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: How the proposed changes to the tax on split income under section 120.4 apply in certain circumstances.
Position: General comments provided on certain issues related to the definition of excluded shares and excluded business.
Reasons: Wording of proposed legislation.
Author: Chong, Henry
Section: Proposed Amendments to Section 120.4
May 25, 2018
XXXXXXXXXX concerns relating to the application and administration of the proposed amendments to the tax on split income (“TOSI”) under section 120.4 of the Income Tax Act (Canada) (the “Act”).
XXXXXXXXXX. For ease of reference, we have included the form of the statement or question substantially in the form that was submitted by XXXXXXXXXX for our response or comment.
We have also provided some general introductory comments which provide some background on our understanding of the scheme of the amended TOSI and the role of the “excluded shares” and “excluded business” safe harbours, which we hope will assist in interpreting the proposed amendments.
On July 18, 2017, the Department of Finance announced proposed changes to the taxation of private corporations. These changes included expanding the existing TOSI to include individuals age 18 years or over in order to restrict the benefits of income sprinkling with adults (the “July Proposals”). Under the July Proposals, “split income” earned by adults would be subject to the TOSI but only to the extent that the amount was considered to be unreasonable having regard to certain specific factors. The July Proposals were released for public consultations. After receiving feedback from Canadians across the country, the proposals were revised and new draft legislation was released on December 13, 2017 (the “December Proposals”), which included the addition of “safe harbour” exclusions from the TOSI for income from “excluded shares” or from an “excluded business” of the adult individual. The December Proposals, with some minor revisions, have been included in Bill C-74, tabled on March 27, 2018 (the “Proposed Legislation”).
Our understanding is that the Proposed Legislation, including the addition of the safe harbour exclusions, does not reflect any change to the basic tax policy underlying the July Proposals and the amendments to the TOSI. In general, the intent of these changes remains that any split income of an adult will be subject to the TOSI to the extent that the amount received exceeds a “reasonable return.” Whether an amount is excluded from split income because it is a reasonable return is determined based on certain specific factors. The factors differ depending on whether the individual is between age 18 and under 25 years of age; or age 25 or over.
To alleviate its compliance burden on taxpayers, the Proposed Legislation added the two safe harbour exclusions from TOSI for income from “excluded shares” or an “excluded business”. The “excluded shares” exception is available only for individuals age 25 or over. 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 met the reasonableness test under the July Proposals and do not raise any policy concerns.
In cases where a safe harbour exclusion does not apply, whether the TOSI should apply is generally determined on the basis of whether the amount received is a reasonable return according to the factors applicable in the circumstances. 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.
The CRA expects to generally interpret these safe harbour exclusions consistent with the scheme of the TOSI and our understanding of the underlying rationale of such safe harbours. The interpretation of such exclusions and of other issues relating to TOSI will develop over time and based on experience.
XXXXXXXXXX Question on Excluded Shares
XXXXXXXXXX asked the CRA to comment on the following statement:
The “excluded shares” exclusion may not be available to common business structures. For example, if a spouse is paid dividends through a holding company (of which they own more than 10% of the shares) or a family trust which derives all its income from a related manufacturing company, their income will be subject to TOSI. If the dividends were paid out directly from the manufacturing company, they would be able to take advantage of the bright line test.
The income of the spouse from the holding company or from the family trust that is derived directly or indirectly from the manufacturing company’s business which is a related business of the spouse (for instance, because a person related to the spouse is actively engaged on a regular and continuous basis in the activities of the corporation) will not be split income and subject to TOSI if it is an excluded amount.
Based on the facts provided, the income of the spouse may, among other things, be an excluded amount if the spouse is age 25 or over and it is income from, or a taxable capital gain from the disposition of, excluded shares of the spouse. We are assuming that the spouse referred to in the question is age 25 years or over.
The definition of excluded shares is set out in subsection 120.4(1). In general, shares of the capital stock of a corporation owned by an individual will be excluded shares of the individual if the conditions set out in paragraphs (a) to (c) of the definition are met.
The definition of excluded shares should generally not include shares of a holding corporation or shares of a corporation held by a family trust in the circumstances described in the question. This is because, in the case of a holding company, it will not meet the requirement in paragraph (c) of the definition as all or substantially all of the income would generally be derived from another related business in respect of the individual. In the case of a family trust, the beneficiaries will not meet the requirement in paragraph (b) of the definition as the beneficiaries will not directly own shares of the capital stock of the corporation.
As a result, the shares of the holding company held by the spouse or of the related manufacturing company held by the family trust will not be excluded shares of the spouse or of the beneficiaries of the family trust and the dividends or trust distributions will not be excluded from split income as an excluded amount and will be subject to the TOSI unless another exclusion applies.
For the 2018 taxation year, the requirement in paragraph (b) of the definition of excluded shares that the specified individual have the requisite share ownership can be met immediately before the relevant time or at the end of 2018. Taxpayers should review the share ownership of their corporate structures with their tax advisors in a timely manner before the end of 2018 to determine whether any action needs to be taken based on each taxpayer’s particular circumstances.
Depending on the circumstances, the spouse’s income may also be excluded from split income if the income is from a related business that is an excluded business of the spouse. The question does not provide sufficient information to determine whether such income is from an excluded business of the spouse.
As discussed, the safe harbour exclusions from split income for income from excluded shares or an excluded business of an individual are not intended to apply in all circumstances. Where these safe harbour exclusions do not apply, the 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 whether the amount received is a reasonable return according to the specific factors applicable in the circumstances.
XXXXXXXXXX Question on Excluded Business
The “excluded business” exclusion is difficult to apply in situations where an operating company may include several businesses. For example: a situation where a business owner owns a construction business and a property management business both operated through one corporate entity. Spouse B works 25 hours in the property management business, but not the construction business. Do we now have to trace the flow of funds from the property management business to Spouse B to ensure they are “excluded amounts”?
The income of Spouse B from the related business carried on by the operating company will not be split income and subject to TOSI if the income is an excluded amount.
Based on the facts provided in the questions, the income may, among other things, be an “excluded amount” if Spouse B is age 18 or over and it is income derived directly or indirectly from an excluded business of the spouse. We are assuming that the spouse referred to in the question is age 18 or over.
The definition of excluded business is set out in subsection 120.4(1). In general, a business is an excluded business of a specified individual if the individual is actively engaged on a regular, continuous and substantial basis in the activities of the business in either the relevant taxation year; or any five prior taxation years of the specified individual.
In general, whether a specified individual is actively engaged on a regular, continuous and substantial basis in the activities of the business is a question of fact that will depend on the facts and circumstances of each case.
In addition, a specified individual is deemed under paragraph 120.4(1.1)(a) to have been actively engaged on a regular, continuous and substantial basis in the activities of a business in a taxation year of the individual if the individual works in the business at least an average of 20 hours per week during the portion of the year in which the business is carried on.
In the facts presented in the question, the corporation carries on two businesses, a construction business and a property management business.
Provided that Spouse B works 25 hours a week in the property management business of the corporation during the relevant taxation year of the spouse or in any five prior taxation years of the spouse, the property management business will be an excluded business of the spouse in the taxation year as the spouse is deemed to be actively engaged in a regular, continuous and substantial basis in the activities of that property management business because the spouse works in that business an average of more than 20 hours per week.
Provided that Spouse B has not worked in the construction business of the corporation during the relevant taxation year of the spouse or in any five prior taxation years, the construction business will not be an excluded business of the spouse because the spouse is not, and will not be deemed to be, actively engaged in a regular, continuous and substantial basis in the construction business of the corporation.
As a result, any income of Spouse B that is derived directly or indirectly from the property management business will be income from an excluded business of the spouse and will not be split income subject to TOSI. Any income of the spouse that is derived directly or indirectly from the construction business will not be income from an excluded business of the spouse and will be split income subject to TOSI unless another exclusion applies. This will require separate accounting for each business and a tracing of funds.
Depending on the circumstances, the income from the management business (or the construction business) could also be excluded from split income if the income is from shares that are excluded shares of the individual. The question does not provide sufficient information to determine whether Spouse B owns shares of the operating corporation that qualify as excluded shares of Spouse B.
If the requirements of the safe harbour exclusions cannot be met, then the determination of whether the income received by a specified individual from a related business is split income should be based on whether the amount is a reasonable return according to the specific factors applicable in the circumstances (or, if the spouse is between age 18 but less than age 25, a “safe harbour capital return” of the spouse). The question does not provide any information on the specific factors required to determine whether the amount is a reasonable return.
XXXXXXXXXX Question on Excluded Business and the 20 Hours Test
What will be the burden of proof for a business owner to show that a spouse or child worked at least 20 hours in the business in the past five years if they did not keep any formal records of their work (e.g. timesheets or logbooks)?
In general, records such as timesheets, schedules, or logbooks retained by either an individual or a business will be sufficient to establish the number of hours the individual worked in a given year. Where the individual also receives a salary or wages from the business, we would also consider information contained in payroll records that supports the number of hours the individual worked.
After the rules first come into effect, the CRA recognizes the challenges presented where family members continue to derive income from a business in which they had been actively involved (or could be deemed to be so under the proposed amendments) during years for which records were not required and which may no longer be available or were not formally maintained.
In such situations, the CRA will consider all information that can be made available related to the history of the business, in particular in relation to the involvement of family members.
Where such information is provided in support of assertions that the 20 hour per week threshold was met in prior years, the CRA will if necessary, consider whether the assertions are reasonable having regard to such factors as
* The type of business and duties performed as they relate to the main activities of the business
* The individual’s education, training and experience
* Any particular knowledge, skills or know-how that the individual possessed
Going forward, the ongoing maintenance of such records in respect of any family members involved in the business will ensure that businesses are able to comply with the new rules and obtain the benefits of available exclusions, even as family members leave the business.
Example on Excluded Shares and the Provision of Services
The XXXXXXXXXX provided the following examples for comment:
Two families start new businesses at the same time. Family 1 starts a hair salon. Family 2 starts a pizzeria. The hair salon business derives more than 90% of its income from the provision of services. The pizzeria does not derive more than 90% of its income from the provision of services. In each case, the business is carried on through a corporation. The shareholders of each corporation are spouses, each of whom own 50% of the issued and outstanding shares of the corporation. We are assuming that the spouses are age 25 or over.
The shares of the corporation carrying on the pizzeria business should qualify as excluded shares.
The shares of the corporation carrying on the hair salon business should not qualify as excluded shares.
Based on the information provided, we agree with the conclusion that the shares of the corporation operating the pizzeria business will qualify as excluded shares of both spouses; and that the shares of the corporation operating the hair dressing business will not qualify as excluded shares of both spouses.
The shares of the corporation carrying on the hair salon business will not qualify as excluded shares because, among other things, more than 90% of its income is from the provision of services.
The rationale for the shares of a corporation of a specified individual that has 90% or more of its income from the provision of services, or of a professional corporation, not qualifying as excluded shares of the individual appears to be based on the presumption that income derived from such a business would generally fail to qualify as a reasonable return based solely on ownership of such shares and the specific factors applicable in the circumstances to such ownership, including the property contributed directly or indirectly in support of the related business and the risks assumed in relation to the related business. Because the exclusion from split income for income from excluded shares of an individual is intended as a bright line proxy for circumstances where the amount of income would otherwise be a reasonable return, the rationale would not apply in the case of many service or professional corporations.
Depending on the circumstances, one of the other safe harbours could apply. For instance, the income derived from the hair salon business may not be split income if the income is from an excluded business. The question, however, does not include sufficient information to determine whether that safe harbour could apply.
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.
Note that for purposes of determining whether a business derives less than 90% of its income from the provision of services, the reference to income is to gross income. Where a business has income from the provision of both services and non-services (including from a sale of tangible or in some circumstances, intangible property) such as a business carried on by plumbers, mechanics or other contractors that sell replacement parts or materials, the income from the provision of non-services will generally be taken into account in determining whether shares of a corporation are excluded shares of an individual unless such income can reasonably be considered to be necessary but incidental to the provision of the services (for instance an office cleaning service if it billed separately for the cleaning supplies used).
We are in the process of preparing examples to illustrate how the determination of whether less than 90% of the income of a corporation is from the provision of services is made. These examples should be available in the near feature on the CRA website.
As well, 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.
We hope the foregoing will be of assistance to you.
Please call if you have any other questions.
for Division Director
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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