Split income: Exceptions to the rule when it comes to TOSI

Canadians will soon face their third year under the tax on split income (“TOSI”) regime. Income subject to TOSI (e.g. dividends or gains on private corporation shares, benefits from a trust or corporation, etc.) will continue to be taxed at the highest personal tax rate, eliminating any income splitting benefits with family members. As the taxman continues to issue pronouncements on how to interpret these relatively new rules, it is a good time for business owners to consider implementing an alternative strategy to enable income splitting in the new year while avoiding TOSI.

There are many specific exceptions to TOSI, a common one being the “excluded share” exception. Specifically, dividends paid on, or gains from the disposition of, excluded shares are not subject to TOSI. To meet this exception, the individual must be at least 25 years old and directly own 10 per cent or more of the votes and value of the corporation. In addition, the corporation itself cannot be a professional corporation or operate a service business. Depending on the specific situation, we suggest a few viable strategies to meet this exception:

Direct ownership

Family members can be introduced directly into the business as shareholders. The individual can subscribe for voting common shares of the corporation from treasury at their fair market value. For an established corporation, a so-called “freeze” can be structured so that the value of the new shares can be affordable for those family members. As the company grows in value and the old “frozen” shares are redeemed, those new shareholders can receive dividends not subject to TOSI if other conditions described above are also met.

Where a family trust is the shareholder of the corporation, the Trust can distribute its shares to its beneficiaries. This can generally be implemented on a tax-free basis, not requiring any capital contribution from the individual.

It’s important to note that, as each individual needs to retain 10 per cent of the votes and value of the corporation to meet this exception, the number of new shareholders under this strategy is limited, and the original shareholders should be prepared to reduce their own participation in profit and growth. Appropriate consideration should be given to the introduction of minority shareholders in the corporation. 

Corporate partners

Where there is a two-tiered structure involving a holding and operating company, it may be beneficial for the (non-professional/non-service) business to operate under a partnership structure. A recent position released by the CRA supports that the business of a partnership is also considered to be the business of a corporate partner. Based on this position, the shares of each corporate partner in a partnership could qualify for the excluded share exception. In comparison, the shares of a holding company owning shares of an operating company will not qualify.

There does not appear to be a minimal amount of partnership interest required for corporate partners to meet this position. This can offer flexibility to involve and income split to a greater number of individuals through more corporate partners. Of course, the income distribution from the partnership is still limited to the partnership interest of each partner, and the partnership still needs to conduct true business operations. 

This article only provides a very general overview of some examples for this exemption. The actual implementation of a strategy will depend on your specific circumstances and will require careful planning. If you are interested in exploring options available to your business, we commended consulting with your tax advisor before proceeding. To find out more about MNP’s tax services and guidance in managing your organization’s tax strategies, please contact one of our advisors or visit www.mnp.ca.

Gavin Miranda is a partner and regional tax leader in MNP’s Ottawa office.