Tax on Split Income Changes (TOSI)

In the July 2017 announcement, the federal government announced some significant changes coming to the tax on split income rules. The changes became official with the December 2017 proposals. In this instalment, we take an in-depth look at these new rules.

Significant Change to the “Specified Individual” Definition

The major change brought to the Tax on Split Income (TOSI) rules is to the definition of the “specified individual”. For 2018 and on, a specified individual is any taxpayer who is a resident of Canada (for a child under 18 years old, one of the parents must be a resident) [ITA 120.4(1)]. This is quite different from prior years, where a specified individual was only a taxpayer that was under 18 during the tax year. Because of this change, the process to determining if there is TOSI to pay or not will depend on the source of the income (split income), and the age of the recipient. The exclusions to TOSI have also been reworked.

Changes to the Process of Determining TOSI Application

The following sections not only indicate the changes to the process, but the sequence of the process itself in determining if TOSI applies or not.

Split Income Definition

Additions have been made to the definition of “split income”. To the existing types of incomes, we now also include income from debt obligations from a private corporation, gains from the sale of private corporations shares, and income from property with historical Tax on Split Income [ITA 120.4(1)].

Excluded Amount General Definition

Extensive changes have been brought to exclusions. Amongst them:

• An age limit (under 25 years old) has been added to existing exclusions of property received from the death of a parent, and from any other person if the specified individual is a full-time student [ITA 120.4(1)].
• Property received because of a decree, order, judgment or separation agreement due to a breakdown of a marriage or common-law partnership is now excluded from TOSI [ITA 160(4)] [ITA 120.4(1)].
• Gain from a deemed disposition on the death is excluded [ITA 70(5)] [ITA 120.4(1)].
• Gain from the disposition of a property eligible for the Capital Gains Deduction is excluded [ITA 120.4(1)] (unless the specified individual is under age 18 and the disposition is to a non-arm’s length person).

Other exclusions have been added that are age-dependent, which will be discussed in the following sections.

Specified Individuals under 18

If it is determined that the taxpayer under 18 has received split income and does not have any exclusions mentioned above, if the income is the result of a capital gain from the transfer of a private corporation shares to a non-arm’s length individual, then that taxable capital gain is deemed not to be a taxable capital gain and twice the amount is deemed to be received by the specified individual in the year as a non-eligible dividend subject to the regular gross-up and taxed at the highest marginal rate [ITA 120.4(4)]. Otherwise, the TOSI rules apply and the taxable capital gain, as well as any other income, are taxed at the highest marginal tax rate of 33% [ITA 120.4(2)].

Specified Individuals 18 and Over

If the taxpayer has split income and does not have an excluded amount (see above), a few more tests are performed to determine if TOSI applies. Does the income come from a “related business”? A related business can be summarized as a business carried on by a “source individual” (related person), a partnership in which the source individual is a member, or a corporation in which that source individual owns at least 10% of the FMV of the shares [ITA 120.4(1)]. If not, no TOSI is applicable.

If the answer is “Yes” to the question above, now a new exclusion has been added. If the specified individual is actively engaged on a regular, continuous and substantial basis (average 20-hour work weeks) in the activities of the business in either the taxation year or any of the 5 preceding tax years, no TOSI is applicable. If not, more tests must be applied based on age.

Specified Individuals Between 18 and 24

At this stage, we must determine if the split income is above the “safe harbor capital return” [ITA 120.4(1)]. This return is the FMV of the property contributed by the specified individual in support of a related business multiplied by the prescribed interest rate [ITA 120.4(1)]. TOSI does not apply if the income is within this safe harbor.
If the split income is above the safe harbor, the “reasonable return” test is done on the excess amount. The “reasonable return” is based on the contributions made by the specified individual or a related person, having regard only to the contributions of arm’s length capital.

Specified Individuals 25 and Over

For specified individuals 25 and over, the next test is to determine if the income came from “excluded shares” [ITA 120.4(1)]. Shares are excluded if:

• Less than 90% of the business income of the corporation for the last taxation year of the corporation that ends at or before that time was from the provision of services;
• The corporation is not a professional corporation;
• The shares owned by the specified individual represent 10% of the votes and value of the corporation;
• Less than 10% of the income received by the corporation came from a related business.

If the shares are excluded shares, TOSI is not applicable. If not, a new “reasonable return” test is added. In this case [ITA 120.4(1)], reasonable return is split income of the specified individual that is deemed reasonable based on work performed, property contributed, and amounts paid for the business [ITA 120.4(1)].  Anything within the reasonable return is exempt from TOSI. Any amount above the reasonable return is subject to TOSI.