Dividend sprinkling among family shareholders, and its limits under TOSI

A primer on the TOSI “tax on split income”

There are many tax benefits to running a business through a corporation.

Operationally, corporate tax rates are generally lower than your personal marginal tax rate. Though personal tax will eventually apply when dividends are paid out of the corporation, in the meanwhile you are able to reinvest more dollars into that business within the corporation.

At the ownership level, you can control the amount and timing of dividends to yourself as shareholder. This allows you to defer the personal income and associated tax until you need cash for personal spending purposes.

If you bring in other shareholders and possibly more share classes, you can also control who receives those dividends. And when those additional shareholders are lower income family members, you may be able to ratchet down the household tax bill. Years ago, it was almost that simple, but today there are increasingly complex rules that must be navigated.

TOSI emerges in 2000 as the ‘kiddie tax’ for minors

A couple of decades ago, it was routine tax planning to pay dividends to family, including minor children. Whether a child owned shares directly or was a beneficiary of a trust that held shares, dividends could be taxed to that child. With little to no other income, the tax would be correspondingly low, and practically the net-of-tax money ended up under the same roof.

In 2000, the TOSI was brought into law to prevent this kind of dividend sprinkling. It applied (and still does) to dividends paid to a child under the age of 18 throughout the year. Despite such dividends being legally paid to the recipient, TOSI causes them to be taxed at the highest bracket rate, essentially ignoring the recipient’s own tax rate.

This is an important distinction from being an attribution rule, where tax is imposed on a person who would have otherwise been entitled to certain income, being the parent in this example when dividends are paid to a minor child. With an attribution rule, it would be a no-better-off scenario if a higher bracket parent was taxed on the dividend. But things are especially unpalatable under the TOSI where tax is automatically imposed at the highest rate, making it a worse-off deal if the parent’s income level is anywhere less than top bracket.

TOSI comes of age in 2018, extending to adults in the family

In 2017, the federal government proposed a variety of changes for private corporations and their shareholders. While some of the proposals were shelved, the TOSI changes proceeded into law in 2018, with TOSI now extending to adults, capturing both adult children and spouses. Fortunately, these new rules for adults are not as unbending as the kiddie tax version. Where there is sufficient economic substance to the involvement of the adult child or spouse, TOSI may not apply.

Make no mistake though, these rules are very (very!) complex. There are new definitions, layers of application, and multiple exceptions. Some of those exceptions have objective criteria, while others require an exercise of discretion on the particular facts. To help, the government has collaborated with external stakeholders to publish examples to guide the application of TOSI in its Guidance on the application of the split income rules for adults, found at https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-agency-cra/federal-government-budgets/income-sprinkling/guidance-split-income-rules-adults.html.

What follows is a high-level outline of the TOSI and its exceptions, using some of the technical terms, but with streamlined phrasing in order to convey the core points. Readers should consult a qualified professional to determine applicability in individual circumstances.

Continuing planning that is not affected by TOSI

It is worth noting that the TOSI rules do not prohibit family members from owning private corporation shares. Though the original 2017 proposals cast the net widely to encompass the lifetime capital gains exemption (LCGE), that part was dropped. Accordingly, it is still possible to plan for sharing future capital gains with family, including the LCGE – of course with qualified professional advice.

Also, TOSI has no effect on the bona fides employment of family members. As long as the wages paid are reasonable in relation to the services rendered, this is simply treated as taxable employment income of the recipient. This is true even for minor children.

Who and what is potentially open to the TOSI rules?

TOSI may apply if a person receives “split income” and is either an adult resident of Canada, or a minor (under the age of 18) who has at least one parent who is a resident of Canada.

“Split income” includes taxable dividends, shareholder benefits and interest payments, from or related to a private corporation. It may also include distributed capital gains where underlying income would have been split income, but generally not capital gains arising on the sale of farms, fisheries or small business shares. Income from a partnership or trust that arose out of rental property may also be caught.

It does not apply to securities or debt of public corporations, government debts, or to mutual funds that hold those listed sources. Deposits with banks and credit unions are also clear of TOSI.

Exclusions from TOSI

The rules are targeted at circumstances where unintended advantage may be gained. As there remain plenty of reasons and arrangements where family members may hold shares and legitimately be entitled to dividends, the rules allow for several exclusions. For simplicity, we’ll refer to dividends within the following explanations, understanding that split income is in fact broader, as noted above. See the Flowchart on the next page for a graphic representation of the key decisions.

All adult recipients

The recipient has been “actively engaged” in the business in the current year, or in any five years leading up to the year the dividend is paid. The five years do not have to be consecutive. This will generally be met if the person works an average of 20 hours per week. If the business is only active part of the year (eg., seasonal), the working time would be applied to the portion of the year when the business operates. A lesser time commitment may suffice, but that would depend on the facts and circumstances of the case.

Adult recipients age 25 or over

Even if the actively engaged threshold is not met, a dividend may be considered a “reasonable return” based on a combination of factors, including labour contribution, property contribution, risks assumed and historical payments. Importantly, this exclusion is not available where the business is principally a service business or a professional corporation.

Adult recipients age 18 to 24

Younger adults may also be able to claim a reasonable return, but based only on property contributed by that individual, and with the size of the return subject to a ceiling prescribed by formula.

Principal shareholder is over 65, recipient is spouse

Many business owners will have planned their retirement on the expectation of being able to share with a spouse in those later years. Accordingly, if the principal shareholder is 65 or over, dividends paid to a spouse will not be subject to TOSI. This is specifically intended to align with the age for pension income splitting.

Trusts and small business corporations – Flexibility in family wealth management

The trust has existed under common law for centuries and can be devoted to a wide variety of purposes. In essence, a trust structure separates legal ownership of property from beneficial ownership. In the hands of a business owner, a trust may likewise be applied for many purposes, but the focus is often on tax results.

For that business owner, the property in question consists of shares of a business corporation, with the trust beneficiaries being a combination of spouse, children and possibly extended family members. The business owner would generally be cast in the role of trustee – often with one or more other trustees – having the ability to legally manage the shares on an ongoing basis.

Though not exhaustive, summarized below are a number of key benefits of this arrangement. Circumstances will dictate whether and to what extent this may impact a particular individual or business, and therefore, consultation with qualified tax and legal professionals is a must before acting upon any of this information.

From an income perspective:

Shares may be structured in such a way so dividends can be paid to the trust as a shareholder. In turn, the trustees will have the power to manage the distribution of dividends to the trust beneficiaries. As a flow-through from the trust, beneficiaries receiving dividends will generally be entitled to the dividend gross-up and tax credit.

The effective tax rate on Canadian dividends is less than it is for regular income (e.g., interest and registered plan income), and can even be lower than the rate for capital gains, particularly for those individuals not in the top income tax bracket. There is actually a level where a taxpayer will pay no tax on the dividends if that person has no other income. For ineligible dividends (where the prior corporate income benefited from the small business deduction), the ‘tax-free’ dividend level ranges from a low of $7,000 to about $35,000, depending on the province.

Note that an anti-avoidance measure (known colloquially as the “kiddie tax”) effectively negates the preferential tax treatment of such dividends paid to minors related to the business owner, whether directly or via a trust. This measure may also apply to capital gains if dividend payments have been withheld on the shares.

From an ownership perspective:

Generally, capital gains on business corporation shares will be realized on disposition at the business owner’s initiative, or possibly deemed so upon that person’s death. One or more trusts are often components of an estate-freezing exercise whereby eventual capital gains on these shares are sought to be pushed to younger generations. The freeze can be implemented by changes in beneficial ownership that may involve absolute transfers or may instead make use of intermediate vehicles, such as further corporations and/or trusts.

In addition to the capital-gains-freeze aspect, the concurrent purpose of this exercise is to multiply access to the lifetime capital gains exemption on qualifying small business corporation shares. The exemption (proposed to increase from $750,000 to $800,000 pursuant to the 2013 Federal Budget) is a per-person entitlement and can be structured using one or more trusts so the tax benefits can be achieved without the business owner losing control of the enterprise.

From a protection and control perspective:

Subject to share provisions and/or a shareholders’ agreement, direct share owners generally have full ownership rights. Even when in a minority position, securities legislation may entitle a shareholder to require a corporation to take actions contrary to the controlling majority’s wishes. By separating beneficial from legal ownership, a trust can help the business owner achieve wealth- and estate-planning ends while muting business complications that might otherwise arise.

In addition to being subject to attack from others, property owned directly by an individual is exposed to the individual’s own frailties. A trust can provide a greater degree of insulation against present and future risks and uncertainties, such as creditor claims, matrimonial disputes, mental incapacity or the death of that individual.

Spousal loans still on 1% sale

For the 14th consecutive quarter, the prescribed rate on spousal loans is 1%.

To put that in context, during the 25 years leading up to April 2009, the lowest rate was 2%, and it only occurred in three quarters during that interval.

So is it time for spouses to get on this bandwagon?

A spousal loan recap

Our tax system is based on the individual as the taxable unit, as compared to some economies where spouses or a broader family unit is the taxable entity.

That being the case, taxpayers have an incentive to split income – or at least attempt to do so – with household members who face lower tax rates on their marginal income.

In response, the Income Tax Act has a number of anti-avoidance rules that attribute income earned on transferred assets or sources back to a transferor. An exception to attribution is available on loans between spouses at the prescribed rate.

A low-income spouse could be taxed on the investment income generated on borrowed money. Interest charges paid to the higher-income spouse would be deductible to the borrower spouse, and correspondingly taxable to the higher income lender spouse.

Be careful when servicing the loan

The lower the interest rate allowed on such loans, the more desirable the arrangement could be. This is particularly so because such loans have no mandatory horizon date, and the rate can be locked-in for life at the initial rate setting.

Still, the decision to establish a loan cannot be dictated by tax considerations alone, even when the 1% rate is the lowest possible point (based on the rounding formula used in the regulations).

As well, a significant disparity in spouses’ marginal tax rates may make this strategy appealing, but there are no guarantees. For example, had a loan been established back in 2009, the intervening interest payments would have been taxable income to the lending spouse, and yet the borrowing spouse may not have experienced much or any income or gains in that time period.

Indeed, had the investments declined in value, the higher income spouse may have been able to make more effective use of resulting capital losses.

Thus, tax motivation must be tempered with investment risk and outlook.

What’s more, the borrowing spouse must keep that loan in good standing every year. This means the interest must be paid during the year or within 30 days of its end, and those payments must be made from the borrowing spouse’s own resources.

In particular, if some of the investment portfolio is sold or redeemed in order to make those interest payments, in effect the lending spouse is getting his or her own money back. The attribution rules would apply from that point forward, even if the loan is properly serviced in future years.

With all that in mind, the borrowing spouse should consider including income-generating components within the portfolio to cover the interest charges. To be even more tax-efficient, Canadian dividends may be particularly worthwhile, as the gross-up/credit treatment leads to a much lower effective tax rate at lower brackets.