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: 1. Does the reasonable return exception to the tax on split income (TOSI) rules apply in a particular scenario? 2. Can the specified individual in the particular scenario look to the undistributed retained earnings of the corporation as capital that is at risk, for purposes of the reasonable return exception?
Position: 1. Insufficient facts to conclude, however general comments have been provided. 2. No.
Author: Verlinden, Nicole
Section: Subparagraph 120.4(1)(g)(ii) of definition of Excluded Amount and definition of Reasonable Return in subsection 120.4(1)
November 2, 2018
Re: Tax on Split Income and the Meaning of “Reasonable Return” in a specific scenario
In the Explanatory Notes to section 120.4 of the Income Tax Act (Canada) (“Act”) (endnote 1), the Department of Finance noted that a “reasonable return” (for the purposes of subparagraph 120.4(1)(g)(ii) of the definition of “excluded amount”) should consider a number of factors, including risks assumed with respect to a “related business”.
Consider a fact scenario where Mr. X and Mrs. X (both over 25 years old) incorporate a new corporation, XCo, to commence operating a highly speculative business. Mr. X and Mrs. X grant a mortgage on their jointly-owned family home and loan the mortgage proceeds to XCo as start-up capital (the “Loan”). At all relevant times thereafter: (i) Mr. X has no involvement in XCo’s business operations; and (ii) the only issued and outstanding shares of XCo are 100 voting common shares owned by Mrs. X and 100 non‑voting common shares owned by Mr. X. Each class of common shares was acquired by Mrs. X and Mr. X for nominal consideration.
It is now several years later and XCo has repaid the Loan and Mr. X and Mrs. X have repaid the mortgage to their bank.
1. Notwithstanding that the Loan and the mortgage have been repaid, can Mr. X continue to look to the reasonable return exception to tax on split income (“TOSI”) in consideration of the risks he initially assumed on the start-up of XCo’s business, or would he only be able to look to this exception while the Loan and mortgage are outstanding?
2. Can Mr. X look to the undistributed retained earnings of XCo as capital that is at risk for purposes of the reasonable return exception, assuming that Mr. X has taken little or no dividend income historically?
This response will provide you with general comments about the provisions of the Act. 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 particular transactions 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.
Overview of the TOSI Framework
In responding to your questions, we have made the following assumptions with respect to the applicable taxation year in which a dividend is received by Mr. X from XCo:
* Mr. X would be a “specified individual” for the taxation year because he would be a resident of Canada at the end of the taxation year.
* Mrs. X would be a “source individual” in respect of Mr. X for the taxation year because she would be a resident of Canada and related to Mr. X, pursuant to paragraph 251(2)(a).
* The business carried on by XCo would be a “related business” in respect of Mr. X for the applicable taxation year because Mrs. X would own shares of XCo with a fair market value (“FMV”) that is equal to at least 10% of the FMV of all the issued and outstanding shares of the capital stock of XCo (paragraph (c) of the definition of “related business”).
* Any dividend received by Mr. X would be derived directly or indirectly from the related business carried on by XCo.
If Mr. X receives a dividend from XCo in a particular taxation year, such dividend will be “split income” unless it is an “excluded amount”. Pursuant to subparagraph (g)(ii) of the definition “excluded amount” in subsection 120.4(1), such dividend could be an excluded amount of Mr. X to the extent that it is a “reasonable return” in respect of Mr. X. Whether such dividend would be a reasonable return in respect of Mr. X would depend on whether it is reasonable having regard to the following factors relating to the relative contributions of Mr. X and Mrs. X in respect of the related business carried on by XCo:
(i) the work they performed in support of the related business,
(ii) the property they contributed, directly or indirectly, in support of the related business,
(iii) the risks they assumed in respect of the related business,
(iv) the total of all amounts that were paid or that became payable, directly or indirectly, by any person or partnership to, or for the benefit of, them in respect of the related business, and
(v) such other factors as may be relevant.
Response to Question 1
In determining whether an amount received by Mr. X from XCo at a particular time would be a reasonable return, an analysis of all the relevant factors must be undertaken at that time, based on the relative contributions of Mr. X and Mrs. X to the related business of XCo. For example, we would consider the fact that both Mr. X and Mrs. X risked their family home by mortgaging it in order to provide the Loan to XCo; and we would also consider whether Mr. X and Mrs. X were adequately compensated for taking this risk, based on the terms and conditions of the Loan.
If the terms and conditions of the Loan were not sufficient to adequately compensate Mr. X and Mrs. X for the risk they assumed when mortgaging their home and providing the Loan to XCo, the relative risk that was assumed by each of them in mortgaging their home and providing the Loan could be taken into account in determining whether a dividend received by Mr. X after the repayment of the Loan is a reasonable return in respect of Mr. X (among the other factors noted above).
We refer you to Example 2 of the CRA’s Guidance on the application of the split income rules for adults, which deals with a “reasonable return” on start-up capital loaned to a family member’s business.
Finally, in determining whether the payment constitutes a reasonable return, the CRA does not intend to generally substitute its judgment of what would be considered a reasonable amount where the taxpayers have made a good faith attempt to do so based on the above-noted reasonableness factors.
Response to Question 2
As noted in the response to Question 1 above, whether a particular dividend would be a reasonable return in respect of Mr. X would depend on whether it is reasonable having regard to the above-noted factors relating to the relative contributions of Mr. X and Mrs. X in respect of the related business carried on by XCo.
The focus of the inquiry into whether an amount is a reasonable return in respect of a specified individual is on the relative contributions of the specified individual and each source individual in respect of the specified individual. Since the undistributed retained earnings of XCo would not, in the scenario presented above, represent capital contributed directly or indirectly by either Mr. X or Mrs. X, the existence of such undistributed retained earnings would not be relevant in assessing their relative contributions to the related business carried on by XCo.
We trust these comments will be of assistance to you.
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
1 Unless otherwise noted, all references herein to sections or components thereof are references to the Income Tax Act, R.S.C. 1985, c.1 (5th Supp.), as amended, or the Income Tax Regulations, C.R.C., c. 945, as appropriate, and all references to monetary amounts are in Canadian dollars.
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