2019-0814161E5 Application of Reasonable Return - TOSI

Principal Issues: Whether a dividend allocated by a trust to an individual would be an exempt amount pursuant to subparagraph 120.4(1)(g)(ii) of that definition.

Position: Question of fact - but based on facts as presented - No.

Reasons: Legally the particular individual has not made a contribution to the business.

Author: Thomas, Allison
Section: 120.4

XXXXXXXXXX                                                                         2019-081416
                                                                                                 Allison Thomas
August 7, 2019

Dear XXXXXXXXXX:

Re:  Application of Reasonable Return

This is in response to your letter dated June 20, 2019, where you requested our views on whether the “reasonable return” exception in subparagraph (g)(ii) of the definition of “excluded amount” would apply to preclude the application of the tax on split income (“TOSI”) rules in section 120.4 of the Income Tax Act (the “Act”) to taxable dividends designated by a family trust under subsection 104(19) of the Act in the following fact situation.

An adult individual who is resident in Canada (“Spouse A”) incorporated a company (“Opco”) to operate a non-services business. Spouse A’s initial investment in Opco was in the form of common shares of Opco that Spouse A received as consideration for the cash subscription price. Sometime later, and during a period of financial difficulty, Spouse A made a cash loan to Opco. Opco later repaid the cash loan to Spouse A. In both cases, the cash that was used by Spouse A came from a joint account in the name of Spouse A and his/her spouse (“Spouse B”).

The common shares of Opco are now held by a holding company (“Holdco”). The common shares of Holdco are held by a discretionary family trust (Family Trust”) in which Spouse A is the sole trustee, and Spouse A and Spouse B are among the beneficiaries. When Opco is profitable, taxable dividends are paid from Opco to Holdco and then from Holdco to the Family Trust. The Family Trust designates this taxable dividend income equally to Spouse A and Spouse B.

Spouse A has always been actively involved on a regular, continuous and substantial basis in the business of Opco. However, Spouse B has never been involved in the business of Opco. Spouse A and Spouse B are both at least 24 years old.

Your primary question is whether the “reasonable return” exception in the definition of “excluded amount” would apply to preclude the application of TOSI to dividends designated by the Family Trust to Spouse B.

OUR COMMENTS

This technical interpretation provides general comments about the provisions of the Act and related legislation. 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 70-6R9, Advance Income Tax Rulings and Technical Interpretations.

Under the TOSI rules in section 120.4, TOSI will apply to tax the “split income” of a “specified individual” at the highest marginal rate unless the amount is an “excluded amount,” as all terms are defined in subsection 120.4(1). Where the “excluded share” or “excluded business” safe harbour exceptions 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.

In the above-noted fact situation, it has been assumed that Spouse A has always been actively engaged in the business of Opco on a regular, continuous and substantial basis but Spouse B has never been actively engaged in Opco’s business. In such circumstances, the “excluded business” safe harbour exception in subparagraph (e)(ii) of the “excluded amount” definition in subsection 120.4(1) would be met for Spouse A but not Spouse B. Consequently, in the above-noted situation, taxable dividends received by Spouse A from the Family Trust pursuant to a subsection 104(19) designation would not appear to be subject to TOSI. However, taxable dividends received by Spouse B from the Family Trust pursuant to a subsection 104(19) designation would be split income subject to TOSI, unless the “reasonable return” exception in subparagraph (g)(ii) of the excluded amount definition applies.

Based on our limited understanding of the facts in the above-noted situation, although the cash used to fund Spouse A’s initial share investment in Opco and to make the loan to Opco was stated to be from cash that came from a joint account in the name of Spouse A and Spouse B, the legal form of these transactions strongly suggests that Spouse B has not made any direct or indirect contribution of property to Opco. However, this is a mixed question of fact and law that can only be determined after a review of all the facts and circumstances applicable to a particular situation.

Notwithstanding the above, in such types of situations taking an overly broad interpretation that a specified individual has made an indirect financial contribution to a business such that the reasonable return exception in subparagraph (g)(ii) of the definition of excluded amount would apply to prevent the amount from being split income would appear to frustrate the underlying tax policy of the TOSI rules.

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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