2018-0745871C6 CALU Conference Question 6 - Tax on Split Income
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA. Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: Interpretation of definition of excluded shares. Part (a) - What is included as income from the provision of services? Part (b) - Can shares of a holding corporation qualify as excluded shares?
Position: Part (a) - Whether income of a corporation is income from the provision of services will depend on the facts and circumstances of each case. Part (b) - Shares of a holding corporation will generally not qualify as excluded shares.
Reasons: Wording of the provisions.
Section: Subsection 120.4
CALU Roundtable - May 2018
Question 6(a) - Excluded Shares & Provision of Services
Under the TOSI rules, TOSI will apply to the “split income” of a “specified individual” unless the amount is an “excluded amount”, all as defined in subsection 120.4(1). Subparagraph (g)(i) of the “excluded amount” definition excludes from “split income” income from, or a taxable capital gain from the disposition of, “excluded shares” held by an individual over the age of 24. “Excluded shares” is defined in subsection 120.4(1) and lists a number of conditions including subparagraph (a)(i) which requires that the shares be of a corporation that earns (in its prior tax year, or in its current tax year if no such prior tax year exists) less than 90% of its business income from the provision of services. The term “provision of services” is not defined for the purposes of section 120.4. (footnote 1)
Without a definition, a taxpayer is presumably left with interpreting the term under general business principles. From an economic perspective, there is a relatively clear delineation between the provision of “goods” versus “services”. It is understood that goods are physical objects whereas services describe the performance of work for others. Services often lack physical identity and cannot be distinguished from the service provider. Commonly cited examples of service businesses include banking, insurance, transportation and communications. There may also be some businesses which offer a mix of goods and services. One example is a restaurant business, where food is prepared for consumption (a good), and services are also provided (waitering, valet parking, etc.).
Many businesses will be considered to be engaged in the provision of services. In fact, Statistics Canada data indicates that at the end of 2015 over 75% of small businesses were categorized as being in the service producing sector. (footnote 2) For these businesses to qualify under this exemption, they will need to demonstrate that more than 10% of their income in any given year arises from the provision of goods. (footnote 3) Also, looking at the types of businesses that are in the service producing sector (financial services, retail trade, healthcare, scientific and technical services), it can be expected that most of these businesses will not qualify for the “excluded shares” exemption as they will not be able to satisfy the “10% test.”
For example, a building contractor may otherwise meet the “excluded shares” definition, because its business involves the provision of goods, whereas a technology consulting firm (even if it has multiple offices employing a number of full time staff) will not, because its business involves the provision of services. Of particular concern may be the impact on technology-based businesses in Canada who are typically involved in the provision of services and are also the subject of specific government initiatives designed to encourage the growth of a robust innovation-based economy.
Assume Mr. X, 35 years old, owns 15% of the issued and outstanding shares of Transportco (giving him 15% of the votes and value in the corporation). Transportco earns all or substantially all of its income from a business that sources drivers on contract for logistics companies. Mr. X is not actively involved in the business. Mr. X’s brother is also a shareholder of Transportco (owning 25% of the issued and outstanding shares) and is actively involved in the business as President of the corporation. Transportco has over 100 employees consisting of drivers and administrative staff.
Can the CRA confirm that it will interpret subparagraph (a)(i) of the “excluded shares” definition such that, if 90% or more of Transportco’s business income is from the provision of drivers to logistics companies, the shares of Transportco cannot qualify as “excluded shares”? Can the CRA provide guidance on what businesses will be considered to be engaged in the provision of services for the purposes of subparagraph (a)(i) of the “excluded shares” definition? Specifically, can the CRA advise whether, in its view, the business of selling life insurance policies and/or provision of investment and retirement products will be considered a provision of services for the purposes of subparagraph (a)(i)? Can it equally provide its view of the provision of financial and investment advice?
In general, under the proposed legislation to amend the TOSI, income of a specified individual such as Mr. X who is age 25 or over from a related business of the individual will not be split income and subject to TOSI if the amount is considered a reasonable return according to the specific factors (as described below) provided in the definition of that term in subsection 120.4(1) as are applicable in the circumstances, or the income is otherwise an excluded amount.
To alleviate its compliance burden, the proposed legislation included in Bill C-74 tabled on March 27, 2018 expands the definition of excluded amount to include certain safe harbours from split income, including an exclusion for income from, or capital gains from the disposition of, excluded shares. In general, these safe harbour exclusions provide a bright line test and are intended to act as a proxy for situations that would have otherwise been a reasonable return and do not raise any policy concerns.
The safe harbour for excluded shares applies where the specified individual is 25 years of age or over. A share owned by such a specified individual is an excluded share if:
(a) the following conditions are met:
i) less than 90% of the business income of the corporation for the last taxation year of the corporation that ends at or before that time (or, if no such taxation year exists, for the taxation year of the corporation that includes that time) was from the provision of services, and
ii) the corporation is not a professional corporation;
(b) immediately before that time, the specified individual owns shares of the capital stock of the corporation that:
i) give the holders thereof 10% or more of the votes that could be cast at an annual meeting of the shareholders of the corporation, and
ii) have a fair market value of 10% or more of the fair market value of all of the issued and outstanding shares of the capital stock of the corporation; and
(c) all or substantially all of the income of the corporation for the relevant taxation year in subparagraph (a)(i) is income that is not derived, directly or indirectly, from one or more related businesses in respect of the specified individual other than a business of the corporation.
You have asked whether the condition in subparagraph (a)(i) of the definition of excluded shares can be met in the case of the shares of Transportco held by Mr. X in the circumstances described in the question.
The CRA can confirm that the safe harbour for excluded shares will not apply to the shares of Transportco held by Mr. X by reason of subparagraph (a)(i) of the definition if 90% or more of its business income is from the provision of the services as described in Question 6(a), being the provision of drivers to logistics companies.
In general, the definition of excluded amount includes safe harbours that could apply depending on the age and circumstances of the specified individual. Depending on the facts, more than one safe harbour may apply in any given fact circumstance. For instance, where the safe harbour for excluded shares does not apply, the income of the specified individual may not be split income if it is income from an excluded business. Based on the facts in Question 6(a), it does not appear that any other safe harbour could apply to Mr. X.
Where none of the applicable safe harbour exclusions apply, whether the TOSI should apply is determined on the basis of whether the amount received is a reasonable return according to the specific factors applicable in the circumstances, including the work performed, the property contributed in support of the business, the risks assumed by the specified individual or a related individual; prior amounts received by them in respect of the business; and any other factor as may be relevant.
The safe harbour exclusions, including the one for excluded shares, are not intended to apply in all circumstances. Where the safe harbours do not apply in a particular case, the general underlying rationale is that in such circumstances, the most appropriate test for determining whether the income of a specified individual from a related business should be excluded from split income should be based on the general test of whether the amount received is a reasonable return. The fact that a safe harbour exclusion does not apply should not be interpreted as a judgement on the bona fides or commerciality of the conduct of the taxpayer’s business operations.
Based on the facts described in Question 6(a), the shares of Transportco do not qualify as excluded shares because Transportco only earns income from the provision of services. You have also asked the CRA to comment on what businesses will be considered to be engaged in the provision of services for the purposes of subparagraph (a)(i).
Whether a business will be considered to be engaged in the provision of services will depend on the facts and circumstances of the businesses. The CRA expects that in most cases, the distinction between whether income is from the provision of services or is other income should be clear. In cases of uncertainty, we will be prepared to provide guidance as required based on a review of all of the relevant circumstances and our understanding of the rationale for the safe harbour exclusions. The interpretation of the requirements for the excluded shares and other issues relating to TOSI will develop over time.
Question 6(b) – Excluded Shares & Shares of Holding Corporations
Paragraph (c) of the “excluded shares” definition provides that shares will not be “excluded shares” unless all or substantially all of the income of the corporation (in its prior tax year, or in its current tax year if no such prior tax year exists) is not derived, directly or indirectly, from one or more related businesses in respect of the “specified individual”. In the explanatory notes that accompanied the TOSI Rules, Finance states:
“This limitation is intended to prevent the circumvention of the TOSI rules by splitting a services business into services and non-services parts. For example, this would apply to the use of holding companies and so-called ‘side car’ structures (e.g., where property used in a services business is leased to a corporation carrying on the services business by another corporation in which the specified individual has an interest).”
Can the CRA advise whether the shares of a holding corporation can otherwise qualify as “excluded shares”?
The definition of excluded shares should generally not include shares of a holding corporation. This is because, in the case of a holding corporation, all or substantially all of the income would be derived from a related business in respect of the individual (other than a business carried on by the holding corporation).
As a result, the shares of a holding corporation held by a specified individual will not be excluded shares of the individual and any income from, or a taxable capital gain from the disposition of, such shares, will not be an excluded amount and will be split income of the individual and subject to the TOSI unless another exclusion applies.
Depending on the circumstances, the income may not be split income if the income is from a related business that is an excluded business of the specified individual.
As discussed, where none of the safe harbour exclusions apply, whether the TOSI should apply is generally determined on the basis of whether the amount received is a reasonable return according to the specific factors applicable in the circumstances, including the work performed, the property contributed in support of the business, the risks assumed by the specified individual or a related individual, prior amounts received by them in respect of the business, and any other factor as may be relevant.
May 8, 2018
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 However, the term is used in other sections of the Act like paragraph 20(1)(bb), section 68 and subsections 125(3.2) and (7).
2 Statistics Canada – Business Register, December 2015 (as reported in Statistics – Key Small Business Statistics – June 2016).
3 This will in turn place a higher reporting and compliance burden on small businesses.
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