The tax on split income is like an escape room where people can’t find easy exit. The federal government has expanded Tax on Split Income (TOSI) rules on January 01, 2019. What is income splitting from the CRA’s point of view? It is defined as; “An income-splitting technique that shifts income received from an incorporated family business from someone in a high-income tax bracket to individuals in a low-income tax bracket (usually family members) to produce income tax savings”.
For example, assume you’re a shareholder in a private corporation and you are taxed at the highest income tax rate. Your spouse and your adult children don’t have any source of income. They subscribe for shares in your corporation. What happens is that instead of having the corporation’s after-tax earnings paid to you as dividends and taxed in your hands at the highest tax rate, the after-tax earnings can be paid as dividends to your spouse and to your adult children that will be taxed in their hands at lower rates.
How does Income Splitting Work in Canada Now?
Tax on Split Income (TOSI) was previously applied only on the individuals under the age of 18, but now, the split income of those over the age of 18 will be subjected to TOSI.
According to the Canada Revenue Agency (CRA), the split income of all persons over 18 will be taxed at “the highest marginal tax rate”. In effect, the new rules take away the ability to leverage lower tax rates by splitting your income with a family member in a lower tax bracket.
Income subject to TOSI
TOSI potentially applies if business owners or their family members earn the following types of split income:
- Dividends and shareholder benefits from a private corporation
- Income received from a partnership or trust, where the income is derived from a related business or a rental income where a related person is involved
- Income on certain debt from a private company, partnership or trust
- Income or gains from the disposition of private shares or other property with historical TOSI
Although, most of the tax exemptions on split income have been removed by the CRA but there are some exceptions to TOSI that business owners can still leverage moving forward. In examples mentioned below, the split income recipient must be an immediate family member i.e. parent, child, or sibling, not an aunt, uncle, nephews, or nieces.
What are Exempted from TOSI?
- Excluded Business Gains
If the family member is 18-24 years of age and has worked with the business for an average of at least 20 hours per week in the current tax year, then their gains are exempted from TOSI. Moreover, if the business only operates for part of the year (e.g. 6 months), you only need to demonstrate the family member’s work input during that period.
Remember! The new TOSI rules do not apply to salaries and wages paid for work performed. Whereas, the dividend received by an adult family member from a family business will be subject to new TOSI rules. In order to qualify for the benefits of ‘Excluded Business Gains’ exemption, the family member must be 18 years of age or older and that he/she must have worked at least 20 hours a week on average in 5 years at any time in the past, any dividends they receive now or in the future will be generally not to subject to new TOSI rules.
- Excluded Shares
If the relative of the business owner is 25 years of age or older and owns at least 10% of the company in both votes and value, then their dividends are exempted from Tax on Split Income.
This exemption will only be applicable if the corporation earns less than 90 percent of its income from the provision of services and are not professional corporations, such as law firms, accounting firms, or dentistry and physician clinics etc.
- Reasonable Returns
If a family member doesn’t meet the exemption criteria of the excluded business gains and the excluded shares, there is another exception based on a reasonable return that can be applied on adult family members who are 25 years of age and older. The reasonability of the return will be determined based upon many factors. For example, work performance, risk assumption by an individual, historical payment made by the business to an individual and other relevant factor.
- Other Exemptions
Business Owners Aged 65+
Split income derived by spouses of business owners who made contributions to the business and who are also over 65 years of age will not be subject to TOSI.
The New Rules are Complex
The new TOSI exemption rules are complicated that include significant changes to the taxation of private corporations and their shareholders.
This article is just a brief look into the New Tax Rules for Split Income in Canada. To have more knowledge and a better understanding of the potential benefits of the exemptions of TOSI, we recommend you step forward and speak to us at GTA Accounting as we fully understand the legal environment and the nature of your business.
Sohail Afzal, CPA, CMA, MBA
Sohail Afzal, (CPA, CMA, MBA) is the founder & CEO of GTA Accounting Professional Corporation. He is a highly experienced Chartered Professional Accountant and businessman himself and understands the challenges that many businesses face when it comes to cash flow management. As an experienced business consultant & tax advisor, he is helping companies grow by providing the technical, financial, and contractual information necessary for strategic decision-making.