2018-0771861E5 TOSI: Second generation income

Principal Issues: 1. Is the second generation income earned by a holding company on dividends it received from its shares in an operating company, which is then paid out to one of its shareholders, derived directly or indirectly from a related business in respect of the particular individual shareholder, in a specific scenario? 2. Is the payment of the entire investment portfolio to a shareholder as a dividend-in-kind by the holding company derived directly or indirectly from a related business in respect of the particular individual shareholder, in a specific scenario? 3. Would our conclusions change if the dividends from the operating company to the holding company were all paid prior to 2018?

Position: 1. The conclusion depends on whether or not the holding company in the scenario has a business, such that it is a related business in respect of the particular individual shareholder receiving the dividend. 2. The conclusion depends on whether or not the holding company in the scenario has a business, such that it is a related business in respect of the particular individual shareholder receiving the dividend. Numerical example provided. 3. No.

Author: Verlinden, Nicole
Section: Subparagraph 120.4(1)(e)(i) of definition of Excluded Amount

XXXXXXXXXX                                                                                                           2018-077186
                                                                                                                                   Nicki Verlinden
November 2, 2018

Dear XXXXXXXXXX:

Re:  Tax on Split Income and the Meaning of “derived directly or indirectly from a related business” in a specific scenario

Scenario

Mr. A and Mrs. A are spouses over the age of 30 and, at all relevant times since incorporation, each of them has owned 50% of the issued and outstanding voting common shares of Investco. More specifically, Mr. A owns 100 Class A common shares and Mrs. A owns 100 Class B common shares of Investco. At all relevant times, Investco owned all of the issued and outstanding shares of Opco, which carries on a non-services business.

Mr. A is actively engaged in Opco’s business on a regular, substantial and continuous basis; however, Mrs. A is not actively engaged in Opco’s business on a regular, substantial and continuous basis.

Historically, Opco paid taxable dividends to Investco from its after-tax earnings, all of which Investco has invested into shares of publicly-traded corporations, which pay dividends annually.

Questions

Assuming that Investco pays all of the dividend income that it receives from these publicly-traded corporations to Mrs. A, would the dividend income received by Mrs. A be considered income that is derived directly or indirectly from a related business for the purposes of section 120.4?

1.    To the extent that Investco distributes its stock portfolio to Mrs. A as a dividend‑in-kind, would the dividend received by Mrs. A be characterized as income that is derived directly or indirectly from a related business for the purposes of section 120.4?

2.    If all of the dividends paid to Investco by Opco were paid prior to 2018 (prior to the enactment of the amendments to section 120.4), would this alter CRA’s conclusion?

CRA Response

This response will provide you with general comments about the provisions of the Income Tax Act (Canada) (“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.  All statutory references herein are to the provisions of the Act.

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 Mrs. A from Investco:

*    Mrs. A would be a “specified individual” for the taxation year because she would be a resident of Canada at the end of the taxation year.

*    Mr. A would be a “source individual” in respect of Mrs. A for the taxation year because he would be a resident of Canada and related to Mrs. A, pursuant to paragraph 251(2)(a).

*    The business operated by Opco would be a “related business” in respect of Mrs. A for the applicable taxation year because Mr. A (who we assume is a source individual) would be actively engaged on a regular basis in the activities of Opco related to earning income from its business in such taxation year. (footnote 1)

The scenario described does not state whether or not Investco operates a business of earning income from its investments.  Whether or not Investco would be considered to have a business or not is a question of fact that could only be determined following an exhaustive analysis of all the facts and circumstances in a given situation. Therefore, it is not clear from the facts provided whether or not Investco has a related business in respect of Mrs. A.

A dividend received by Mrs. A from Investco for a taxation year will be “split income” unless the dividend is an “excluded amount”.  Pursuant to subparagraph (e)(i) of the definition of “excluded amount”, a dividend received by Mrs. A would be an excluded amount if it is not derived, directly or indirectly, from a related business in respect of Mrs. A.  Furthermore, paragraph 120.4(1.1)(d) states that:

(d) for greater certainty, an amount derived directly or indirectly from a business includes

   (i) an amount that

(A) is derived from the provision of property or services to, or in support of, the business, or

(B) arises in connection with the ownership or disposition of an interest in the person or partnership carrying on the business, and

   (ii) an amount derived from an amount described in this paragraph.

Response to Question 1

Dividends paid by Investco out of its after-tax income from its investments in publicly‑traded corporations would not be considered to be derived, directly or indirectly, from the related business of Opco in respect of Mrs. A.  Therefore, if Investco does not have a related business in respect of Mrs. A, the dividends it pays to Mrs. A that are derived from income and gains earned from its investments in publicly‑traded corporations would be an “excluded amount” in respect of Mrs. A under subparagraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1).

If Investco has a related business in respect of Mrs. A, dividends paid by Investco to Mrs. A out of its after-tax income from its investments in publicly-traded corporations would be an amount derived directly or indirectly from that related business, and therefore would not be an excluded amount under subparagraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1).  Mrs. A would need to determine if one or more of the other exceptions to split income contained within the definition of excluded amount are met in this case.

Response to Question 2

For the purposes of providing this response, we will use the following numerical example:

*    In Year 1, Opco pays a dividend to Investco in the amount of $1,000,000 and Investco invests that $1,000,000 in shares of publicly-traded corporations; and

*    In Year 2, Investco pays a dividend-in-kind to Mrs. A of its entire stock portfolio of publicly-traded corporations which, at that time, has an aggregate FMV of $1,100,000. (footnote 2)

The portion of the FMV of the distributed stock portfolio that represents the initial investment of the dividends paid by Opco to Investco would be considered to be derived, directly or indirectly, from the related business of Opco in respect of Mrs. A.  However, gains earned by Investco as a result of the investment of those dividends would not be considered to be derived, directly or indirectly, from the related business of Opco in respect of Mrs. A.

On this basis, only $1,000,000 of the $1,100,000 dividend-in-kind received by Mrs. A in Year 2 would be considered to be derived, directly or indirectly, from the related business of Opco in respect of Mrs. A.

If Investco does not have a related business in respect of Mrs. A, $100,000 of the $1,100,000 dividend-in-kind would not be considered to be derived, directly or indirectly from a related business in respect of Mrs. A, and therefore would be an excluded amount in respect of Mrs. A pursuant to paragraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1).

If Investco has a related business in respect of Mrs. A, the entire $1,100,000 dividend‑in‑kind received by Mrs. A in Year 2 would be considered to be derived, directly or indirectly, from the related businesses in respect of Mrs. A, and therefore would not be an excluded amount under subparagraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1). Mrs. A would need to determine if one or more of the other exceptions to split income contained within the definition of “excluded amount” would be met.

Response to Question 3

Our conclusions would not change if the dividends paid by Opco to Investco were all paid prior to 2018.

We trust these comments will be of assistance to you.

Yours truly,

Kimberley Wharram
Manager
Resources Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  Paragraph (a) of the definition of related business.
2  For clarity, we assume that Investco does not have any other retained earnings.

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