2020-0856081I7 Interaction of subsection 82(3) and section 120.4

Principal Issues: 1, Is there an ordering rule with respect to the subsection 82(3) election and the application of section 120.4? 2. Provide examples of the TOSI analysis in circumstances where an election under subsection 82(3) is filed.

Position: 1. There is no specific rule in the Act that governs the interaction of subsection 82(3) and the TOSI rules. Based on the text of the provisions, the subsection 82(3) election takes precedence over the TOSI rules. 2. Three hypotheticals provided.

Reasons: 1. Text of the provision. The contextual and purposive interpretation of the provisions does not clearly provide for a different result. This tax result is not inconsistent with the scheme of the TOSI because had the electing spouse received the dividends directly, the same tax consequences would have resulted (i.e. the TOSI would apply to the recipient based on the recipient’s tax circumstances). On the same basis, the result should generally also not be subject to the GAAR. 2. See discussion of hypothetical examples.

Author: Flisfeder, Anna
Section: 120.4, 82(3); 118(1)(a)

                                                                                             August 16, 2021

SMED/DPME Technical Section                                    HEADQUARTERS
Ottawa                                                                              Income Tax Rulings Directorate
                                                                                           Anna Flisfeder
Attention: Minguy Choi,
Senior Technical Specialist
                                                                                          2020-085608

RE: Interaction of subsection 82(3) and section 120.4

We are responding to your request seeking our input on the interaction of subsection 82(3) and the tax on split income rules found in section 120.4 (the “TOSI”) of the Income Tax Act (Canada) (the “Act”). Unless otherwise indicated, all statutory references are to the Act.

In general terms, the TOSI rules expand on the “kiddie tax” and restrict a particular form of income splitting involving the payment of dividends by family or closely held private companies on shares acquired directly or indirectly by low taxed family members (including a spouse and adult children) from the corporation. The TOSI aims to remove the incentive for the payment of private company dividends to lower income family members by eliminating the tax benefits of this kind of tax planning. It does so by taxing such dividends (technically, “split income”) of the dividend recipient (the “specified individual”) at the top personal tax rate rather than the lower rate otherwise applicable to that individual, and all personal tax credits - except for the disability tax credit under section 118.3, the dividend tax credit under section 121 and the foreign tax credit under section 126 - are denied (see subsection 120.4(3)). The TOSI rules are drafted very broadly, and contain a number of exclusions (“excluded amounts”) to identify those recipients of dividends paid on private company shares whom the legislator has determined are acceptable recipients of such income (“Acceptable Recipient”).

The subsection 82(3) election operates independently from the TOSI, and generally facilitates a form of income splitting of dividends for married spouses or common-law partners. The election enables a couple to maximize the dividend tax credit and the spousal tax credit, thereby reducing their overall tax payable. In particular, subsection 82(3) allows a taxpayer to elect to have a taxable dividend from any taxable Canadian corporation, whether family owned or otherwise, received by the taxpayer’s spouse or common-law partner included in the taxpayer’s income, where such an inclusion increases the taxpayer’s married or common-law partner credit under paragraph 118(1)(a) (the “spousal tax credit”). Generally, there is an incentive for the higher income spouse to elect under subsection 82(3) as the increase in the spousal tax credit from the election should exceed the tax payable on the dividend in the higher income spouse’s hands taking into account the dividend tax credit and the higher spousal tax credit which can now also be claimed by that spouse after the election.

You are seeking guidance with respect to the following questions:

1. Is there an ordering rule with respect to the subsection 82(3) election and the application of section 120.4? In other words, if the TOSI would otherwise apply to dividends received by a spouse or common law partner, can the other spouse or common law partner file an election under subsection 82(3) to tax the dividends in their hands which may potentially not be subject to the TOSI?

2. Provide examples of the TOSI analysis in circumstances where an election under subsection 82(3) is filed.

The following comments are limited to the application of the TOSI to income splitting structures involving adult family members.

Our Comments

1. There is no ordering rule with respect to the subsection 82(3) election and the TOSI.

As you correctly noted, there is no specific rule in the Act that governs the interaction of subsection 82(3) and the TOSI rules. Based on the text of the provisions, the subsection 82(3) election takes precedence over the TOSI rules.

Subsection 82(3) provides:

“(3) Dividends received by spouse or common-law partner — Where the amount that would, but for this subsection, be deductible under subsection 118(1) by reason of paragraph 118(1)(a) in computing a taxpayer's tax payable under this Part for a taxation year that is less than the amount that would be so deductible if no amount were required by subsection (1) to be included in computing the income for the year of the taxpayer's spouse or common-law partner and the taxpayer so elects in the taxpayer's return of income for the year under this Part, all amounts described in paragraph (1)(a) or (a.1) received in the year from taxable Canadian corporations by the taxpayer's spouse or common-law partner are deemed to have been so received by that taxpayer and not by the spouse or common-law partner.” [Emphasis added.]

Because subsection 82(3) deems all subject dividends to be “received” by the electing spouse while the TOSI applies to dividends received by a specified individual, based on the text, subsection 82(3) applies before the TOSI rules. When a taxpayer makes an election under subsection 82(3), all of the dividends received by his or her spouse or common-law partner from taxable Canadian corporations, are deemed to be received by the taxpayer for that year, and not by their spouse or common law partners. Thus, the electing spouse becomes the specified individual from the perspective of applying the TOSI rules. Where, because of their personal circumstances, the electing spouse is an Acceptable Recipient of the subject dividends, then such dividends will not be subject to the TOSI. The contextual and purposive interpretation of the provisions does not clearly provide for a different result. We have determined that this tax result is not inconsistent with the scheme of the TOSI because had the electing spouse received the dividends directly, the same tax consequences would have resulted (i.e. the TOSI would not apply). On the same basis, the result should generally also not be subject to the GAAR.

2. Three examples of the TOSI analysis where subsection 82(3) election is filed.

In your request, you identified two scenarios involving the interaction of subsection 82(3) and the TOSI Rules. We have adapted these scenarios as well as added a third. A description of each and our response is below.

The hypotheticals are based on the following. Subsection 120.4(2) levies an additional tax on the “split income” of a “specified individual” except to the extent of such income that is an “excluded amount”. We have assumed that the dividends referred to in the hypotheticals are split income and that the Electing Spouse and the Recipient Spouse are specified individuals. Excluded amount is defined in subsection 120.4(1) and includes amounts described in subparagraphs (a) through (g). The most relevant excluded amounts for purposes of this letter are described in the definition under subparagraph (e), which deals with the excluded business exemption, as well as subparagraph (g), which deals with the excluded shares exemption. Though less common, an excluded amount can technically also include a dividend that is paid from a corporation that does not carry on a related business in respect of the specified individual. (footnote 1) A related business includes a business carried on by a corporation where a Canadian resident person (the “source individual”) related to the specified individual owns shares that exceed a prescribed threshold.

First Hypothetical – Excluded Business

The First Hypothetical is as follows:

* Electing Spouse is the higher earner, but is not taxed at the highest personal rate.

* Electing Spouse does not own shares of Aco, but is actively engaged in the business of Aco.

* Recipient Spouse owns less than 10% of the votes and value of Aco, and is not actively engaged in the business of Aco.

* Dividends are paid by Aco to Recipient Spouse. The dividend paid by Aco is not an excluded amount of the Recipient Spouse.

* Electing Spouse makes an election under subsection 82(3) to include in Electing Spouse’s income all of Recipient Spouse’s taxable dividends received from a taxable Canadian corporation (which includes the dividends on the Aco shares).

* The dividend paid by Aco that is deemed by subsection 82(3) to be received by the Electing Spouse, is derived from an excluded business and is therefore an excluded amount of the Electing Spouse.

Discussion

In the First Hypothetical, the filing of the election converts what would have been split income subject to TOSI to the Recipient Spouse, to an income inclusion for the Electing Spouse that is an excluded amount of the Electing Spouse based on the Electing Spouse’s personal circumstances. The dividend income is taxed at the Electing Spouse’s marginal rate, and only one set of personal tax credits is applied to the split income. Taxing the dividends in the Electing Spouse’s hands achieves the same result as if Aco paid the dividends directly to the Electing Spouse (had they owned shares of Aco), who is an Acceptable Recipient under the TOSI rules because they qualify for the excluded business exemption.

Second Hypothetical – Related Business

The Second Hypothetical is as follows:

* Electing Spouse is the higher earner, but is not taxed at the highest personal rate.

* Electing Spouse does not own shares of Aco, and is not actively engaged in the business of Aco.

* Recipient Spouse owns less than 10% of the votes and value of Aco, and is not actively engaged in the business of Aco.

* Aco is controlled by Recipient Spouse’s mother who is actively engaged in the operation of the business, Mother-in-Law (source individual).

* Dividends are paid by Aco to the Recipient Spouse. Such dividends are split income and are not an excluded amount with respect to the Recipient Spouse. In particular, the dividend is received from a related business in respect of the Recipient Spouse (i.e. from a corporation controlled by Mother-in-Law) and, accordingly, does not qualify as an excluded amount that is a dividend that is not received from a related business.

* Electing Spouse elects under subsection 82(3) in respect of taxable Canadian dividends received by Recipient Spouse for the year (which includes the dividends on the Aco shares).

* The dividend deemed to be received by Electing Spouse is not an excluded amount, because it is not a dividend from an excluded business or from excluded shares.

Discussion

This hypothetical demonstrates that a subsection 82(3) election cannot be used to circumvent the related business rule in the TOSI. The definition of “related persons” in paragraph 251(2)(a) together with paragraphs 251(6)(b) and 251(6)(b.1) – which, in general terms deem persons to be related to their in-laws – ensure that dividends from a related business do not lose related status when they are deemed to be received by the Electing Spouse under subsection 82(3). In this hypothetical, the business of Aco is also a related business of Electing Spouse because Electing Spouse is related to Mother-in-Law (the source individual). Thus, the TOSI would apply to the Aco dividends whether or not the subsection 82(3) election is filed.

Third Hypothetical – Excluded Shares Exception

The Third Hypothetical is as follows:

* Electing Spouse is the higher earner, but is not taxed at the highest personal rate.

* Aco is in the business of manufacturing widgets.

* Aco has three shareholders, Brother, Electing Spouse and Recipient Spouse. All three are related.

* Brother is actively engaged in the business of Aco, while Electing Spouse and Spouse B are not. Brother holds 75% of the votes and value of Aco, while Electing Spouse holds 20% and Recipient Spouse holds 5%. Each owns a separate class of shares of Aco.

* Aco pays a dividend to the Recipient Spouse.

* Dividends paid by Aco to Recipient Spouse will be split income subject to TOSI.

* Electing Spouse makes an election under subsection 82(3) to include in her income all of Recipient Spouse’s taxable dividends received from a taxable Canadian corporation (which includes the dividends on the Aco shares).

* Any dividends paid by Aco directly to Electing Spouse would not be split income because they would be an excluded amount as income from excluded shares.

Discussion

In the Third Hypothetical, the Electing Spouse is deemed by the subsection 82(3) election to have received the dividend paid on the Aco shares held by the Recipient Spouse. Subsection 82(3) does not deem the dividend to be paid on the class of Aco shares actually held by the Electing Spouse or deem the Electing Spouse to own the Aco shares on which the dividend is actually paid. Nevertheless, the income on the Aco shares will not be subject to TOSI because the income is considered to be from excluded shares. For these purposes, we are prepared to accept that the dividend deemed to be received by the Electing Spouse under subsection 82(3) was paid on the Aco shares actually held by the Electing Spouse. (footnote 2) The dividend income is taxed at the Electing Spouse’s marginal rate, and only one set of personal tax credits is applied to the split income. Taxing the dividends in the Electing Spouse’s hands achieves the same result as if Aco paid the dividends directly to the Electing Spouse, who is an Acceptable Recipient under the TOSI rules.

3. Other Issues

Where Electing Spouse is not an Acceptable Recipient

The election under subsection 82(3) provides a benefit to certain taxpayers. It is possible that, in determining whether to make the election, the TOSI rules can reduce that benefit when dividends that would not have been subject to TOSI in the hands of one spouse, become subject to TOSI in the hands of the other spouse. This may happen, for example, in circumstances where the Recipient Spouse is eligible for an exclusion under the TOSI rules (i.e. is an Acceptable Recipient), while the Electing Spouse is not.

In our view, as the subsection 82(3) election is discretionary, it is up to the taxpayer to consider the implications of the TOSI when determining whether filing a subsection 82(3) election is beneficial to the couple as a whole.

Excluded Shares

Another potential example considered is how the subsection 82(3) election could interact with the definition of “excluded shares” in subsection 120.4(1), and in particular the ownership requirements in paragraph (b) of that definition. It was determined that subsection 82(3) would not interact with the definition of “excluded shares” because the election deems the receipt of dividends by the taxpayer, but does not deem the taxpayer to own the underlying shares. Therefore, if shares held by an Electing Spouse were not excluded shares before the election, they will not become excluded shares after (i.e. an Electing Spouse who owns 6% of the votes and value of Opco, will not be deemed by the subsection 82(3) election to own the 5% of shares of Opco that are held by their lower income spouse). The same result would apply if the Electing Spouse was not a shareholder of the corporation that paid the dividend or the dividend was paid on shares owned by the Recipient Spouse that were excluded shares of the Recipient Spouse. Similar to the second hypothetical, the subsection 82(3) election cannot be used to convert an Electing Spouse into an Acceptable Recipient under the TOSI rules.

Tax Planning – Late filed elections

We considered whether the ability to late file or amend a subsection 82(3) election presents an inappropriate tax planning opportunity. In our view, the subsection 82(3) election enables a taxpayer to do indirectly what the TOSI rules encourage private companies to do directly, namely, pay dividends to Acceptable Recipients. The same result could have been obtained by simply having the private corporation pay the same dividend directly to the Electing Spouse. In our view, the filing of the subsection 82(3) election is not inconsistent with the TOSI policy, and this view is not impacted by the ability to late file or amend a subsection 82(3) election.

We trust these comments will be of assistance.

Sincerely,

H. Chong
for Director
Partnerships and Corporate Financing Section
Reorganizations Division
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 Subparagraph (e)(i) of the definition of “excluded amount” in subsection 120.4(1).
2 See our comments in Doc. No. 2019-0799961C6 where we considered the application of the exemption from TOSI in subparagraph 120.4(1.1)(c)(ii). In general terms, this provision allows income splitting between spouses using a private corporation in circumstances where the spouse has died or reached the age of 65. In particular, the provision deems an amount received by a specified individual (Spouse B) to be an “excluded amount” if the amount would have been an excluded amount of their spouse (Spouse A), in the spouses’ terminal year, or in the current year where the spouse is over 65 years of age. In the document we considered how the subparagraph 120.4(1.1)(c)(ii) exemption applies in circumstances where Spouse A qualified for an exemption under the excluded share exemption based on direct ownership of the shares, while the specified individual/Spouse B currently holds shares indirectly through a trust (which fact disqualifies Spouse B from the excluded share exemption). Ultimately, we took the position that the circumstances of Spouse A, and not those of the specified individual/Spouse B, are what must be considered when determining whether the amount would have been an excluded amount in the hands of Spouse A.

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