How will the new tax rules impact your family business? A discussion of tax on split income (TOSI)

On July 18, 2017, Finance Minister Morneau introduced a new set of rules, subsequently implemented, which limit income splitting amongst family businesses and family members. The new rules are referred to as Tax on Split Income or TOSI.

Canada’s tax system is primarily based on income earned by the individual and not the family as is the case in the U.S. Consequently, due to graduated tax rates, a family with one income earner receiving $100,000 will pay more tax than a family where two spouses each earn $50,000. The current federal government believes a private corporation or trust should not be utilized to reduce the tax bill of a family unit and are trying to eliminate the ability to reduce the overall family tax bill with the TOSI rules.

If an individual receives income, dividends or capital gains realized from a family-owned business in excess of a “reasonable” return on labour and capital, the amounts may be taxed at the top marginal tax rate. The Canada Revenue Agency (CRA) will effectively be evaluating the contribution of each family member to the family business to determine what is reasonable.

For example, prior to the 2018 Budget, an incorporated family business earning income of $300,000 before salaries to shareholders and related parties had the ability to pay salaries and dividends to family members such that the overall after-tax income was maximized. The new TOSI rules will restrict this planning and are proposed to apply to the 2018 and subsequent taxation years.

What is reasonable compensation?

Going forward, taxpayers will be responsible for demonstrating that a family member has meaningfully contributed to the business. If the compensation is not reasonable, the TOSI rules will apply. The CRA will decide if the compensation is reasonable based on a number of factors, including:

• The role and duties of the individual
• The capital contributed by the individual
• The risks assumed by the individual with regards to ownership in the business
• The historical amounts paid to the individual
• Any other factors that may be relevant

In addition to the reasonability test, the government has added several safe harbours where TOSI will not apply. Shareholders of a business are allowed to income split with:

• A spouse, where a business owner is age 65 or older (aligning the rules with existing pensions splitting rules) *Note: this is the age of the owner, not the age of the spouse
• Any family member where the capital gain qualifies for the capital gains deduction (qualified small business corporation shares or qualified farm property)
• Any family member where the shares are inherited from a deceased by will
• Excluded shares (discussed below)
• Excluded business (discussed below)

There are a few exemptions from the TOSI rules:

Excluded business

Individuals will be exempt from TOSI on amounts received from an excluded business, defined as a business where the individual is actively engaged on a regular, continuous and substantial basis in the year or in any combination of five previous years. The Department of Finance has clarified that an excluded business will include one where an adult individual (aged 18 or older) works an average of 20 hours per week during the part of the year that the business operates.

If the 20 hours per week threshold is not met, it may still be possible for an individual to be actively engaged in a business, depending upon the facts.

Furthermore, an individual will be exempt from TOSI if they have previously met the above test for at least five years within the history of the business. This can be any five years, they need not to be continuous or recent. Once this test is met, income can be split for a lifetime.

Excluded shares

Amounts derived from excluded shares are also exempt from TOSI. Excluded shares are those owned by an individual who is 25 or older and owns at least 10 percent of the votes and value of the shares of the corporation (need not be the same class of shares), and the corporation meets certain conditions, including:

1. It earns less than 90 percent of its income from the provision of services and
2. It is not a professional corporation (physicians, dentists, lawyers, etc.)

Issues with trust

Under the CRA’s guidance, if shares are owned by a family trust, they will not be considered to be owned by the beneficiaries for purposes of the 10 percent test. Because of this, the beneficiaries of a family trust are not able to rely on the excluded shares exception to TOSI, as the shares must be owned by the individual directly.

Example: In 2007, Company ABC completed an estate freeze and reorganization. The Company engaged a Chartered Business Valuator (CBV), which concluded an en bloc fair market value of $2 million. Al and Anabelle Smith were the original owners of Company ABC. Al and Anabelle effected the estate freeze of $2 million (under S.86 of the Income Tax Act) in order to pass future growth on to the next generation. Al and Anabelle exchanged their common shares for $2 million redeemable, non-participating, voting, preferred shares.

Immediately after, new common shares were issued to a discretionary trust for the benefit of their adult children, Bob and Brenda. Bob and Brenda are not actively involved in the business and have received dividends from the business from 2007 to 2017.

Since Al and Anabelle hold the fixed-value ($2 million) preferred shares, any future growth in the value of the company will accrue to the common shares held by the trust.

Due to the new rules Al and Anabelle are contemplating a reorganization in order to ensure that Bob and Brenda’s ownership interests meet the excluded share exemption rules and are therefore not subject the TOSI rules. They are contemplating a reorganization which would see a portion of the shares, exceeding 10% of the votes and value, held in Bob and Brenda’s hand rather than the trust.

As a result of these issues, many business owners are asking: “Is it time to simplify my structure?”

Planning considerations:

Review your share structure to determine if a corporate reorganization should be considered.

• Modifying the share structure could allow shareholders to qualify for the excluded share rules
• Consider transferring shares out of a family trust to the individual beneficiaries
• Aunts, uncles, nieces and nephews are not related individuals and therefore TOSI will not be applicable
• Multiple classes of shares may make it easier to issue dividends to allow for optimal shareholder planning opportunities. If more than one shareholder owns shares of the same class, you may be required to pay the same rate of dividends to all shareholders of the same class of shares. If you cannot pay dividends to one shareholder without causing another shareholder to receive dividends that would be taxed at the highest tax rate, you might consider a corporate reorganization such that the shareholders own different classes of shares.

Is a valuation required to substantiate the 10 percent votes and fair market value test?

• There can be issues related to prior estate freezes that may have been implemented, specifically regarding the value of the non-participating, voting, preferred shares; and the voting rights attributable to each class of share.
• There is a need to consider the impact of minority share discounts to arrive at 10 percent of votes and fair market value test.
• The company must be valued en bloc (i.e., 100 percent), and then the value can be allocated to each class of share.
• TOSI will not apply to compound income or income derived from property acquired as a result of a marital breakdown.

You have until the end of 2018 to complete any planning for income that will be distributed amongst a family group in 2018. For years after 2018 you will still have the opportunity to complete most of this planning however, you will lose the benefits for the 2018 year. Talk to your MNP tax and valuations advisors to see if you should consider any planning opportunities.

Craig Maloney, MBA, CPA, CA, CBV, is a Managing Director with the Business Valuation, Litigation Support and Corporate Finance Advisory groups, working out of the Halifax office. Contact him at 902.493.5430 or [email protected]

Andrew Inman, CPA, CA, is a Manager with the Tax and Business Advisory group, working out of the Halifax office. Contact him at 902.493.5445 or [email protected]