Tax Update: Income Sprinkling (TOSI)
On December 13, 2017, the Department of Finance released revised draft legislative proposals on income sprinkling. These updated the original proposals released in July 2017 and were intended to provide simplification and better target the rules. The new draft proposals extend the tax on split income (TOSI) to adult children (over the age of 17) and spouses and are effective as of January 1, 2018.
TOSI was originally introduced in 1999 to prevent income sprinkling of certain income to minor children. The current rules apply to dividends from private company shares and income from trusts or partnerships derived from a business or rental activity of a related individual. TOSI also denies access to the Lifetime Capital Gains Exemption on non-arm’s length dispositions. If TOSI applies, the income is subject to the highest marginal rate with no personal tax credits.
Based on the draft proposals, TOSI will potentially apply to amounts received by a specified adult individual directly or indirectly from a related business. The revisions to the July 2017 proposals include the following:
- Exclusion from TOSI for adult individuals who contribute labour to a related business on a regular, continuous and substantial basis (Excluded Business);
- Exclusion from TOSI for individuals over the age of 24 who have a significant equity investment in a corporation, other than a corporation that carries on a services business or is a professional corporation (Excluded Shares);
- Clarification of the reasonableness test;
- Better alignment with the pension splitting rules for retirees;
- Changes to ensure that TOSI doesn’t apply to capital gains that qualify for the Lifetime Capital Gains Exemption;
- Removal of aunts, uncles, nieces and nephews from the specified individual definition for purposes of TOSI; and
- No application of TOSI to compound income (i.e. income earned from the investment of income previously subject to TOSI).
The new exclusions for Excluded Business and Excluded Shares have been introduced. If one of the exclusions apply, no further consideration as to the application of TOSI or reasonability needs to be undertaken.
An excluded business is one in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year of the individual in which an amount is received or in any 5 previous tax years (not necessarily consecutive). This exclusion is meant to ensure that TOSI doesn’t apply to individuals who make meaningful direct labour contributions. The labour will not need to be valued, but would need to be demonstrated if reviewed. For greater certainty, an individual who works an average of 20 hours per week during the part of the year that a business operates will be deemed to be actively engaged in a regular, continuous and substantial basis for the year. The definition is flexible enough to account for seasonal businesses.
If an individual over the age of 24 is contributing labour but doesn’t meet the hours test above, the amount paid will have to be reviewed to see if it’s reasonable (see discussion below) with any excess considered as TOSI. Individuals between 18 and 24 years old must meet the 20 hours per week test to avoid the distribution being treated as TOSI.
Excluded shares are owned directly by individuals who are over the age of 24. The shares must represent at least 10% of the votes and value of the corporation. In addition:
- The corporation’s income must be less than 90% from the provision of services;
- The corporation cannot be a professional corporation; and
- All or substantially all of the corporation’s income is not derived from a related business.
Dividends received on excluded shares will not be considered TOSI. Taxpayers who want to rely on this exclusion will have until the end of 2018 to meet the condition of owning shares that represent at least 10% of the votes and value of the corporation.
Amounts paid to individuals over the age of 24 that are derived directly or indirectly from a related business and do not meet the exclusions above (either excluded business or excluded shares) will be subject to TOSI but only to the extent that the amounts exceed a ‘reasonable return’. This has been defined as an amount that is reasonable with respect to the contributions made by the specified adult individual to the related business relative to other family members that have contributed to the business. Contributions will include labour, capital, risks assumed and other relevant factors. The intention is that an amount will be considered an unreasonable return from a related business only in cases where it is evident that the amount is disproportionate. It is not meant to second guess a bona fide exercise of business judgement by the participants in a business.
Retirement, Inheritances and Separation/Divorce
Given the fact that retired business owners have put structures in place to facilitate their retirement income, TOSI will not apply to income received by an individual from a related business if the individual’s spouse made the contributions to the business and is at least 65 years old in the year the amounts are received.
In addition, there are special rules to ensure that the beneficiaries of a deceased individual’s estate are able to avoid the TOSI rules based on the contributions of the deceased individual.
Similarly, income derived from property acquired as a result of a marriage breakdown will be exempt from the TOSI rules.
For further details, please visit the Department of Finance webpage.