2019-0814181E5 TOSI - interpretation of "excluded business"

Principal Issues: Whether the “excluded business” exception would apply in a scenario involving the transfer of a business initially operated as a sole proprietorship to a corporation, and in scenarios involving the amalgamation of corporations.

Position: General comments provided. See below.

Reasons: See below.

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

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                                                                                                      Ryan McPherson

August 19, 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 letter dated June 21, 2019, 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 context of the two scenarios outlined in your letter.

Unless otherwise stated, all references to a statute are references to the provisions of the Act, as amended to the date hereof and every reference herein to a Part, section, subsection, paragraph, subparagraph or clause is a reference to the relevant provisions of the Act.

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 70-6R9, Advance Income Tax Rulings and Technical Interpretations.

Scenario A:

Assumed facts:

*     An adult individual resident in Canada (“Mr. A”), operated a catering business on a full-time basis as a sole proprietorship for a period of time being less than 5 years, after which Mr. A transferred the catering business to a newly incorporated corporation (“Opco”) in return for consideration consisting solely of preferred shares of Opco.

*     A family trust (“Trust”) created for the benefit of Mr. A, Mr. A’s spouse (“Mrs. A”) and other family members, also subscribed for common shares of Opco at that time. Mrs. A is an adult individual resident in Canada and an income beneficiary of the Trust.

*     Mrs. A was actively engaged on a regular, continuous and substantial basis (“full-time”) as an employee of Mr. A’s catering business while it was carried on by Mr. A as sole proprietorship. The period of time Mrs. A worked full-time during the period it was operated as a sole proprietorship was less than 5 years.

*     Following the incorporation of Opco, Mrs. A continued to be employed on a full-time basis in the catering business carried on by Opco for a period of time that was less than 5 years.

*     Mrs. A has now completely ceased working in Opco’s catering business.

*     The combined period of time Mrs. A worked full-time in the catering business while it was carried on by Mr. A as a sole proprietorship and while subsequently employed full-time by Opco in its catering business exceeds 5 years.

*     Opco pays a dividend to the Trust, which is then designated by the Trust pursuant to subsection 104(19), to be a taxable dividend received by Mrs. A.

Question:

Will the dividend income received by Mrs. A from the Trust be 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 to Mrs. A?

Our Comments:

In order to provide our general comments, the following additional assumptions have been made:

*     The preferred shares of Opco owned by Mr. A have a fair market value of 10% or more of all the issued and outstanding shares of Opco;

*     Mrs. A 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 Mrs. A;

*     The business carried on by Opco A is a “related business” in respect of Mrs. A for the relevant taxation year by virtue of subparagraph (a)(ii) and paragraph (c) of that definition as set out in subsection 120.4(1); and

*     Any dividends included in income by Mrs. A by virtue of distributions from the Trust will be derived directly or indirectly from a “related business”.

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 safe harbours found in the excluded share and excluded business exceptions do not apply, the amount would be subject to TOSI unless another excluded amount exception applies. Since the scenarios in your letter focus on the “excluded business” safe harbour, we will not comment on any of the other excluded amount exceptions from TOSI.

Pursuant to subparagraph (e)(ii) of the definition of “excluded amount” in subsection 120.4(1), dividend income could be an excluded amount if it is derived directly or indirectly from an “excluded business” of a specified individual for the particular 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”).

On the basis of the assumed facts applicable to Scenario A, the catering business carried on by Opco is a “related business” in respect of Mrs. A for the relevant taxation year. Consequently, the taxable dividend Mrs. A received from the Trust that the Trust received from Opco will be “split income” to Mrs. A and subject to TOSI unless it is an “excluded amount” as each of these terms are defined in subsection 120.4(1).

Since Mrs. A was not employed by Opco in the year the dividend was received, the only way that the business of Opco could qualify as an “excluded business” of Mrs. A is if the five year test in paragraph (b) of that definition can be satisfied.

It is a question of fact as to whether an individual is actively engaged on a “regular, continuous and substantial basis” in a particular business. 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.

Notwithstanding the above, in our view the reference to a “business” in the preamble of the excluded business definition should not, for the purposes of paragraph (b) of that definition, exclude taking into account taxation years where that business was carried on in another form. Our view is supported by the following comment contained in the Explanatory Notes issued by the Department of Finance which accompanied the amendments to section 120.4:

It is intended that the determination of whether a business is an excluded business of the individual will generally not be affected by reorganizations and other changes to the person or partnership carrying on the business. For example, if a business operated as a sole proprietorship is transferred to a corporation, an individual's involvement in the business before the transfer is to be taken into consideration in determining whether the business carried on by the corporation is an excluded business of the individual.

Therefore, in Scenario A, since it has been assumed that Mrs. A has been actively engaged on a regular, continuous and substantial basis in the catering business, carried on first by Mr. A as a sole proprietor and subsequently by Opco, for at least five prior taxation years, the requirement in paragraph (b) of the excluded business definition would be met. As such, the taxable dividend received by Mrs. A from the Trust which was received by the Trust from Opco would be an “excluded amount” under subparagraph (e)(ii) of that definition and not subject to TOSI.

Scenario B:

Assuming the same facts as Scenario A, with the exception of the following:

*     The period of time Mrs. A worked full-time for Opco amounted to at least 5 years.

*     After Mrs. A ceased working for Opco, Opco amalgamated with a second corporation (Opco B), which had also carried on a catering business, forming Amalco.

*     Amalco continues to carry on a single catering business.

*     The business carried on by Amalco remains a related business of Mrs. A.

*     Neither Mr. A nor Mrs. A had ever been involved in the catering business carried on by Opco B.

*     In a particular year, Amalco pays a dividend on the common shares owned by the Trust, which is distributed by the trustees to Mrs. A as an income beneficiary.

*     Mrs. A does not work for Amalco in the year the dividend is received.

Question 1:

Will the dividend income received by Mrs. A be 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 due to her previous full-time employment with Opco A?

Our Comments:

While it is a question of fact as to whether the business carried on by Amalco is the same business that was carried on by Opco A, assuming it is the same business, it is our view that the dividend received from the trust by Mrs. A pursuant to a subsection 104(19) designation would be an excluded amount for the same reasons stated in Scenario A.

Question 2:

If the business carried on by Opco B, prior to the amalgamation was not a catering business and subsequent to the amalgamation, Amalco carried on only the business originally carried on by Opco B, would the dividend income received by Mrs. A be 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 due to her employment with Opco A?

Our Comments:

Since it has been assumed that Mrs. A has not worked at all in the business previously carried on by Opco B, which is now being carried on by Amalco during the relevant taxation year of Mrs. A or in any five prior taxation years, that business will not be an excluded business of Mrs. A. Consequently, the dividend income Mrs. A receives from the Trust that is derived directly or indirectly from the business of Amalco will be subject to TOSI unless another exclusion applies.

Question 3:

If the business carried on by Opco B, prior to amalgamation was not a catering business and subsequent to the amalgamation, Amalco carries on both businesses, would the dividend income received by Mrs. A be 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 due to her employment with Opco A?

Our Comments:

Any income of Mrs. A that is derived directly or indirectly from the catering business of Amalco will be income from an excluded business of Mrs. A and will not be split income subject to TOSI. Any income of Mrs. A that is derived directly or indirectly from the business previously carried on by Opco B will not be income from an excluded business of Mrs. A and will be split income subject to TOSI unless another exclusion applies. This will require separate accounting for each business and a tracing of funds.

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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