2019-0819431E5 TOSI

Principal Issues: 1. Whether the investment activity of PC1 constitutes a business and whether such a determination would impact whether the “related business” exception is applicable to dividends paid by PC1 to Spouse A after December 30 in Year 1? 2. Assuming that the investment activity of PC1 constitutes a business, whether dividends paid by PC1 to Spouse A in Year 2 could be considered derived directly or indirectly from the related business of PC2 such that paragraph (c) of the definition of "excluded shares" could not be met.

Position: 1. Question of fact. In the circumstances described, whether the investment activities of PC1 constitutes a business will not have an impact on whether the “related business” exception is applicable. 2. For Year 2 the test in paragraph (c) of the excluded share definition would refer back to Year 1 so the exception would technically apply for Year 2, but the exception would not apply for subsequent taxation years. CRA would likely seek to apply GAAR where the result is not appropriate.

Reasons: See below.

Author: Ng, Tania
Section: 120.4

XXXXXXXXXX                                                                                2019-081943
                                                                                                        T. Ng
                                                                                                        (519) 200-8908
January 10, 2020

Dear XXXXXXXXXX,

Re: Request for Technical Interpretation – Tax on Split Income (“TOSI”)

We are writing in reply to your letter dated August 8, 2019, wherein you requested our views on the application of TOSI to dividends paid by a corporation in the context of the scenario described below.

Scenario

1.    A professional corporation (“PC1”) is licensed to carry on a business of providing medical services in a province in Canada.  PC1 does not own any tangible or intangible assets used in the medical services business carried on by PC1.  PC1’s taxation year end is December 31.

2.    An adult individual over the age of 24 and resident in Canada (“Dr. A”) is a licenced physician who owns all of the voting shares of PC1 and 50% of a class of non-voting participating shares of PC1.  Dr. A is actively engaged in PC1’s business on a regular, substantial and continuous basis and is remunerated by way of salary and/or dividends paid by PC1.

3.    Dr. A’s spouse (“Spouse A”) is an adult individual over the age of 24 and resident in Canada.  Spouse A is not a licenced physician and is not involved in PC1’s medical services business.  Spouse A is precluded by law from owning any voting shares of PC1, however, Spouse A can, and does, own the remaining 50% of the class of non-voting participating shares of PC1.

4.    PC1 also has a substantial investment portfolio (“Portfolio”) of publicly traded securities that it acquired with the undistributed after-tax earnings it earned from the medical services business and reinvested earnings from the Portfolio investments.

5.    The Portfolio is managed by a financial institution that has the authority to make the day-to-day investment decisions without any input from Dr. A and/or Spouse A.  Consequently, Dr. A and Spouse A have limited involvement with the investment activities pertaining to the Portfolio.

6.    On December 30 of Year 1, PC1 surrendered its permit to practice medicine and ceased carrying on its medical services business such that going forward its only activity was the investment activities pertaining to the Portfolio.

7.    On December 31 of Year 1, Spouse A acquired 50% of Dr. A’s voting shares of PC1 for their fair market value.

8.    On January 1 of Year 2, Dr. A incorporated a new professional corporation (PC2) to carry on the medical services business formerly carried on by PC1.  The share structure and ownership of PC2 mirrored that of PC1 prior to December 30 of Year 1.  PC2 will not contribute any capital towards the investment activities in PC1 in Year 2.

Your Questions

1.    Whether the investment activities of PC1 constitute a business and whether such a determination would impact whether the “related business” exception is applicable to dividends paid by PC1 to Spouse A after December 30 in Year 1?

2.    On the assumption that the investment activities of PC1 constitute a business, will the shares of PC1 held by Spouse A qualify as “excluded shares” as that term is defined in subsection 120.4(1) in Year 2?  Specifically, you wish to know whether the dividends paid by PC1 to Spouse A in Year 2 could be considered to be derived directly or indirectly from the related business of PC2, such that paragraph (c) of the definition of “excluded shares” could not be met.

Our Comments

The situation described in your letter appears to relate to a specific factual situation involving specific taxpayers and which involve various questions of fact.  As set out in Information Circular IC 70-6R9, Advance Income Tax Rulings and Technical Interpretations (IC 70-6R9), the CRA’s position on circumstances where a technical interpretation or advance income tax ruling will not be issued would include a situation where the issue requires primarily a factual or legal determination such as whether a business is being carried on (refer to paragraphs 7(e) and 19(h) of IC 70-6R9).

Notwithstanding the above, this technical interpretation will provide some general comments about the provisions of the Income Tax Act (the “Act”) as it may or may not pertain to your particular situation.  It is not intended to confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.

Response to Question 1

The question of whether a corporation carries on one or more than one business can only be resolved after the review of all the relevant facts and circumstances.  The term “business” is not defined in the Act.  Subsection 248(1) only broadens the term “business” to include, among other things, an undertaking of any kind whatever.  The courts have generally held that the level of activity required to conclude that a corporation has a business is low. (footnote 1)

In order to determine whether the “related business” exception will apply in a particular situation, a taxpayer must make a determination after considering all the relevant facts and circumstances.  This exception, which is found in subparagraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1) provides that an amount that is not derived directly or indirectly from a related business in respect of the individual for the year is an excluded amount.  Accordingly, it must first be determined whether the amount (i.e., in this particular case, the dividend income) was derived directly or indirectly from a related business, and second whether such amount was from a related business in respect of the individual for the year.  In the event that both tests are satisfied, the amount in question would not be excluded from split income under the “related business” exception.

In a situation where the only activity of the corporation in question is earning investment income from portfolio investments, the availability of the “related business” exception will turn on whether the investment activities of that corporation constitute a business.  Such a situation was addressed in the response to Question 9 at the 2018 CTF Roundtable. (footnote 2)

However, in the scenario described above, whether the investment activities of PC1 in Year 1 constitutes a business is not determinative of whether the “related business” exception is available because PC1 also carries on a medical services business in Year 1 which would be considered a “related business” in respect of Spouse A who is a “specified individual” as defined in subsection 120.4(1).  Moreover, whether the “related business” exception is available does not turn on whether the dividends were paid out before or after December 30 on Year 1 (i.e., the date the medical services business ceased) because the definition of “related business” specifically states that a business is a related business of a specified individual for a taxation year if at any time in the year, the source individual (Dr. A) in respect of the specified individual (Spouse A) is actively engaged on a regular basis in the activities of the corporation (PC1) that is related to earning income from business (see subparagraph (a)(ii) of the definition of “related business” in subsection 120.4(1)).  Furthermore, the definition of “related business” also includes a business of a corporation if at any time in the year, the source individual (Dr. A) in respect of the specified individual (Spouse A) owns, generally speaking, at least 10% of the fair market value of the corporation (PC1) (see paragraph (c) of the definition of “related business” in subsection 120.4(1)).

As such, if it can be determined that the dividends paid by PC1 are “derived directly or indirectly” from a related business, which is likely given that the capital invested in the Portfolio was wholly-derived from either after-tax earnings of PC1’s medical services business or reinvested investment income, the “related business” exception would not be available and such amounts would be included into the split income of Spouse A unless another exception applies.

Response to Question 2

To determine whether the shares of a corporation (PC1) qualify as “excluded shares” for a specified individual for a particular time after Year 1, one must determine whether the following conditions set out in that definition are met at the particular time: (a)(i) less than 90% of the business income of PC1 for its last taxation year was from the provision of services; (a)(ii) PC1 is not a professional corporation; (b)(i) the shares of PC1 owned by the specified individual represent 10% or more of all the voting shares of PC1; (b)(ii) such shares represent 10% or more of the fair market value of all the shares of PC1; and (c) for the relevant taxation year in (a)(i), all or substantially all of the income from PC1 was income that was not derived directly or indirectly from one or more related businesses in respect of the specified individual other than a business of PC1.

In respect of Year 2, it appears that the conditions in subparagraphs (a)(ii), (b)(i) and (b)(ii) of the “excluded share” definition are met in that year.  However, the relevant taxation year for applying the conditions in subparagraph (a)(i) and paragraph (c) for PC1 in Year 2 is Year 1.  Provided that less than 90% of the income of PC1 for Year 1 was earned from the medical services business (such that the condition in subparagraph (a)(i) is met), the shares of PC1 would qualify as “excluded shares” in Year 2 as the condition in paragraph (c) also would appear to be technically satisfied.  More specifically, all or substantially all of the income of PC1 is derived directly or indirectly from one or more related businesses (i.e., the medical services business and the investment business) in Year 1, and PC1 is still carrying on these businesses in Year 1.  Accordingly, if the PC1 shares held by Spouse A qualify as “excluded shares” in Year 2, any dividends paid from PC1 to Spouse A in Year 2 would be an “excluded amount” and not subject to TOSI.

We note that in contrast, it would appear that the shares of PC1 held by Spouse A would not qualify as “excluded shares” in Year 3 and subsequent years.  While the conditions listed in paragraphs (a) and (b) of the definition of “excluded shares” could possibly be met in those years, it does not appear that the condition in paragraph (c) would still be met.  Contrary to Year 2, the exception in paragraph (c) is no longer available for any taxation year after Year 2.  This would be the case where, in the relevant taxation year referred to in paragraph (c) of the “excluded share” definition (being the last taxation year referred to in subparagraph (a)(i)), Dr. A (a source individual in respect of Spouse A) is actively engaged in the medical services business being carried on by PC2.  It is our view that in these circumstances, any dividend paid by PC1 to Spouse A would be considered to be derived directly or indirectly from a “related business” carried on by PC2 (and not PC1) in Year 2 and subsequent years. (footnote 3)   As the PC1 shares held by Spouse A would not qualify as “excluded shares” in Year 3 and subsequent years, any dividends paid from PC1 to Spouse A in those years would be subject to TOSI unless another exception applies.

Notwithstanding the above, while it is a question of fact, the facts in the above scenario strongly suggest that these transactions were undertaken primarily to ensure that the shares of PC1 could meet the definition of “excluded shares” such that the “excluded amount” exemption would be available to Spouse A.  If it is determined that any transaction, either alone or as part of a series, has been undertaken primarily to obtain the “excluded amount” exemption under paragraph 120.4(1) in a manner that would frustrate the object, spirit and purpose of section 120.4, the CRA would seek to apply the GAAR.

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

FOOTNOTES

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

1  There is a rebuttable presumption that income received from or generated by an activity done in pursuit of an object set out in the corporation’s constating documents is income from a business.  See Canadian Marconi Company v. The Queen, 86 DT 6526, Weaver et al v. The Queen, 2008 FCA 238 and Hickman Motors Ltd. v. The Queen, [1997] 2 S.C.R. 336.

2  See 2018-0779981C6.

3  See paragraph 120.4(1.1)(d).  While the Act does not provide a definition for the expression “derived directly or indirectly”, the courts have repeatedly concluded that the expression “derived from” can have a broad meaning.  See for example how the phrase was interpreted by the Supreme Court of Canada in the case of MNR. v. Hollinger North Shore Exploration Co. Ltd. 63 DTC 1031.  The fact that this expression has been combined with the words “directly or indirectly” indicates that the phrase is meant to be interpreted broadly.  See document 2018-0779981C6 for additional discussion on the interpretation of the expression “derived directly or indirectly”.

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