2018-0770911E5 Revised income sprinkling rules

Principal Issues: If a specified person is only able to work for part of the year due to a maternity leave, would dividends paid on the shares held by such person an "excluded amount" under the definition in subsection 120.4(1) on the basis that the "excluded business" exception would apply?

Position: Question of fact but if that person meets the average of 20 hours per week for the portion of the year they actually worked then it is possible for the excluded business exception to apply.

Reasons: Guidance from the explanatory notes issued by Finance Canada.

Author: McPherson, Ryan
Section: 120.4(1) and (1.1)

XXXXXXXXXX                                                                                                     2018-077091
                                                                                                                             Ryan McPherson
September 26, 2018

Dear XXXXXXXXXX:

Re:  Labour contributions of specified individual

We are writing in response to your correspondence dated July 14, 2018, wherein you wanted to know how the tax on split income (TOSI) rules in section 120.4 of the Income Tax Act (“Act”) would apply to dividends your spouse may receive from your corporation.

More specifically, you indicate in your correspondence that your spouse, who is a shareholder of your corporation, would normally work, on average, more than 20 hours per week in the corporation’s business for the year. However, you also indicated that your spouse is currently unable to work for a period of time due to the birth or adoption of a child. Under these circumstances, you want to know if your spouse could still be considered to have been “actively engaged on a regular, continuous and substantial basis” in the activities of the business for the year that your spouse is on such leave.

OUR COMMENTS

This technical interpretation provides general comments about the provisions of the Act and related legislation (where referenced). It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Background

On July 18, 2017, Finance Canada announced proposed changes (the “July Proposals”) to the taxation of private corporations that included expanding the existing TOSI rules to include adult individuals. Under the July Proposals, “split income” earned by adult individuals resident in Canada would become subject to the TOSI but only to the extent that the amount of split income received in the year was considered to be unreasonable having regard to certain specific factors. However, after receiving feedback from Canadians across the country, the July Proposals were revised and new draft legislation was released on December 13, 2017, that with some minor revisions, became law on June 21, 2018 (the “New TOSI Rules”). The New TOSI Rules included the addition of two “safe harbour” exclusions from the TOSI to alleviate some of the compliance burden on taxpayers. Under the New 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).

The first safe harbour exclusion from TOSI is for income received by a “specified individual” from owning “excluded shares”. The “excluded shares” exclusion is available only for specified individuals age 25 or over. The definition of “excluded shares” is set out in subsection 120.4(1). Shares of the capital stock of a corporation owned by an individual will be excluded shares of the individual if all the conditions set out in paragraphs (a) to (c) of the definition are met. 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.

While your correspondence does not provide sufficient information to allow us to conclusively determine whether the shares of the corporation that your spouse owns would qualify as excluded shares, based on the limited information you have provided, we have assumed that such shares would not qualify as excluded shares.

The second safe harbour exclusion from TOSI is for income received by a “specified individual” from an “excluded business”. 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. Whether an individual has been actively engaged in the activities of a business on a “regular, continuous and substantial basis” in a year will depend on the circumstances, including the nature of the individual’s involvement in the business (i.e., the work and energy that the individual devotes to the business) and the nature of the business itself. The more an individual is involved in the management and/or current activities of the business, the more likely it is that the individual will be considered to participate in the business on a regular, continuous and substantial basis.

However, without limiting the generality of the “regular, continuous and substantial basis” test described above, for the purposes of this safe harbour exclusion, a specified individual will be 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 operates. Paragraph 120.4(1.1)(a) is considered as a “bright-line deeming rule” that is intended to eliminate some of the uncertainty inherent in the “regular, continuous and substantial basis” test described above.

Although the New TOSI Rules do not specifically deal with the situation described in your correspondence the explanatory notes accompanying the New TOSI Rules provide some insight:

“Without limiting the generality of the "regular, continuous and substantial" test described above, new paragraph 120.4(1.1)(a) contains a deeming rule that provides additional certainty in determining whether an individual is actively engaged on a regular, continuous and substantial basis in the activities of a business. This bright-line deeming rule is generally based upon an average of 20 hours per week of work throughout the portion of the year when the business operates. An average work commitment of less than 20 hours per week could qualify as regular, continuous and substantial where, for example, an individual works 30 hours per week in a year-round business up to the start of July, after which they are unable to continue working throughout the remainder of the year (e.g., because of injury, illness or the birth or adoption of a child).”

Based on the above, there are certain situations where the average work commitment could be considered as being “regular, continuous and substantial” even if the bright-line deeming rule is not met. Accordingly, the fact that an individual was unable to work for a portion of a year in which the business operated due solely to the adoption or birth of a child would not, in and by itself, mean that the individual was not otherwise considered to meet the regular, continuous and substantial requirement for that year. However, such a determination will depend on the facts and circumstances of each case.

If the requirements of one of the above-noted 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).

Additional guidance on the New TOSI Rules can be found on the Canada Revenue Agency (CRA) website 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.

We trust these comments will be of assistance to you.

Yours truly,

Michael Cooke, CPA, CA
Manager
Corporate Reorganizations Section II
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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