The New TOSI Rules: Simplified for Whom?

On December 13^th of 2017, the Department of Finance (“Finance”) released new taxation of split income (“TOSI”) rules, after considerable scrutiny of the July 18^th “Private Corporations” proposals. At the same time, Finance eliminated the proposed anti-surplus stripping rule,[1] and delayed the passive income proposals until Budget 2018.[2] These amendments are largely similar to the July 18^th proposals but contain key differences and revisions. Referred to as the “Simplified Measures to Address Income Sprinkling,”[3] this set of revised rules is intended to be simpler, easier to implement and, of course, fairer. The rules are effective January 1^st, 2018.

In this article, I provide a high-level overview of the new TOSI rules and consider potential problems that might arise, particularly for the owner-manager of a small to medium size business. My suggestion is that the rules are still unnecessarily complex, carry peculiar inconsistencies and will be costly and problematic to follow without the use of specialized tax counsel – hardly a welcome eventuality for a middle class business owner. As well, the use of broadly-worded terms will surely be a point of litigation and dispute.

The Rules

The rules deem a “specified individual,” i.e. an individual resident in Canada,[4] to be taxed at the top marginal tax rate on their “split income.” “Split income” is defined as income that can reasonably be considered to be derived directly or indirectly from a “related business,”[5] i.e. a business of which another related individual owns at least 10% of the fair market value.  “Split income” includes dividends and interest (but not salary) and can include capital gains from the disposition of certain property.[6]

TOSI does not apply to an “excluded amount.” This exception applies differently depending on the age of the taxpayer, as described below. There are also exceptions for inherited property or income,[7] taxable capital gains arising on death,[8] and capital gains subject to the lifetime capital gains deduction.[9] Spousal income splitting is also permitted for individuals 65 years of age and older.[10]

For individuals 18 years of age and older, an “excluded amount” includes income derived from an “excluded business” – a business in which the individual is actively engaged on a regular, continuous and substantial basis in the taxation year or any of the previous five taxation years. Meeting a bright line threshold of working 20 hours a week is sufficient but not necessary - a factual determination may be made on the particular circumstances of each case. A business could also qualify as an excluded business even if it derives income from another related business that is not an excluded business.[11]

For individuals between the ages of 18 and 24, two further exceptions are provided: the “safe harbor capital return” and “reasonable return” exceptions, the latter being based on “arm’s length capital.” The “safe harbor capital return” is based on a prescribed rate, currently 1%,[12] and “arms length capital” is defined as property contributed to the business that is not derived from the income of a related business or transferred from a related person, and is not borrowed – not even from an arm’s length source. Labour contributions are irrelevant to this determination.

Individuals who are 25 and over must instead rely on the “excluded shares” or “reasonable return” exceptions. “Excluded shares” are shares that must represent at least 10% of the votes and value of a corporation, less than 90% of the business income of which is from the provision of services and that is not a professional corporation. All or substantially of the income of the corporation also must not be derived from a related business. “Reasonable return” is no longer based on the “arm’s length capital” standard, but rather the work performed, property contributed, risks assumed and total amounts paid or payable to the individual in respect of the business.

The Problems

The first and most obvious problem is that the rules remain quite complex. Different age groups must meet different criteria. This is difficult to navigate for lawyers, accountants and tax professionals – individuals who practice in this area day to day. One can only imagine the puzzled expressions on the faces of the majority of business owners who are not trained in tax. These rules will require considerable expenditures by owner-managers in retaining advisors simply to understand if their business affairs must be re-arranged to prevent unintended tax consequences.

Furthermore, there are peculiarities and inconsistencies within the exceptions. While it seems the different age categories are based on the university age cohort, one wonders why is it that an “excluded business” can be a business that derives income from a related business[13] that is not excluded, but “excluded shares” must not be shares of a business that earns any income from a related business [14]. Why does a “reasonable return” for those between the ages of 18 and 24 not include the consideration of labour contributions, but does so for those aged over 25?  Further, limiting the “reasonable return” to “safe harbor capital” which cannot be borrowed, even from an arm’s length source, seems arbitrary and harsh – suppose a university student wants to borrow money from the bank to invest in the shares of her parents business while she studies, taking a risk just as any other regular investor. The risk she takes would count towards whether the “reasonable return” exception is met if she were over the age of 25, but not if she is of “university age”(i.e. 18 – 24).

The exceptions are also out of touch with business realities. Small to medium level business owners rarely track their work hours, nor do their family members who may be part of the family enterprise. Businesses can suddenly thrive through a new major client or shipment order – nowhere is the performance of the business mentioned as a factor in considering whether the return is indeed “reasonable.” And it can be difficult to value particular contributions to a business—a new idea, perhaps created in the course of a  conversation over a coffee, that takes the business into a new and more profitable direction ought to be compensated, perhaps highly so.

Finally, the elephant in the room: the “reasonableness” standard. While the concerns surrounding this point may be somewhat overblown at times, given that this threshold is used on a fairly predictable basis not only in tax, but numerous other areas of law, this is still a problem. Creating a means for second-guessing a business owner’s decisions will result in litigation and uncertainty. Putting yet another “reasonableness” standard in the Act means more disputes, more debates and more time spent by business owners on considering the tax implications of their business decisions, as opposed to efficiently and decisively running their business.

Conclusion

The TOSI rules have been pushed through quite quickly, with only an 18-day period from introduction to application. Perhaps the Federal government was wary of again receiving considerable pushback by small business owners and tax professionals, and decided to foreclose any such opportunity to do so – during the holiday period, to boot.

In any event, one wonders whether these rules can really be called “simplified,” and how business owners will arrange their affairs going forward to adapt to the new changes. This remains to be seen.

 

About The Author

Hennadiy Kutsenko is a tax associate at Norton Rose Fulbright LLP. He is currently earning his Professional LLM in Taxation at Osgoode Hall and sits on both the Taxation and Pension & Benefits Sections Executive Committees with the Ontario Bar Association.

Any article or other information or content expressed or made available in this Section is that of the respective author and not of the OBA.