Second-generation income and TOSI

If your client earns investment income on funds sourced from dividends paid from the family business, they’ll want to know whether this passive, second-generation income will incur the tax on split income (TOSI).

The new TOSI rules, in effect since January 2018, take aim at income sprinkling by applying top marginal tax rates on amounts paid — such as dividends from private corporations — to certain related individuals, including adults. (Exclusions are available that generally aim to align an individual’s compensation from, and contributions to, the business.)

Under the new regime, one of the triggering factors in the application of TOSI for those 18 and older is if the income is derived, directly or indirectly, from a related business.

For example, if your client uses a traditional holding-company structure, dividends paid to the holding company from the operating company are considered income derived from a related business. As a result, any dividends paid by the holding company to shareholders may be subject to TOSI.

However, the CRA was asked to confirm its position on TOSI where the initial capital of a holdco (which is derived from the operating company and subject to TOSI) is invested and creates second-generation income. Would this passive income be subject to TOSI?

The facts were as follows:

Mr. and Mrs. A, both 30 years old, respectively own 100 Class A and 100 Class B common shares of Investingco. Investingco owns all the shares of Opco. Mr. A is actively engaged in the Opco business on a regular, substantial and continuous basis; Mrs. A isn’t. Historically, Opco paid taxable dividends to Investingco from its retained earnings, all of which were used to invest in dividend-paying stocks of publicly traded companies.

Investingco pays all the dividends from the investment portfolio (i.e., second-generation income) to Mrs. A, the non-active shareholder. The CRA was asked whether these amounts would be considered derived from a related business.

The CRA said the dividends received by Mrs. A from the investment portfolio would be an excluded amount and thus not subject to TOSI — assuming Investingco wasn’t carrying on a business.

If Investingco were carrying on a business, the CRA’s position changes.

In the case of carrying on a business, the CRA said the dividends paid to Mrs. A would be an amount derived, directly or indirectly, from a related business, and therefore may be taxed under TOSI at the highest marginal tax rate. To avoid TOSI, Mrs. A would need to qualify for a different exclusion.

In another scenario, the CRA was asked to comment on whether TOSI would apply where Investingco paid a dividend-in-kind from the investment portfolio to Mrs. A.

In its response, the CRA provided the following example. In the first year, Opco pays a $1-million dividend to Investingco, which is invested in a portfolio of publicly traded securities. In the second year, Investingco pays Mrs. A a dividend-in-kind of its entire investment portfolio, now worth $1.1 million.

CRA said the $1 million of the dividend-in-kind received by Mrs. A is derived, directly or indirectly, from a related business (i.e., the capital invested originated from after-tax business profits) and thus would be subject to TOSI. Consistent with the first scenario, the CRA said the remaining $100,000 wouldn’t be derived, directly or indirectly, from a related business and thus wouldn’t be subject to TOSI — again, assuming that Investingco wasn’t carrying on a business.

The CRA’s comments make clear that the key factor in this case is whether Investingco is carrying on a business or not. This requires a deeper analysis of Investingco’s activities, including the number, volume and frequency of transactions and the turnover and nature of investments, to name a few. This is a topic for another day; however, it’s important to note that the burden is on your business-owner client to demonstrate that Investingco isn’t carrying on a business.

The TOSI rules’ complexity has led to significant uncertainty in their application, increased compliance burden and an overall concern that even the most well-intended plans may be under the proverbial microscope and scrutinized by CRA officials.

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.

Frank Di Pietro

Tax & Estate

Frank Di Pietro, CFA, CFP, is assistant vice-president of tax and estate planning at Mackenzie Investments. He can be reached at fdipietr@mackenzieinvestments.com.