2018-0783741E5 TOSI and the meaning of "Excluded Business"

Principal Issues: Whether a business described in a hypothetical scenario would be considered an "excluded business" such that the dividend income received by a particular individual is not subject to the TOSI.

Position: Yes.

Reasons: See below.

Author: Ng, Tania
Section: 120.4

XXXXXXXXXX                                                                                                                                       2018-078374
                                                                                                                                                               T. Ng
                                                                                                                                                               (416) 512-4013
February 27, 2019

Dear XXXXXXXXXX,

Re: Request for Technical Interpretation – Tax on Split Income (“TOSI”) and the Meaning of “Excluded Business”

We are writing in reply to your email query dated October 7, 2018, wherein you requested our views on the interpretation of paragraph (b) of the definition of “excluded business” in subsection 120.4(1) of the Income Tax Act (the “Act”) in the following scenario.

Mr. A is the sole shareholder of a corporation (“Opco”) that is a Canadian-controlled private corporation (“CCPC”) as that term is defined in subsection 125(7) of the Act. Opco has carried on an active business since it was incorporated and continues to carry on that same business. From 2001-2006 inclusive, Ms. B worked as a full-time employee of Opco. On average, Ms. B worked approximately 40 hours per week. In 2007, Ms. B ceased working for Opco and has not worked for Opco since that time. In 2018, Mr. A and Ms. B, who are both 35 years of age, were married and shortly thereafter Ms. B acquired non-voting shares of Opco.

You want to know if dividend income received by Ms. B from Opco on her non-voting shares will be considered as an “excluded amount” under subparagraph (e)(ii) of that definition by virtue of the fact that paragraph (b) of the “excluded business” exception will apply because of her previous employment with Opco.

Our comments:

This technical interpretation provides general comments about the provisions of the Income Tax Act (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 70-6R8, Advance Income Tax Rulings and Technical Interpretations. All statutory references herein are to the provisions of the Act.

In order to provide our general comments, the following assumptions have been made for the 2019 taxation year:

*     Mr. A and Ms. B are residents of Canada for the entire 2019 taxation year;

*     Ms. B is a “specified individual” as defined in subsection 120.4(1);

*     Mr. A is a “source individual” as defined in subsection 120.4(1) in respect of Ms. B;

*     The business carried on by Opco is a “related business” in respect of Ms. B for the relevant taxation year because Mr. A owns shares of Opco having a fair market value (“FMV”) that is equal to at least 10% of the FMV of all the issued and outstanding shares of its capital stock (see paragraph (c) of the definition of “related business”); and

*     Any dividends received by Ms. B on her Opco shares will be derived directly or indirectly from the “related business”.

If Ms. B receives dividends on the non-voting shares of Opco in a particular taxation year, such dividends will be “split income” unless it is an “excluded amount”. Pursuant to subparagraph (e)(ii) of the definition of “excluded amount”, such dividends could be an excluded amount to the extent that it is derived directly or indirectly from an “excluded business” of the individual for the year. The term “excluded business” is also defined in subsection 120.4(1) and means a business in which the specified individual is actively engaged on a regular, continuous and substantial basis in the year (see paragraph (a) of the definition of “excluded business”) or in any five prior years (the “five-year test”) (see paragraph (b) of the definition of “excluded business”). Gains from the disposition of property (as described in paragraph (e) of the definition of “split income”) will be an excluded amount because of the excluded business exception only if the individual satisfies the five-year test.

Since Ms. B has not worked for Opco since 2007, the only way that the business of Opco could qualify as an “excluded business” of Ms. B is if the five-year test can be satisfied.

It is a question of fact as to whether an individual is actively engaged on a “regular, continuous and substantial basis”. Whether an individual has been actively engaged in the activities of a business on a “regular, continuous and substantial basis” in a particular year will depend on the circumstances, including the nature of the individual’s involvement in the business and the nature of the business itself.  Whether an individual is actively engaged in a business will generally turn on the time, work and energy the individual devotes to the business. 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. Likewise, the more an individual’s contributions are integral to the success of the business, the more substantial they would be.

Without limiting the generality of the “regular, continuous and substantial” test described above, there is also a deeming rule found in paragraph 120.4(1.1)(a), which provides a bright-line test in determining whether a specified individual is actively engaged on a regular, continuous and substantial basis in the activities of a particular business for a particular year. This bright-line test is generally based upon an average of 20 hours per week of work throughout the portion of the year when the business operates.

Based on the wording of the legislation, there is no requirement that the prior taxation years where the specified individual is actively engaged on a regular, continuous and substantial basis must be consecutive, nor is there a requirement that the specified individual must be related to the particular source individual at the time such qualifying activities are performed.  The Explanatory Notes issued by the Department of Finance which accompanied the amendments to section 120.4 support this view.  The Explanatory Notes indicate that the five-year test is intended to ensure that individuals who have made significant labour contribution to a business over a number of years will continue to be exempt from the TOSI in respect of income derived from the business after the individual has retired from, or reduced their involvement in, the business.  In order to qualify, it is not necessary that the five preceding years be continuous and moreover, it was noted that these years can be before the effective date of the amendments to section 120.4.

While a question of fact, assuming Ms. B has been actively engaged on a regular, continuous and substantial basis in the business activities of Opco for at least five years, the five-year test in paragraph (b) of the definition of “excluded business” would appear to be met.

We trust that these comments will be of assistance.

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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