What TOSI means for succession planning

After months of hand-wringing from business owners, the Department of Finance released revised income sprinkling rules on Dec. 13. These revisions were somewhat helpful in narrowing the rules’ application by introducing a number of “exclusions” from TOSI (Tax on Split Income).

If your client meets certain criteria, amounts received from a related business would be an “excluded amount” and not be caught by TOSI.

If your clients fail to qualify for any of the exclusions, the last resort is the reasonable return tests outlined by Finance to determine if amounts received, either partially or fully, are considered to be reasonable.

Meeting any of the exclusions or reasonableness tests would allow your client to avoid top tax rates on certain amounts received from a related business.

Read: Feds clarify income sprinkling proposal

The following is a list of the exclusions available to your clients. Generally, an excluded amount would apply to people who receive amounts from a related business, and:

• work in the business and meet specific bright-line tests (“excluded business”)
• are at a minimum 10% individual shareholders (in terms of votes and value) of non-service and non-professional corporations that meet specific conditions (“excluded shares”);
• are deemed to dispose of their shares as a result of death;
• sell qualified property eligible for the lifetime capital gains exemption;
• receive amounts as a result of a marriage breakdown or divorce;
• are the spouse of a business owner older than 65 who made contributions to the business;
• are between the ages of 18 and 24 and do not receive amounts in excess of either the safe harbour capital return (i.e., the prescribed rate) or reasonable return on arm’s length capital; or
• inherit property from a parent or another person and meet certain conditions.

We’ll focus on the last exclusion: inherited property. The Finance Department’s technical backgrounder says that “the person inheriting the property will generally not face a less favourable treatment than the deceased.”

A deeper look into the legislation reveals when TOSI would and would not apply. These details are critical for any advisor, business owner and other professional to know when developing a succession and/or an estate plan for the business.

Read: How to keep splitting income with family members in 2018 and beyond

Expanding exclusions beyond minors

Existing legislation already provided an exclusion from TOSI for minors (under 18 years old) who inherited property as a result of a death. The legislation ensured that top tax rates would not apply on:

• the income or gain from property acquired as a consequence of the death of a parent, and;
• the income or gain from property acquired as a consequence of the death of any other person as long as that person is either a full-time post-secondary student or qualifies for the disability tax credit.

The new legislation extends these rules to age 24 (specifically, the year the person turns 24).

The government also provided more exclusions for individuals 18 and older who inherit property from a deceased person. These are referred to as the continuity rules, and are generally designed to ensure that the person who inherits the property is not exposed to TOSI and subjected to top marginal tax rates if the deceased was able to avoid TOSI.

The first exclusion is applicable if the deceased had avoided TOSI by virtue of meeting the “reasonable return” criteria. That criteria, available to those over the age of 24, measures the person’s relative contributions to the business based on a number of factors, such as labour contributions, capital contributions, and risk assumed in support of the business.

If the deceased met these criteria and avoided TOSI, then the continuity rule means the exclusion would pass to the descendent and TOSI would not apply. The key here is that the factors determining whether an amount is reasonable are the contributions made by the deceased during his or her lifetime, and not contributions made by the descendant.

Read: Tax questions for business owners in 2018

There’s also a rule that deems the person inheriting the property to be at least 25 years old as long as the deceased would have been 25 or older in the year of death. This rule applies specifically where the deceased met either the reasonableness criteria or excluded share exclusion, and ensures that if the descendent is between 18 and 24, he or she will be deemed to be at least 25 years old for the purposes of determining whether TOSI applies.

This is key, since those under 24 are generally not otherwise eligible for the excluded share exclusion. There is also a much stricter reasonableness criteria for people in this age bracket that is avoided with this deeming rule. In essence, the descendant inherits the same tax treatment as the deceased.

Excluded businesses and spouses

The other scenario where the continuity rule applies is when the descendant inherits property from a deceased person who avoided TOSI on amounts received by virtue of the “excluded business” exclusion. This exclusion applies if the deceased was actively engaged on a regular, continuous and substantial basis in the business in any five previous taxation years.

Similar to the above, the continuity rule means the exclusion will flow through to the descendant, who will be deemed to have also been engaged on a regular, continuous and substantial basis in the business in any five previous taxation years. This continuity rule ensures that the descendant will not be subject to TOSI on amounts received from the business on a go-forward basis.

Finally, a special rule applies to spouses or common-law partners. If the inheriting spouse receives amounts that would have been excluded for the deceased spouse, then they will also be excluded for the surviving spouse or partner. Unlike most exclusions, there is no age requirement for either spouse.

The inherited property exclusion is an important tax and estate planning tool that any business owner may look to use as part of a succession plan. However, be cognizant that this exclusion may not apply in all cases where the deceased had avoided TOSI while alive. Instead, its purpose is to ensure that the next generation is not subject to TOSI.

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.