Income Splitting In Canada

Recent Changes in Income Splitting Rules for Canadians (TOSI Rules)

In 2017 the Canadian government tabled laws to make it much harder for owners of incorporated businesses to split income with a spouse or child who doesn’t work in the business. These rules are referred to as the TOSI rules, where TOSI stands for “Tax On Split Income” and deals with income sprinkling or splitting. These TOSI rules, which came into effect in 2018, have especially increased the tax burden on families who operate service businesses and want a spouse who focuses on managing family life or works outside of the business. 

The government claims it’s to make the tax burden fairer than that faced by salaried employees at companies who can’t split income with their spouse or children through corporate dividends. However, the risks taken by entrepreneurs are much greater than those taken by salaried employees in big companies and TOSI changes are just further government overreach that will discourage the small business sector in Canada. (Now you know how I really feel.) 

Business owners with significant income turn to family trusts as a way to split income with family members and pass the business to other family members with the lowest tax implications. This article won’t deal with family trusts – we’ll just look at income splitting within a Canadian-controlled private corporation (CCPC).

This article will not attempt to comprehensively cover the topic of income splitting. We’ll just look at the situation where the owner of an incorporated service business wants to split income using dividends to a spouse or child who does not actively work in the business – because that’s the situation the government specifically went after with the 2018 changes. The TOSI rules seem to have specifically targeted 100% services businesses because there is an exemption if less than 90% of your income is from services.  

This article by Peter Spiro, a tax lawyer, was one of the most helpful summaries of the overall TOSI situation that we found.

An Introduction to Canadian TOSI Rules

According to the CRA’s FAQ on income sprinkling, “Income sprinkling – sometimes referred to as “income splitting” – is a strategy that can be used by high-income owners of private corporations to divert their income to family members with lower personal tax rates.”

The reason you’d want to split income is to reduce your tax burden. Peter Spiro gives this example:

If there is only one person in a family who is receiving income, and earns an income of $400,000 per year, the family’s total income tax bill will be about $180,000. If instead two individuals each make $200,000, the family’s tax bill drops to about $146,000. If four individuals each make $100,000, the family’s total tax bill drops to about $108,000. This example is perhaps somewhat unusual, but it is indicative of the potential for substantial savings in some situations.

Peter Spiro

The TOSI rules penalize you because when you try to move a portion of your income to, say, a child under 18, who should have a much lower marginal tax rate, TOSI kicks in, and that income gets taxed at the highest marginal tax rate (currently 53.5% in Ontario).

“The TOSI applies the highest marginal tax rate (currently 33%) to “split income” of an individual under the age of 18. In general, an individual’s split income includes certain taxable dividends, taxable capital gains and income from partnerships or trusts.”

CRA Guidance on the application of the split income rules for adults

A couple of other key points from the FAQ are:

• “It is proposed to extend the application of the TOSI rules to individuals over the age of 17, but only with respect to income derived from a “related business”.
• In this context, “split income” will generally include dividends or interest, but not salary, paid by a private corporation directly or indirectly to an individual from a related business in respect of the individual and certain capital gains unless the amount falls within a specific exclusion (the “Excluded Amount” or “Excluded Amounts”).
• It is also proposed to extend the definition “split income” to include income received from certain debt obligations and taxable capital gains or profits from the disposition of certain properties.”

TOSI Rules Exemptions

If you are the owner of a Canadian-controlled private corporation (CCPC) looking to lower your family tax burden through income splitting, you need to research and understand what types of businesses are exempt from the TOSI rules.

Income that won’t be subject to TOSI is called an Excluded Amount and relates to Excluded Business or Excluded Shares or a payment that qualifies as a reasonable return (“Reasonable Return”).   This CRA article gives many examples to provide general guidance on how the CRA intends to administer the different Excluded Amounts.

Here are some examples where you could split income with your child or spouse without a TOSI penalty applying.

1. You run a service business, but you get >10% of your income from non-services, and the individuals you are splitting with are age 25 or over, and they have at least 10% of the shares. Shares are excluded from TOSI if they qualify as Excluded Shares and the individuals are age 25 or over. To qualify as Excluded Shares, all of these must be true:
   1. less than 90% of the corporation’s business income was from the provision of services and the corporation is not a professional corporation;
   2. the shares represent 10% or more of the votes and value of the corporation; and
   3. all or substantially all of the income of the corporation is not derived from another Related Business in respect of the individual other than a business of the corporation
2. Your adult child or spouse is Actively Engaged in your business, meaning that they work an average of 20 hours per week during the portion of the taxation year of the individual that the business operates or meets that requirement for any five prior years.

TOSI Exemption For Services Business With >10% Non-Services Income

So if you run a service business, but you get or could get more than 10% of your corporate income from non-services, like goods you sell, and you meet the other criteria above, then you may be able to have your shares qualify as Excluded Shares. 

Depending on how much tax you’d save through income splitting – it might be worth figuring out how to sell goods to complement your services. In Peter Spiro’s example above, a business owner making $400k could save $72k/yr in taxes through income splitting. That would be a reasonable incentive to many entrepreneurs, especially given how easy it is to set up a Shopify or Amazon site.

In discussing this with an accountant we know, they mentioned that the goods would need to be closely related to the services to be considered the same business. They cited the example of how the CRA sees investment revenue as a different business from the operating revenue of a company. Based on that example, they thought the CRA might go after corporations where the service/product exemption is being used, and the products sold are not closely related to the service.

In this CRA guidance the CRA stated that the business income test is based on the corporation’s gross income (i.e., revenue or sales before deducting expenses). 

In that same article the CRA offers guidance about what constitutes a service and income with service and non-service components.

CRA Guidance on Defining Non-service Income

1. The non-service portion of the income cannot be from the sale of goods that are considered incidental to the services, like consumable cleaning products, because they were used in providing the services. See the Cleaning business examples below.
2. In the case of clearly consumable products, like cleaning products, which no longer exist after they have been used, the guidance seems to suggest that they have to be sold separately to purchasers who might or might not be service customers for them to qualify as non-service income.
3. Income from tangible, non-consumable items like computer hardware sold by a consulting firm or deck materials sold by a deck construction company were deemed non-services income.
4. There is no clear guidance we can find on whether the sale or resale of software would be considered non-service income. Software used in the provision of a service bears some resemblance to the cleaning company’s cleaning products in that they are required to perform the service, but software is different in that it is not consumed or used up during the service like a cleaning spray would be. Hopefully, the CRA will clarify that in due course. One might argue that selling software along with the service is similar to the construction company building decks example below. In that example, the CRA decided the materials used to build the deck constituted non-service income.

Example: Consulting business that provides services and sells computer hardware to its clients

A corporation carries on a management consulting business that provides services to other businesses and sells computer hardware to its clients. The guidance is not explicit but seems to suggest that the income from sales of computer hardware would be non-services income as long as the income from the sales of computer hardware was >10% of the gross income,  the shares of the corporation would be excluded shares, and therefore TOSI would not apply.

Example: Plumbing business

A corporation operates a plumbing business. The main business activity is providing repairs and maintenance services. The corporation also operates a retail store to sell parts and plumbing fixtures. The retail products are not used in providing the services but are sold separately to customers. The income from the sales of parts and fixtures was determined to be non-service income so as long as the income from the sales of parts and fixtures was >10% of the gross income,  the shares of the corporation would be excluded shares, and therefore TOSI would not apply.

Example: Cleaning business that does not sell cleaning products but uses them to provide services

A corporation’s cleaning business uses cleaning products as a part of the cleaning services it provides, but it does not sell the cleaning products. The cleaning products are incidental to the provision of the cleaning services. Assuming that the corporation’s only income is from providing cleaning services, the CRA stated that 100% of the corporation’s gross income is from the provision of services, and the cost of the cleaning products is not deducted from this amount (since the amount should be gross income). As such, the shares of the corporation would not qualify as excluded shares, and therefore TOSI would apply.

In this example, the CRA considered the cleaning products to be incidental to the services since they were used in providing the services. So the amount of the incidental goods ($150,000 cost of the cleaning products) would not be subtracted from the service part of the gross business income, and therefore, the shares of the corporation would not qualify as excluded shares, and therefore TOSI would apply. And they said the cleaning products would still be incidental if an amount for the goods were listed separately on the invoice for services or on a separate invoice.

Example: Cleaning business that sells cleaning products

In the second example they give, the corporation still operates a cleaning business, but it also sells cleaning supplies and equipment separately to purchasers who may or may not be customers of the cleaning services business. For the purposes of the 90% test, the CRA provided that gross income from cleaning services is service income and gross income from selling the cleaning products is considered non-service income. In the specific example, the service income made up 80% of the corporation’s total income, so the shares of the corporation were excluded shares, and therefore TOSI would not apply.

Example: Construction business and materials costs

The corporation is a construction business that designs, constructs, and repairs decks. With respect to deck construction and repair, the corporation bills separately for materials and labour. In computing the service and non-service income for this example, the CRA decided that the income from materials is non-service income and income from labour is considered service income. Therefore, the excluded share exception can be met if the bill for the materials is greater than 10% of the total bill.

Setting Up Your Corporation To Allow For Income Splitting Via Different Classes Of Shares

To enable income splitting, you need to create different classes of shares when you incorporate, so you can use the different classes to enable a targeted allocation of dividends to shareholders. One common approach used by entrepreneurs is to create a different class of shares for each family member they might wish to disperse corporate income to. So if you have 5 family members, including yourself, you might create classes A, B, C, D, and E and allocate one to each family member.

But you cannot just give your children the shares. They must pay for them, and you must keep a record of the payment in order to avoid tax problems later.

A company cannot issue a share before it gets some sort of consideration whether that be money or other compensation for it. In addition to money, services or properties can be offered as well as consideration for shares.

OMQ Law

TOSI in Retirement

As Peter Spiro notes, a retired business owner can share income from passive investments held in a corporation with their spouse without the TOSI penalty applying:

“Finally, a corporation, including a professional corporation, can accumulate savings from previous retained profits. These can be invested in bonds, real estate, or the stock market, and earn interest, rent, dividends, or capital gains. This is referred to as “passive income” earned within the corporation. If the primary owner of the business turns 65 and retires, income from this source can be shared with a spouse through dividends (regardless of the receiving spouse’s age), without the TOSI penalty. There was already a tax rule that allows the splitting of pension income with a lower income spouse. This exemption from TOSI is therefore a fairness provision for people who were self-employed, for whom their corporation may take the place of a pension. Even for younger people setting up new corporations, this is something to factor into their long-term plans for retirement.”

Peter Spiro

Related Articles

• What is the Scope for Income-Splitting in Canada after the 2018 Amendments to the Income Tax Act? (Peter Spiro, Rogerson Law Group)
• How to minimize taxes when transferring shares in your corporation (BDC)
• Transferring Business To Family Member In Canada (Allan Madan)

Conclusion

As we wrote this article, it was clear that we were tackling such a huge and important topic with many nuances. Income sprinkling laws in Canada are so complex – we were tempted just to say “ask your accountant” and move on. And you should definitely consult your accountant and even a tax lawyer as you make your tax plans, but we hope this article has given you some topics you can ask them about.

Making tax plans without professional advice could easily result in a large, unexpected tax bill. This article is intended to make you aware of concepts that we have learned based on professional advice we have received and research we have done. It should not be taken as tax advice for your specific situation.