Let’s see what the harassed tax adviser (or front-line CRA auditor) must do to answer basic client questions about the new tax-on-split-income (TOSI) rules.
Scenario 1
Husband (H) and wife (W), both of whom are residents of Canada for the purposes of the Income Tax Act (Canada), each own 50 Common Shares in the capital of Opco, which carries on an active business. Opco was founded in 2008. H is active in the business, and he is a director of the corporation, but W is not active and she is not a director of Opco (until now she has stayed home to take care of their children). They both paid a nominal amount for their shares 10 years ago, and neither of them has contributed any assets (H personally guaranteed a bank loan). In 2018, Opco declares a $100,000 dividend on its Common Shares. What is the tax result for W?
W is a “specified individual” (and so is H for that matter). She is an individual resident in Canada at the end of 2018 (s 120.4(1) “specified individual” (a)(ii)), she is related to H who is not a trust and who is a resident of Canada at any time in 2018 ((b)(i) and (ii)) and her income includes the dividend, which is derived from a business that is carried on by a corporation (Opco) of which H is a specified shareholder ((b)(iii)(B)(I)–(III)).
As a result, the dividend is “split income” to W (“split income” (a)(i)) unless the dividend is an excluded amount. Is it? It will be an excluded amount for W only if it is not a “split portion” (“excluded amount” (b)).
The dividend will be a “split portion” under paragraph (b) of that definition because
- the dividend would be split income (if “excluded amount” is read without paragraph (b) and “split income” is read without paragraphs (e) and (g));
- the dividend is a “reference amount”, which is the dividend, or an amount derived directly or indirectly from one or more amounts received from a person (an “operating entity”); and
- the dividend exceeds what the operating entity would have paid—as the dividend or “reference amount”—to W if they dealt at arm’s length having regard to ‘the functions relating to the “source business” performed by [W]’ to the extent W, before the amounts were paid or payable, was engaged in the activities of the business (she wasn’t); the assets W contributed to the source business (they were nominal); the risks she assumed in respect of the source business (there were none); and the total of all amounts paid to W before the end of 2018 in respect of the source business (not relevant here because it seems the dividend will be a split portion even without any grind for previous payments).
It turns out that Opco is an “operating entity” because the dividend is described in paragraph (a) of the definition of split income and because H is a “connected individual” with respect to Opco (“connected individual” (a)(ii)).
It appears, then, that the entire amount of the dividend will be split income to which TOSI applies so that W will be required to pay tax on the dividend at the top marginal rate.
That wasn’t so bad, right?
Yes, that was in fact sarcasm. It’s incomprehensible to me that Finance believes we can actually work with these rules on a day-to-day basis.
Scenario 2
The facts are the same as in Scenario 1 except that the year is 2028, and H and W sell their Opco shares to an arm’s length party for fair market value proceeds. They realize a $1 million capital gain ($500,000 each). The shares, at the time of the sale, are qualified small business corporation shares, the capital gains on which, all other things being equal, could be sheltered by the capital gain exemption. What is the tax result for W?
It appears that W will be required to include the entire amount of the gain in her “split income” and pay the TOSI on it. She will not be entitled to claim capital gain exemption on the gain. W is still a specified individual, and the taxable capital gain she realized is split income per new (e)(i)(A) and (ii) of the definition. The gain is also a split portion (see “split portion” (c)(i) and (ii)). New paragraph 110.6(12)(d) excludes the gain from eligibility for the capital gain exemption because the gain was included in “split income”)
Notice that H and W would likely have been better off if H had been the only shareholder of Opco. If H had realized the entire gain, then, given his active involvement in the business and the risks he took as Opco’s sole director, it seems likely that the CRA wou
Scenario 3
The facts are the same as in Scenario 2 except that in early 2019 W became the office manager and bookkeeper for Opco. She worked full-time as such from 2019 to 2028, but she did not become a director, she took on no other risks in respect of Opco’s business and she did not contribute any more assets to the business. She was paid $40,000 annually for her work.
Let’s assume that we can demonstrate (exactly how we’ll leave for another day) that an arm’s length employer would have paid W $60,000 annually for the work she performed. It would seem to follow that some portion of the gain she realizes on her Opco shares should not be split income. What is that portion? Is it $20,000 multiplied by 10 (the number of years she worked in the business)? (Note, however, that dividends previously paid, even if they were subject to the TOSI, would reduce the latter amount.) Is it some other amount because the “only” contribution she made, compared to H, was the work she performed? That is, do we need to measure somehow her contribution against his in figuring out what an arm’s length payer would pay? Does it matter that H received “compensation” by way of salary and dividends from 2008 to 2018? Or is there an entrepreneurial premium (an amount over and above the total arm’s length compensation to which they were entitled) that both H and W should share because they both worked in the business?
What about H’s “split income”? He is in the same position as W vis a vis Opco. Is some portion of his gain now liable to TOSI because what an arm’s length person would have paid him is reduced by his previous earnings and because W worked for Opco for less than her market entitlement? Does the fact that he was the sole director of Opco help? Does the answer to the question change if the director liability risks are mitigated (for example, through insurance)?
