TOSI and Dividends from Rental Income: New Rules, Old Problems

This article deals with the taxation of dividends from a private corporation that derives its income from one or more rental properties: Will dividends received by family members who are not active in the business attract the tax on split income (TOSI) in section 120.4?

Assume, for example, that Holdco is controlled by a parent who owns the voting shares. A daughter (aged 27) and a son (aged 25) own non-voting participating shares and have received dividends from Holdco for a number of years. How will those dividends be taxed under the new TOSI rules for post-2017 taxation years? A threshold question is whether the rentals are income from a business or income from property.

The answer is often uncertain because the legislative rules, the existing jurisprudence, and the CRA’s interpretive policies are not always consistent. The proper characterization of the rental income is important: if rental operations do not rise to the level of a common-law business, an important exception to the TOSI rules (subparagraph (g)(i) of the definition of “excluded amount” in subsection 120.4(1)) will not apply.

There are no bright-line tests for determining when an amount earned by a corporation should be regarded as income from property. In the well-known case of Canadian Marconi v. R (1986 CanLII 42 (SCC)), which dealt with the meaning of “income from an active business,” the court noted that the terms “business” and “property” are loosely defined and held that a low level of corporate activity will support a finding of income from a business.

In Ollenberger v. Canada (2013 FCA 74), the court said that only a minimum degree of activity is required for a corporation to be carrying on a business. In Spire Freezers Ltd. v. Canada (2001 SCC 11), the court said that “a business may be established even in circumstances where the sole business activity is the passive receipt of rent, as was noted by L’Heureux-Dubé J. in Hickman Motors Ltd. v. Canada, 1997 CanLII 357 (SCC).”

The CRA took the position (2018-0744031C6, May 29, 2018) that the shares of a corporation that has no business income and derives only property income (possibly rental income if the activities are not sufficient to constitute business income) cannot qualify as excluded shares. However, in “Guidance on the Application of the Split Income Rules for Adults,” examples 8 and 12, shares of a corporation earning income from passive investment assets qualified as excluded shares.

The CRA has said (2018-0780081C6, November 27, 2018) that “the corporations in examples 8 and 12 of the Guidance maintained a sufficient level of activity to support the view that their income may be considered to be from such a business.” The CRA also said that “it is a question of fact as to whether the income is from a business or property which can only be resolved after the review of all the facts and circumstances.” It made a similar statement at the 2018 APFF Tax Conference Roundtable (question 9(a)).

These CRA positions and interpretations lead to uncertainties, since they are based on questions of fact—namely, what constitutes a sufficient level of activity, and how one establishes a clear distinction between income from a business and income from property. Even if a threshold requirement for a business is low, it must be considered before any changes to share structures are recommended in order to avoid the application of the TOSI rules.

The preamble to the definition of “split income” exempts excluded shares, and a dividend on an excluded share that is received by an individual older than 24 is not subject to the TOSI rules (subparagraph (g)(i) of the definition of “excluded amount” in subsection 120.4(1)). A share is an “excluded share” under subsection 120.4(1) if, inter alia, “less than 90% of the business income of the corporation . . . was from the provision of services.”

In the Holdco structure described above, the children must hold shares with at least 10 percent in votes and value in order to meet the excluded-share criteria. This requirement gives rise to two caveats. First, the parent must be comfortable with the children owning voting shares. Second, the children must grow into the 10 percent value test, which may not happen soon; if the parent gifts shares (of at least 10 percent value) he or she may consequently incur personal taxes—a course that might not be prudent.

In summary, the TOSI rules incorporate a problem by reference—what constitutes income from a business and / or a property. How will the courts deal with such cases when they consider appeals from TOSI assessments? It is perhaps worth noting that much of the existing jurisprudence on this question was decided in the context of the ABI rules. Further, as is the case with many tax changes, the new TOSI rules may force owners to consider the extent to which otherwise desirable business decisions should be re-evaluated in the light of the tax consequences.