The federal government introduced the Tax on Split Income (“TOSI”) rules effective as of the start of 2018. The purpose of the rules was to prevent Canadian business owners from splitting their income in ways that were not available to salaried employees.
For example, prior to the TOSI, let’s say a client, we’ll call her “Danny,”* had an active business producing, buying and selling things, that earned about C$500,000 per year in profits. The way Danny had been paying herself (prior to working with me) was to give herself a bonus of $500,000 just before the end of every tax year. Her corporation would then have no profits, and she would just pay the tax on the income. Since Danny lives in Alberta, the maximum tax rate back in the days of the “Alberta Advantage” was 39%, so she got $340,000 after tax on the bonus, and this was just the easiest way to manage things. But then the Alberta government cranked up personal tax rates and she wanted to see what she could do to reduce her tax.
So back in the days before TOSI, I advised Danny that step one was to do a “freeze” to herself. She exchanged her 100% of the common shares, and took back preferred shares equal to the current value of the businesses, and then the corporation issued voting common shares to herself, and issued a class of non-voting common shares with a right to a discretionary dividend to her spouse and each of their three daughters. Her eldest daughter was away at University, and Danny had been paying tax on her bonus, and then paying for the daughter’s tuition and living expenses with after-tax dollars. When she was paying for all of this with effectively “61-cent dollars”, this was not too bad, but with “52-cent dollars”, once tax rates went up in Alberta, it was costing her a lot more to pay for the same thing.
Again, back in the good old-pre-2018-pre-TOSI days, if Danny decided not take such a big bonus, and allowed the corporation to make a profit of say $250,000, her corporation would pay the 15% small business rate tax leaving her ($250,000-$37,500=) $217,000 in the corporation. She could then dividend out $54,000 each to her spouse and their three daughters once they were over 18 years of age. Given their personal deductions, plus tuition tax credits, their tax rate was a lot less than the rate Danny would have had paid on the additional $250,000 in bonus. Danny would still be paying a lot of tuition and other expenses for her family, but now with closer to “85-cent dollars”.
Unfortunately, shortly after we put the structure in place, the current federal government thought that this was all unfair, and that business people were somehow getting away with something that wage-earners could not. However, I would argue that was exactly the point! People who create businesses and jobs for other people really ought to get a bit of a break on their taxes because otherwise you are not incentivising entrepreneurship! The new TOSI rules effectively tax all of the “split” income from dividends to family members at the top marginal rate from the first dollar. So the new TOSI rules shut this kind of planning down. …. or did they?
Danny, who was more “liberal” in her outlook, had been a fan of our current government, but when they hit her personally in the pocketbook for no good reason other that they thought it was “unfair”, she was really upset about TOSI. But then I told her that the TOSI rules are full of very specific loopholes. First of all, there is the “exempt business” exception to TOSI. Effectively[1], this rule states that if: a) a family member is actively involved in the business on a regular, continuous and substantial basis, or for a minimum of 20 hours per week, then dividend income is not TOSI and not taxed automatically at the highest marginal rate.
In Danny’s case, her spouse works in the business but does not get paid. Danny, like most small business people, is on the phone with her spouse at least three times per day. Danny knows her business, but being the boss is hard, so she needs someone to bounce things off of. It also turns out that although the business is doing well, Danny still has a $500,000 line of credit for the business, but the bank would not give it to her unless she pledged all of her personal assets, including the family home, as collateral. Of course, Danny’s spouse had to sign off on that.
Post-TOSI, I suggested that Danny get her spouse a company phone and email, and have her spouse appointed as a director of the corporation. I also advised that her spouse also be appointed as an officer of the corporation, as VP of Policies. All corporations now must have a ream of policy documents (health and safety, anti-harassment, environmental responsibility etc.), that, frankly, many small companies just do not bother with at their very real financial and legal peril.
As a director of the corporation, the spouse also gets a vote on the board of directors, but we also changed the corporation’s bylaws, so Danny, as chairman of the board of directors, gets an additional deciding vote in the event of a tie. So really nothing changes, except for the spouse now is liable for a lot of things, including the company’s Canada Pension Plan, Employment Insurance and payroll withholding and Goods and Services Taxes remittances. Generally speaking, taking on this kind of liability requires some form of proper compensation.
I also suggested that Danny and her spouse take the a trip down to Caribbean for 9 days in November so the spouse could do the 3-day accredited director course put on by the Chartered Governance Institute (see https://www.charteredgovernanceinstitute.ca/page/deap). They also do the same programme here in Canada, but the Caribbean in November seems like a lot more fun…
So now, as an Accredited Director, given the personal liability for “Crown Trust accounts” for taxes, the guarantee for the line of credit, and the spouse’s time attending director’s meetings and dealing with policies, in addition to the daily consultations, then it is it not arguable that the spouse has an active role to play in the business in an regular, continuous and substantial basis?
Of course, the CRA may beg to differ, and I would not want to advise a client into a risky or “aggressive” situation. At the same time, the exact meaning of “actively involved in the business on a regular, continuous and substantial basis” has not been litigated. Given the facts, this not does seem like the kind of situation that the CRA would actually want to go to Tax Court over. The last thing the CRA would want is for someone to win a TOSI case on these facts., then everyone would know what you had to do to split income just like in the good old days.
Overall, the point is that although the current government has tried to eliminate dividend sprinkling, they did not really do a very good job. Despite what you may have heard, if the facts are right, you are in the right kind of business (not services) and if you can make real changes to how you manage certain aspects of your business, or even just start keeping track of the all the contributions made by your spouse to the business, there are still significant tax-saving opportunities available.
*Danny,’s situation represents typical client issues that we deal with on a regular basis here at Andersen. It is always important to remember that ever tax situation is unique. The facts in play will provide both challenges and opportunities for solutions that meet a client’s individual needs. That’s where having an experienced tax advisor is a definite advantage.
[1] Section 120.4(1) of the Act “excluded business, of a specified individual for a taxation year, means a business if the specified individual is actively engaged on a regular, continuous and substantial basis in the activities of the business in either (a) the taxation year, except in respect of an amount described in paragraph (e) of the definition split income; or (b) any five prior taxation years of the specified individual.” Paragraph (e) of the definition of split income refers to capital gains and trust income which are not relevant in this scenario.
