% or more of the corporation’s revenue from its business is derived from the sale of goods or other activities not involving the provision of services (along with meeting all of the other conditions for “excluded shares”). This may require reviewing a company’s service offering and determining whether it is possible to separately invoice customers for goods sold as part of, but not ‘necessary for or incidental to’ the service offering. The temptation would be to inflate the price of the goods component of a sale while reducing the price of the service component, in order to satisfy the 10.01% threshold. However, the risk of doing so is that the CRA has the power to reallocate income between goods and services under section 68 of the Income Tax Act (the “Act”) if they believe the allocation to be unreasonable (note that unlike section 69, section 68 applies even to arm’s length transactions).

By taking the gross income view, the CRA added a significant obstacle for a popular planning idea around excluded shares which was to stuff a service business corporation with an investment portfolio. If the test had been based on net income, a corporation carrying on a service business could potentially meet the excluded shares test if it also carried on an “investment business” that generates investment income exceeding 10% of the service business’ net income. With the test being a gross income test, the size of the portfolio required to generate sufficient investment income to exceed 10% of the service business’ gross income will often be much larger, subjecting a significant amount of equity to business creditor exposure. On the other hand, aggressive-minded taxpayers may attempt to take advantage of CRA’s view on this matter by having their service business corporation enter into financial or other non-service transactions that generate a large gross revenue amount that exceeds 10% of the corporation’s gross revenue but result in a nominal profit or loss. Plan at your own risk.

 

Caution on reliance:

This view took many by surprise because “income” and “income from business” typically means net income in the Act (see sections 3 and 9 of the Act), unless the context suggests otherwise (e.g. in paragraph 20(1)(c), the Supreme Court in Ludco found that the context of the immediately surrounding text requires that the word ‘income’ in that paragraph to refer to gross income). We find it equally persuasive that a contextual and purposive interpretation of the excluded shares definition lead to a conclusion that “business income” refers to net income instead. Accordingly, exercise caution when relying on the generous CRA’s views on this issue.

 

3. Investment corporations – single tier

Where members of a family hold shares in a corporation (Investco) that earns investment income (e.g. property rental, securities portfolio, etc.), it is possible to split income amongst the family through dividends without TOSI applying if either (i) the individual is age 18 or over and the dividend is not derived directly or indirectly from a “related business”, or (ii) the individual is age 25 or over and the shares constitute “excluded shares” to the individual.

In Q5 of the 2018 STEP Roundtable and Q9 of the 2018 APFF Roundtable, the CRA laid out how it approaches this matter. 

The CRA first looks at whether Investco is in fact carrying on a “business”. Whether Investco’s investment activities constitute business income or income from property is a question of fact. The CRA seems to indicate that they will apply a fairly low threshold as to when they will consider investment activities to constitute a “business”, by specifically pointing out that subsection 248(1) of the Act expands the concept of “business” to include “an undertaking of any kind whatever”. Note that the CRA has historically given positive “pipeline” rulings that investment holding companies could qualify for post-mortem pipeline planning by virtue of operating a business of dealing and investing in marketable securities[1] . Case law has also pointed to a very low threshold for what constitutes a business when the activities are carried on by a corporation. The Supreme Court of Canada in Marconi and the Federal Court of Appeal in Weaver took the view that there is a rebuttable presumption that any activities of a corporation are done to earn income from a business such that there is very little that a corporation could do that won’t be considered a business. This would not change even if the investment is managed by a third-party manager, because an active business is no less active merely because it is carried on by an agent. [2]

Once it is determined that the Investco is in fact carrying on an investment “business”, the CRA is of the view that Investco can meet the test that less than 90% of its business income in its prior year is not from the provision of services. Then, assuming the individual meets the 10% votes and value shareholding threshold and all or substantially all of Investco’s income in its prior year is not derived directly or indirectly from another related business, the shares are considered excluded shares and the shareholder is not subject to TOSI on dividends received from Investco.

In the event that the Investco’s investment activities are so passive that they do not rise to the level of a business (e.g. passively investing in a GIC – but even that is debatable as to whether that could constitute a business), the CRA takes the view that Investco shares cannot be excluded shares because it has no business income to apply the 90% test to. In that case though, since the dividend income is not coming from a business, by definition the dividend income is not derived directly or indirectly from a “related business” and therefore the TOSI rules do not apply. 

 

Planning takeaway:

It is debatable whether the CRA’s view that you need to have some business income in order to meet the 90% test is correct. A possible textual interpretation is that a corporation with nil business income can also meet the 90% test because less than 90% of business income (which is $0) is from the provision of services. This interpretation would be more consistent with the context and purpose of that part of the excluded shares definition which is really to weed out service companies and professional corporations – barring corporations with no business from this definition is not congruent with this context/purpose. 

That said, in the fact pattern of a plain vanilla investment corporation structure, whether the CRA is correct on this point is irrelevant, because without a business the shareholders are protected by the related business exemption in any event.[3]  The planning takeaway here is that income splitting is possible through the use of a single-tier investment corporation. In most cases, the Investco is carrying on an investment business, so a shareholder that is age 25 or older will avoid TOSI under the excluded shares exemption as long as the 10% shareholding requirement is met. In the event Investco is investing very passively such that its activities were insufficient to reach the level of a business, a shareholder age 18 or older could avoid the TOSI rules under the related business exemption.  When using Investco to income split, be mindful of the corporate attribution rules under subsection 74.4(2) which may apply if an individual had ever directly or indirectly lent or transferred property to Investco and the shareholders include minors, spouse / common-law partner or a trust with minors or spouse / common-law partner as beneficiaries. Where there is a risk of subsection 74.4(2) applying, consider paying annual dividends or interest to the transferor individual equal to the prescribed rate to avoid the notional income inclusion.

 

4. Holdco – Opco Structure

A Holdco-Opco structure is commonly used for private businesses. Creditor proofing is typically the primary reason for structuring this way, as excess cash can regularly be moved out of Opco into Holdco through tax-free inter-corporate dividends (subject to subsection 55(2)).  Often, there would be multiple Holdcos, one for each owner of the business. The TOSI issue with such a structure is that the shares of Holdco would most likely fail to qualify as excluded shares. This is because paragraph (c) of the excluded shares definition would require all or substantially all of Holdco’s income in its prior year to not be derived, directly or indirectly, from another related businesses (other than a business of Holdco). Therefore, to the extent more than 10% of Holdco’s prior year income consists of dividends from Opco, shares of Holdco cannot be excluded shares in the current year. This leads to the obvious question whether you can plan into obtaining excluded shares treatment by ensuring Holdco receives no dividend income from Opco in the preceding year. 

In Q9 of the 2018 APFF Roundtable, the CRA confirmed this to be true: the test can be met as long as in the preceding year Holdco did not receive any dividend income from Opco. This was not surprising because the words in paragraph (c) of the excluded shares definition are fairly clear in this respect. It was also not surprising that the CRA stated that if the transactions were primarily affected to obtain excluded shares treatment, they would consider applying the GAAR. There are numerous ‘plans’ out there designed to circumvent paragraph (c). For example, Opco pays inter-corporate dividends to Holdco and Holdco pays dividends to the individual shareholders only in Year 1, 3, 5, etc. This way, for each year the individual shareholders receive dividend income, Holdco did not have receive any Opco dividend income in the preceding year – as a result the Holdco shares are “excluded shares” in those years and TOSI is avoided. Another version of this plan is to solely rely on loans by Opco to Holdco to move up cash that Holdco can then use to pay dividends out to the individual shareholders. Since Holdco never receives dividend income from Opco, Holdco should meet the paragraph (c) test every year so that its shares are always excluded shares. This assumes that the relevant corporate statutes allow Holdco to pay dividends despite not having retained earnings. The more aggressive type of this planning even allows access to the excluded shares exemption for Opcos that are service or professional businesses, or for situation where family members own less than 10% of the underlying business. The Opcos in these situations can simply loan funds to a different corporation (“BorrowCo”), which then pays dividends those funds out (to the extent permitted by corporate law of the relevant jurisdiction) to 10% or more shareholders of BorrowCo who each would claim the excluded shares exemption. It is beyond the scope of this article to speculate whether the GAAR applies to all or any of these types of plans, but likely safe to say that the risk of a GAAR application increases greatly if you dial up the aggressiveness scale. 

However, what was somewhat surprising was the CRA’s view on whether investment income earned by Holdco from investing the proceeds from dividend income receipts from Opco is derived directly or indirectly from the related business carried on by Opco. The concept of “derived directly or indirectly from a business”, while already extremely broad, is further expanded by paragraph 120.4(1.1)(d) to include both “an amount that arises in connection with the ownership or disposition of an interest in the person or partnership carrying on a business” and “an amount derived from an amount described in this paragraph”. From Holdco’s perspective, the dividend income received from Opco is surely an amount that arises in connection with its ownership interest in Opco, which is a person who carries on a related business. It would also be reasonable to conclude that the investment income Holdco earns by investing the dividend income proceeds is “an amount derived from” said dividend income – thus concluding that Holdco’s investment income is derived directly or indirectly from Opco’s related business. However, in Q9 of the 2018 APFF Roundtable – as well as in a recent CRA Technical Interpretation[4], the CRA stated its position that if Holdco invests the proceeds from dividend income received from Opco, the resulting investment income earned by Holdco would not be considered to be derived, directly or indirectly, from the related business carried on by Opco. 

The implication of the CRA’s position on this is that taxpayer will benefit in the following ways:

  • There should be no need to track the origin of the capital on which Holdco’s (or any type of entity for that matter) investment income is earned. The investment income would not be considered derived directly or indirectly from the related business that generated this capital;
  • Shares of Holdco can meet paragraph (c) of the excluded shares definition to the extent it does not receive dividend income from Opco in the preceding year, even if Holdco earned investment income in the preceding year from historical Opco dividend receipts. This makes it much easier to manage the paragraph (c) circumvention planning described above (again, subject to the GAAR);
  • Even if Holdco shares cannot meet the excluded shares definition (either because Holdco received dividend income from Opco in the preceding year or because the particular Holdco shareholder does not own 10% or more of the voting and value shares of Holdco), Holdco can still pay dividends to the individual shareholders out of its investment income and TOSI is avoided because the dividend would not have been derived directly or indirectly from Opco’s related business. There are challenges relating to this. Firstly, the CRA says that, in such a scenario, the taxpayer must be able to trace the Holdco dividend income receipt to Holdco’s after-tax investment income, so it will be important for Holdco to cash-dam the investment return in a bank account entirely separate from the account which holds the Opco dividends received. Secondly, this only works if Holdco’s investment activities do not constitute an investment business, which as discussed earlier is very hard for a corporation to do unless the investments or associated activities are extremely passive.

The CRA’s position however can be a double-edged sword and can work against private business families in some circumstances. For example, let’s consider the situation where husband and wife are 50/50 shareholders of a Holdco that owns 100% of an Opco that carries on a service business, and both husband and wife work full time in Opco’s business so that Opco’s business qualify as an “excluded business” for both of them. Opco’s after-tax income is paid up to Holdco as a dividend and in turn Holdco pays such amounts out as dividends to both the husband and wife.  The dividends received by husband and wife will not be subject to TOSI due to the excluded business exemption. However, if after-tax retained earnings are left behind in Holdco or Opco to be invested and if those investment activities rise to the level of a business, then the investment business would likely be a related business distinct from the excluded business carried on by Opco. Taking CRA’s logic that investment income is not derived directly or indirectly from the underlying business that generated the investment capital a step further, this would mean that the investment income is not derived directly or indirectly from the excluded business carried on by Opco. Where a corporation carries on multiple businesses, the CRA has opined that the after-tax income of each business has to be separately tracked in the application of the excluded business exemption in respect of each specified individual.[5] As a result, the excluded business exemption would not protect the portion of any dividends received by husband or wife that were derived from the investment returns to the extent one or both of them was only engaged on a regular, continuous and substantial basis in Opco’s business but not the investment activities. Perhaps the reasonable return test may apply to assist the individuals here, but it is difficult to apply that test with certainty.

 

Planning takeaway:

If income splitting is a primary objective, Holdco-Opco structures should generally be avoided. However, that is easier said than done for existing Holdco-Opco structures and there could well be situations where there are non-tax reasons why a Holdco-Opco structure is needed. The strategy of Opco not paying dividends to Holdco in the preceding year so that Holdco shares may qualify as excluded shares should work, but taxpayers should be prepared to defend against a GAAR assessment by being able to substantiate that the arrangement was undertaken for primarily for a bona fide purpose other than to avoid TOSI.  Taxpayers may also choose to income split with the investment income earned by Holdco but will need to be mindful of the risk that the investment activities may constitute a related business in itself.

Caution on reliance:

Is the CRA correct that investment income is not derived directly or indirectly from the related business that paid the original dividend which the investment income was in turn derived from? As illustrated above, a textual reading of the expanded definition of derived directly or indirectly in paragraph 120.4(1.1)(d) of the Act appears to suggest otherwise. However, it is important to point out that the CRA’s generous interpretation appears to be consistent with the technical notes published by the drafter of the legislation itself (see example 3 of the Department of Finance’s Technical Notes accompanying paragraph 120.4(1.1)(d)). Modern statutory interpretation principles require that the purpose of the legislation be considered along with the text and context of the legislative provision, but typically only where the text is unclear. Given the content of Finance’s Technical Notes, it is certainly possible that the CRA’s interpretation is correct but it is far from certain given the words in paragraph 120.4(1.1)(d) of the Act looks fairly clear to be suggesting otherwise. Even if the CRA’s interpretation is correct, we can’t help but wonder why Finance didn’t used a more narrow wording in paragraph 120.4(1.1)(d) given its apparent intent. The broad wording of that paragraph simply adds more uncertainty to a set of rules already rife with complexity. 

 

5. Opco – Trust – Corporate Beneficiary Structure

In Q11 of the 2018 APFF Roundtable, the CRA commented on a structure where Opco is owned by a discretionary trust in which an Investco is a beneficiary. This is typically referred to as a ‘Triangular’ holding structure. In this particular situation, the Investco is wholly owned by a family member who is not involved with Opco’s business. In the prior year, Opco paid a dividend to the trust which in turn distributed it to Investco as a beneficiary (presumably paid out of Opco’s safe income on hand so that subsection 55(2) is not a concern). Investco also earned investment income in the prior year. The CRA was asked whether TOSI applies to the shareholder of Investco if Investco pays a dividend in the current year.

According to the CRA, if it can be determined that Investco paid the dividend out of its after-tax income from its investment income, then the dividend received by the family member shareholder would not be subject to TOSI since the dividend income received by such a person would not be derived directly or indirectly from a related business. Even if Investco is carrying on an investment business, it would not be a related business provided no persons related to the shareholder are actively engaged in the investment business.  The CRA provides the explicit advice that Investco needs to “adequately monitor” its funds derived from its investment to substantiate that it is paying the dividend out of the investment returns (and not from the Opco dividend itself).

Although not mentioned in the Roundtable response, presumably the answer would be the same if Investco’s investment return is realized from funds received from Opco, consistent with the other CRA views discussed above.

 

Planning takeaway:

The triangular structure is often preferable to the traditional Holdco-Opco structure due to its flexibility. By using a discretionary trust as the direct shareholder of Opco, the trustees are free to direct the allocation of the dividend income to any income beneficiaries they see fit, including to a corporate beneficiary in the event funds are not needed personally by the family. This CRA view confirms that investment income earned by the corporate beneficiary –  Investco – can be paid out as dividends to the individual shareholders without TOSI applying as long as the investment activities do not constitute a related business. Earlier, in the context of the Holdco-Opco structure, we mentioned that there was some uncertainty as to the correctness of CRA’s view that a Holdco’s investment return is not derived directly or indirectly from the Opco’s related business. Our view on this matter is different with a triangular structure. We make this distinction because with a triangular structure, the corporate beneficiary – Investco – does not own an interest in the person carrying on the business (i.e. Opco) since all Holdco has is a beneficial interest in the discretionary trust (thus at least falling outside of the wording of paragraph 120.4(1.1)(d) of the Act). Therefore, Investco’s investment income is less likely to be caught by the phrase derived directly or indirectly, even if the CRA’s interpretation of the scope of that phrase turns out to be incorrect. 

Another major tax benefit of the triangular structure over the Holdco-Opco structure is that it is usually much easier to assess the lifetime capital gains exemption (LCGE) with such a structure, due to (i) most arm’s length buyers are reluctant to buy shares of a Holdco and (ii) it is easier to maintain Opco shares as qualified small business corporation (QSBC) shares than to do the same with shares in a Holdco. Concurrently, this structure allows family members to take advantage of the qualified small business corporation (“QSBC”) or qualified farming / fishing property (“QFP”) capital gain exclusion in the TOSI rules (i.e. TOSI doesn’t apply to taxable capital gains realized on shares that qualify for the QSBC or QFP status). To take this a step further, planning should consider an inter-vivos ‘two-step’ pipeline transaction so that the family is able to surplus strip at capital gains rate that is taxed at each adult family member beneficiaries’ marginal tax rates (regardless of whether they are active).

 

Caution on reliance:

Ownership of the corporate beneficiary – Investco – needs to be carefully structured if income splitting using its investment income is an objective. As discussed, Investco in most cases will be considered to be conducting an investment business. If a related person is actively engaged in managing the investment business, then obviously the investment business becomes a related business and dividend income received from Investco will not be exempt from TOSI. What is not so obvious is that, even if no related person is actively engaged in managing the investment, there will still be no exemption from TOSI if there are two or more related shareholders in Investco. This is because a business of a corporation is automatically a related business if a related person is directly or indirectly a 10% or more shareholder. Therefore, to be prudent, a separate corporate beneficiary Investco should be set up for each family member, who will each wholly own and manage the investment activities of their own Investco. 

 

6. Investment Partnership or Trust

Before we get into the specific situation that the CRA commented on, we need to provide some technical context with respect to how the TOSI rules work with partnerships and trusts. 

TOSI applies to “split income” earned by a specified individual, unless certain exemptions such as the excluded shares, excluded business and related business exemptions can be relied upon. The definition of “split income” in subsection 120.4(1) is written to include certain income received by the specified individual from partnerships and trusts. Below we set out how the split income definition structure this inclusion, and we will be referring to the specific clauses used by the drafter of the TOSI legislation.

When a partnership allocates income to a partner, the Act – by virtue of paragraph 96(1)(f) – considers the partner to have earned that income from the same source as did the partnership. Paragraph (b) of the split income definition will include a portion of the paragraph 96(1)(f) income inclusion required by the partner to the extent the portion:

  • (b)(i)

    is not described in paragraph (a) of the split income definition [paragraph (a) considers as split income any dividend income or shareholder benefit from a private corporation], and

  • (b)(ii)

    can reasonably be considered to be income derived directly or indirectly from

    1. a related business for the year, or
    2. the rental of property if a related person at any time in the year is actively engaged on a regular basis in the rental activities, or a related person has an interest in the partnership through another partnership.

Paragraph (c) of the split income definition casts a similar net for a portion of trust income to the extent the portion:

  • (c)(i)

    is not described in paragraph (a) of the split income definition [i.e. any dividend income or shareholder benefit from a private corporation], and

  • (c)(ii)

    can reasonably be considered

    1. to be in respect of taxable dividends received from a private corporation,
    2. to be in respect of a shareholder benefit received from a private corporation,
    3. income derived directly or indirectly from a related business for the year, or
    4. income derived from the rental of property if a related person at any time in the year is actively engaged on a regular basis in the rental activities.

An astute reader will notice that subparagraph (c)(i) and clauses (c)(ii)(A) & (B), as set out above, appear complete opposite of each other. Subparagraph (c)(i) says that the trust income is caught if it is not dividend income or shareholder benefit from a private corporation to the recipient beneficiary; while clauses (c)(ii)(A) and (B) says that the trust income is caught if it is in respect of dividend income or shareholder benefit from a private corporation.

The reason for this legislative acrobatic is that with distribution of income from a trust to an income beneficiary, the source of the underlying income is not preserved, but the trust may choose to make certain designations under the Act to preserve the nature of a dividend or capital gain. Therefore, if the trust receives a dividend from a private corporation and it makes a designation – under subsection 104(19) of the Act – to pass that dividend income to a beneficiary, that beneficiary is deemed to have received the dividend and not the trust. In that case, the beneficiary does not meet (c)(i), and since (c) requires both (c)(i) and (c)(ii) conditions be met the amount falls completely outside of (c). Nevertheless, the beneficiary would be considered to have received split income under paragraph (a) of its definition because the beneficiary would be deemed to have received private corporation dividend income per subsection 104(19). On the other hand, if the trust does not make the subsection 104(19) designation, the beneficiary is just considered to have received trust income (rather than dividend income). In that case, both (c)(i) and (ii) are satisfied, because the amount received by the beneficiary is not considered dividend income from a private corporation but can reasonably be considered to be in respect of dividends received from a private corporation.

Finally, paragraph (e) of the split income definition treats as split income any taxable capital gains from, or trust income that can be considered to be attributable to a taxable capital gain from, the disposition of private corporation shares.

Now that we have the technical background out of the way, in Q3 and Q4 of the 2018 APFF Financial Instruments and Strategies Roundtable and Q12 of the 2018 APFF Roundtable, the CRA was asked a series of questions relating to a partnership or a trust earning dividend income and realizing capital gains on publicly traded securities, interest income, and rental income. Here are the conclusions arrived at by the CRA (it will be helpful if you refer back to the split income definition excerpts, we set out above when reading the remainder of this section):

  • Income allocated by a partnership to its partner maintains its nature and characteristics by virtue of paragraph 96(1)(f). Therefore, any dividend income or taxable capital gains allocated to a partner relating to publicly traded stocks cannot be split income – given paragraphs (a) and (e) of the split income definition include only dividend income and capital gains from shares that are not publicly listed. As a result, TOSI cannot apply to the partner for such income, but the CRA cautions that subsections 103(1) and (1.1) of the Act may apply if the partnership income allocation is found to be unreasonable and other attribution rules may apply in some circumstances.
  • Distributions to beneficiaries from a trust relating to dividend income from a public corporation cannot be split income – by virtue of paragraph (a) and (c)(ii)(A) of the split income definition applying only to dividend income arising from shares that are not publicly listed. Similarly, distributions to beneficiaries from a trust relating to taxable capital gains from the disposition of public corporation shares cannot be split income – by virtue of paragraph (e) of the split income definition applying only to capital gains arising from the disposition of shares that are not publicly listed. As a result, TOSI cannot apply to a beneficiary receiving trust distributions paid out of dividend income and taxable capital gains in respect of publicly listed shares.
  • Distributions to beneficiaries from a trust relating to interest income may be split income – by virtue of clause (c)(ii)(C) of the split income definition – if it is earned as part of an investment business carried on by the trust and a related person is actively engaged so that it becomes a related business. Therefore, trust income paid out of interest income may potentially be subject to TOSI.
  • For distributions to beneficiaries from a trust relating to rental income, the determination of whether such trust income will be considered split income depends on whether the rental activities are carried on as part of a related business. If the rental activity rises to the level of a business and a related person is actively engaged on a regular basis in that business, then it is a related business. If that is the case, clause (c)(ii)(C) of the definition of split income applies and the trust distribution will be considered split income and potentially TOSI to the beneficiary. Conversely, if the rental activity does not rise to the level of a business, then regardless of whether a related person is involved, it cannot be a related business. In that case, clause (c)(ii)(D) of the split income definition becomes relevant, as that clause catches any rental income of a trust where a related person is actively engaged on a regular basis in the rental activities. Therefore, to the extent a related person of the beneficiary meets the active engagement test, the distribution is split income to the beneficiary even if the rental activities do not rise to the level of a business. However, the CRA then went on to point out that because the definition of “excluded amount” provides an exemption from TOSI for individuals age 18 or over in respect of any amount not derived directly or indirectly from a related business, that trust distribution cannot be subject to TOSI despite it being split income under clause (c)(ii)(D) of that definition.

There are many things that appear to be technically wrong with these CRA views (again, please refer back to the split income definition excerpt from earlier, as you are reading the below). 

First, a partner of a partnership who is allocated dividend income or taxable capital gains in respect of a publicly listed security is indeed not caught under paragraph (a) and (e) of the split income definition because those definitions only applies to private corporation shares. However, the analysis cannot stop there. The inapplicability of paragraph (a) means that subparagraph (b)(i) of the split income definition is satisfied, which then requires us to examine subparagraph (b)(ii). In the instance where the dividend income and taxable capital gains are earned as part of a related business, subparagraph (b)(ii) should be satisfied due to clause (b)(ii)(A) so that the partnership income allocation should indeed be split income and potentially attract the application of TOSI. In other words, if a partnership is factually carrying on an investment business, that business is most likely a related business (a partnership’s business is automatically a related business any time two or more related persons are partners of a partnership) and therefore any dividend income or taxable capital gains derived from such an investment business should be caught by TOSI unless the person is either actively engaged on a regular, continuous and substantial basis in the investment activities or the return does not exceed a reasonable return. The CRA’s conclusion that public company dividends and capital gains earned by a partnership are always excluded from TOSI appeared to be based on a misreading of the split income definition; more specifically they have erroneously ignored subparagraph (b)(ii) of the definition.

Second, if a trust earns dividend income or taxable capital gains in respect of a publicly listed security and the trust designates that income or gain to have been received directly by the beneficiary, those amounts indeed would not be caught under paragraph (a) and (e) of the split income definition. However, similar to the partnership analysis for paragraph (b) above, paragraph (c) also has a two-part requirement. Subparagraph (c)(i) of the split income definition is satisfied because paragraph (a) is inapplicable, but this means we need to examine subparagraph (c)(ii). Clause (c)(ii)(A) of the split income definition is not met since the dividend income is from a publicly listed corporation, but if the trust’s investment activities rise to the level of a business and a related person is actively engaged on a regular basis in the activities, then the situation should fall into clause (c)(ii)(C) of the split income definition thus causing subparagraph (c)(ii) to be satisfied. In other words, if the trust is carrying on an investment business which happens to be a related business, then any distribution of the dividend income and taxable capital gains in respect of publicly listed securities should be split income and subject to TOSI, unless the investment business is an excluded business for that beneficiary or the amount of the distribution does not exceed a reasonable return. The CRA’s conclusion that a trust’s distribution to a beneficiary from dividend income and taxable capital gains from publicly listed securities are always excluded from TOSI is again based on a misreading of the split income definition, more specifically, subparagraph (c)(ii) of that definition.

Lastly, it is necessary to take a step back to see if these CRA interpretations are in line with the overall scheme of the TOSI legislation, since legislation must always be interpreted in a textual, contextual and purposive manner. The overall scheme of the TOSI legislation is primarily the prevention of the enjoyment of marginal tax rates by an inactive family member on income that arises from the contribution of a related person, with limited exemptions. How do the CRA interpretations align with this scheme if they essentially result in unrestricted income splitting opportunities for portfolio investment income carried on by partnerships and trusts (which are themselves key tools for splitting income prior to the new TOSI legislation), especially given that these interpretations do not even appear to follow the text of the legislation? What could the policy reason be regarding the application of TOSI to an investment business that is a related business when it is carried on by a corporation, but not when it is carried on by a partnership or trust?

What about CRA’s statement regarding rental income earned by a partnership or trust? At first glance, the CRA’s position appear to render clause (b)(ii)(B) and (c)(ii)(D) meaningless. These two clauses were specifically put in to cast the TOSI net to situations where the rental activity is not a related business (because otherwise (b)(ii)(A) or (c)(ii)(C) of that definition would have applied). However, the TOSI rules then turn around and exempt (b)(ii)(B) and (c)(ii)(D) from TOSI because of the non-existence of a related business. Is this a technical error in the legislation? It doesn’t appear so. Without (b)(ii)(B) and (c)(ii)(D), rental activities by a partnership or trust that fall below the threshold of a business would not be covered under the split income definition at all, and family could have then split rental income with minors under age 18. Finance drafted the rule this way to ensure that TOSI applies to partners and beneficiaries younger than age 18 for distributed rental income, regardless of whether the rental activities constitute a business. For partners and beneficiaries age 18 or over, the TOSI rules are explicitly permitting the splitting of rental income to the extent the activities by the trust or partnership do not rise to the level of a business. While we can debate the fairness of this policy decision, the technical interpretation by the CRA of this specific matter appears to be correct.

 

Planning takeaway:

Theoretical discussions aside, we are in the business of helping families optimize their tax affairs. Even though we believe the CRA’s interpretations may be incorrect as they relate to the above-mentioned matters for partnerships and trusts, we need to consider how to use them to the taxpayers’ advantage. 

Under these generous CRA’s interpretations, it is open season for families with wealth held outside of the corporate group to structure their affairs using trusts and partnerships to easily split investment income with inactive family members. Funds that are already held by family trusts and partnerships can be deployed to earn public company dividend income and realize taxable capital gains, and to carry on rental activities that do not rise to the level of a business. All such income can then be distributed/allocated to inactive family members with no TOSI implications (assuming the CRA stand by their interpretations). The partnership or trust may want to consider avoiding earning interest income because TOSI would potentially apply to the distribution/allocation of such interest income to the extent the investment activities constitute a related business. If new family trusts need to be established, consider using a prescribed rate loan strategy to avoid attribution. Setting up a partnership to split income this way is typically trickier due to the CRA’s ability to reallocate unreasonable partnership income allocation under subsections 103(1) and (1.1) of the Act.

 

Caution on reliance:

As stated above, we doubt the correctness of CRA’s interpretations on public company dividends and capital gains earned through partnerships and trusts, and the CRA can reverse or refuse to follow their own published views at any time. That said, it is most likely that even if the CRA reverses their views on these matters it may be on a prospective rather than a retroactive basis. More importantly though, we think it is possible to income split with investment income using partnerships and trusts without having to rely on questionable aspects of the CRA’s views.

With respect to dividend income, taxable capital gains and interest income arising from publicly listed securities held by a trust or partnership, it is entirely uncontroversial that as long as such income is not derived directly or indirectly from a related business, then TOSI does not apply when such income is distributed/allocated to the beneficiary/partner. Despite the CRA’s assurance that dividend income and taxable capital gains from publicly listed securities held by a trust or partnership should never attract TOSI, it is prudent to ensure that the trust or partnership’s investment activities do not rise to the level of a business (and therefore impossible to be considered a related business) just in case the CRA’s views on this matter are incorrect. 

 

B. What Constitutes a Business?

As explained in our earlier discussion of the Marconi and Weaver court decisions, the common-law presumption that anything done by a corporation is a business makes it very difficult for a corporation’s investment activities to be anything but a business. To the contrary, individuals, trusts, and partnerships whose members are not corporations are not subject to this presumption. There is a large body of case law on when an individual’s investment activities constitute a business (because it has important implications such as whether a trading loss is a capital loss or a business loss). The common theme amongst these cases is that while all facts need to be considered, some sort of ‘busyness’ is required for a business to exist. For example, a simple long term ‘buy and hold’ investment strategy is likely not a business when it is carried out by a non-corporate entity but is merely the earning of income from property. See for example Noël, ACJ’s explanation of the distinction between income from property versus income from business in Hollinger v. The Queen[6],: 

If income from property has any meaning at all, it can only mean the production of revenue from the use of such property which produces income without the active and extensive businesslike intervention of its owner or someone on his behalf. I have in mind, for instance, property such as bonds or debentures or shares or real property which do not require the exertion of much activity or energy in order to produce the revenue.

In archived Interpretation Bulletin IT-479R (at paragraph 11), the CRA lists the factors that it considers are characteristics of someone carrying on a business when dealing with securities:

  1. (a) high frequency of transactions,
  2. short duration of ownership,
  3. taxpayer has knowledge of and experience in the securities markets,
  4. security transactions form a part of a taxpayer’s ordinary business,
  5. substantial time spent in investment activities,
  6. security purchases are financed by margin or other debts,
  7. the taxpayer has advertised or otherwise made it known that he is willing to purchase securities, and
  8. speculative nature of the securities.

Therefore, provided the nature of the trust or partnership’s investment activities fall outside most or all of the above indicia, it is likely not carrying on an investment business. If that is the case, a trust or partnership distribution of dividend income, taxable capital gains and interest income arising from publicly listed securities to beneficiaries/partners should not attract TOSI even when those receiving the amounts are completely inactive in the investment activities or the underlying family business. Keep in mind though that delegating to a third party manager in itself will not necessarily prevent the investment activities from constituting a business.

With respect to rental income realized from property held by a trust or partnership, care should be similarly taken to ensure it does not rise to the level of a business to take full advantage of the inapplicability of TOSI to such rental income earned by partners and beneficiaries age 18 and over.

 

c. Final Commentary

If you have managed to get to this point, you should appreciate how ridiculously complex, difficult and uncertain the whole TOSI regime has become. Although we have criticized various interpretations from the CRA throughout this article, it may be that the CRA was very aware of the technical issues behind their interpretations but felt that the rules were so broad and difficult to administer that it had to bend over backwards to provide administrative positions that make the rules “workable” for their front line staff. Fault should not lie at the feet of the CRA but instead with our current Government who insisted the Department of Finance draft rules to deal with the perceived mischief – regardless of the complexity and application of the legislation. 

Although we have quoted this previously, we feel there is a no better way to end this article than with this statement from The Joint Committee on Taxation of The Canadian Bar Association and Chartered Professional Accountants of Canada in its March 8, 2018 submission to the Department of Finance regarding the TOSI rules:

“There is a time and place for complexity. Rules likely to apply primarily to multinational corporations, who can be expected to have access to sophisticated advisors can reasonably be complex and involved where necessary for their purpose. The TOSI rules apply in a context that could not be more different. Every single individual resident in Canada who receives or realizes an amount derived from a private corporation, partnership or trust will need to understand these rules in order to comply with the law.”

Be careful out there. 

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[1] See, for example, CRA Document #2016-0670871R3

[2] ESG Holdings Ltd. v. R., 76 DTC 6158 (FCA)

[3] There can easily be iterations of the facts where CRA views that shares in a nil business income corporation cannot qualify for the excluded shares exception will have adverse TOSI implications. For instance, if the Investco’s funds were loaned from another corporation that carries on a related business, and Investco has no business income in the prior year, then if Investco pays out a dividend from those funds in the current year, TOSI potentially applies because the funds were derived directly or indirectly from a related business for the year and the shares would not be excluded shares in the current year.

[4] See CRA Document #2018-0771861E5

[5] See CRA document #2018-0761601E5

[6] 1972 CTC 592 (FCTD)