In 1999, the government introduced the concept of a “tax on split income” (TOSI), which essentially attacked the payment of dividends to minor children. Since then, the payment of dividends to kids under 18 resulted in their being taxed at the highest marginal rate, thus nullifying any advantage of splitting income with minor children. The new rules are intended to extend the concept of TOSI to all individuals who do not make a meaningful contribution to the business or who are being paid beyond a reasonable rate for contributions they make (or made) to the family business. The changes became effective on January 1, 2018.
It is important to consider the nature of the income when applying the TOSI rules. These rules refer, for the most part, to dividends and includes those paid out of both current and past (retained) earnings. Salaries have always been, and continue to be, subject to reasonability tests. Salaries paid to an inactive spouse, for example, were already subject to these tests. The TOSI rules appear to be directed more at dividend payments as a form of income splitting.
The following is a list of exclusions – income that will not be considered split income and therefore not be subject to the TOSI rules:
• Income received by an adult individual from a business where that individual works an average of at least 20 hours per week in that business or worked to that extent in any of the previous five taxation years.
• Any deemed capital gains as a result of an individual’s death owning shares of a corporation where the income on those shares might have previously been subject to the rules.
• Any income received or capital gains realized on shares where the individual owns 10% of the voting rights of the company and 10% of the value of the company. However, this will exclude shareholders of either professional corporations or those corporations that primarily earn their income from providing services. Professional corporations include those of physicians, dentists, veterinarians, lawyers, accountants, engineers, and architects. The term “services” is not defined but would most certainly include consulting.
• A business owner’s spouse where that business owner meaningfully contributed to the business (worked more than 20 hours per week) and is now over the age of 65.
• The capital gain realized by an adult upon the disposition of qualified farm property, qualified fishing property or shares of a qualified small business corporation will be specifically excluded from tax on split income. Practically speaking, this means that non-active adult shareholders of qualifying businesses will still be able to claim their lifetime capital gains exemptions, even if those shares are held through a trust or sold in a non-arm’s-length transaction.
These exclusions apply to a large number of privately held corporations, so fewer corporations will be negatively impacted than we had feared. In addition, the originally announced proposals to tax compounding income from split income and to expand the definition of related individuals to include aunts, uncles, nieces, nephews, and cousins have also been eliminated. The family members of concern for these rules will be spouses, parents, children, grandchildren, and siblings.
There are, however, still many privately held corporations that will be impacted by the following new TOSI rules:
• Adults between the ages of 18 and 24 inclusive will have more stringent tests applied to them with regard to split income if they do not meet the test of working in the business at least 20 hours per week. Any income distributed to these adults will have to be carefully considered with regard to the tax on split income.
• Adults who receive income from a family business through a trust will need to meet the same test of working in the business at least 20 hours per week; otherwise, they could be subject to application of the split income rules.
• Individuals who receive income from a professional corporation or from a corporation whose primary income earning activity is the provision of services will again need to meet the test of working 20 hours per week.
If individuals don’t meet any of the above exclusions, it does not mean that the split income rules will automatically apply to tax them at the highest rate. For example, for adults over the age of 25, the income will not be considered to be split income unless the income received is in excess of a reasonable amount, given their level of contribution to the business.
Items to be considered in determining whether the income is reasonable include the following:
• Labour contribution
• Property contribution
• Risks assumed
• Historical payments (i.e., total amounts paid)
• Any other relevant factor

We have heard that some professional bodies are suggesting that employment contracts should be drafted and records kept to support that a minimum of 20 hours per week are performed by otherwise non-active shareholders. We are concerned that this advice trivializes the intent of the legislation, which appears to be targeted specifically at professional corporations that would likely be subject to a high probability of an audit.
For 2017, we suggested that income splitting be maximized as it might have been the last opportunity to do so. Any income splitting for 2018 and onward should be based on the work performed, and we suggest that support be obtained for any amount you may deem reasonable. For example, you can’t pay a spouse $75,000 for a job for which you would pay an arm’s-length individual $25,000. Actual bona fide work must be performed. Canada Revenue Agency has already published its guidance for and interpretation of these new rules; of note is that it has indicated that taxpayers should be prepared to support the reasonableness of the income being received if they don’t otherwise have any exclusions to rely upon.
In conclusion, individuals who are actively involved in the business should not be impacted by these provisions. Failing active involvement, ownership of at least 10% of the common shares of a corporation can provide an out, but the corporation must not be a professional corporation or one that provides services. Thus, beneficial ownership through a trust or direct ownership of discretionary dividend shares would appear to be issues, and we may consider recommending restructuring in 2018 to meet the new requirements. Income splitting for professional and service corporations will essentially be eliminated unless the individual is actively engaged in the business.

The government appears to be opposed to the use of corporations to save for retirement. This does make sense in that investing in a holding company allows the shareholders to defer personal tax on a larger sum of funds than, say, is allowable under the RRSP rules. An example is a corporation that earns $100,000 more than is needed by its shareholders. After paying corporate tax, it is left with $87,000. That $87,000 can be invested within the corporation (as opposed to the roughly $65,000 or less that would be left after personal tax).
To discourage investing within a corporate structure, the government proposes to tax investment income with a corporation at a rate that could be potentially in excess of 70%. The government has indicated that it intends to grandfather the rules so that only new investment income in excess of $50,000 per year would be subject to the higher rate of tax. We assume that this would exclude previously accumulated holding company investments.

Our advice is to move any excess cash in an operating company to the holding company prior to the upcoming federal budget. This would presumably protect the investments under the grandfathering rules. Assuming that only new investments would be subject to the $50,000 rules, it would follow that a new holding company should be established in early 2018 in which new funds may be invested and the tax would be reasonable up to the $50,000 threshold. We will finalize this advice once we learn more details about the new rules.

As mentioned in the income splitting section, the rules making income splitting undesirable would impact not only current earnings but also previously accumulated passive investments held within a corporation. One of the exemptions announced in December provides for income splitting to a spouse of the active owner where the active owner is 65 or older. In cases where individuals wish to retire prior to reaching the age of 65, the TOSI rules would otherwise apply.

Most of our clients have holding companies that are owned by a family trust. This means that the trust owns the common shares of the holding company. One option would be to distribute the common shares of the holding company from the trust to one of the beneficiaries of the trust. In this case, that would be the non-active spouse. The active owner would essentially be giving the existing holding company asset to the spouse. Since there would then only be one shareholder of the holding company, the income splitting rules might not apply. However, it is important to realize that the asset would no longer be owned or controlled by the active owner. This could become a matrimonial issue if the spouses were to separate. There are also general anti-avoidance rules that could apply, so this strategy should be implemented carefully.
A second option would be to perform a tax planning strategy known as a “butterfly transaction,” where one corporation is split into two. In this case, both the active and the non-active shareholder would each obtain their own holding company (the original holding company would be split into two companies). The same matrimonial and anti-avoidance concerns mentioned above (as with the complete transfer of the holding company asset to the non-active spouse) would apply except that the asset would essentially be split.

A final option would be to have the non-active spouse borrow funds personally and loan them to the holding company. The shares issued back would have a stated dividend return of, say, 10%. The non-active owner would then report the 10% dividend as income that is essentially funded by the dividends paid from the operating company to the holding company—essentially income splitting. The non-active owner would also deduct the interest paid on the loan. Of course, additional cash flow would be required to fund the loan repayments, but the holding company would also have additional cash to invest. This strategy would have the added benefit of allowing income splitting prior to retirement, whereas the other two options would require the use of invested funds originally intended for retirement to fund payments to the non-active spouse. If at any time the spouses wish to unravel this plan, the shares would be redeemed and the money used to repay the loan.

Some of the proposed rules have not been finalized and even once finalized must be passed into legislation. The TOSI income splitting rules became effective on January 1, 2018, but we are unsure of the effective date for the passive corporate investment rules. We are at the very least suggesting that excess funds in an operating company be transferred into the holding company as soon as possible. Due to potential matrimonial concerns, we are not fans of transferring a holding company to a non-active spouse or conducting a butterfly transaction. However, you may wish to consider starting the process of applying for a loan in the name of the non-active spouse. Once the final details of the proposed tax changes are released, we will be in a better position to recommend establishing a loan prior to the upcoming federal budget.