Incorporating your business can provide numerous tax advantages, one of which is the ability to pay dividends to family members who are shareholders of the corporation. This strategy, known as income splitting (or income sprinkling), allows business owners to shift income from a higher-income individual to a family member in a lower tax bracket, ultimately reducing the family’s overall tax liability.
However, the Canada Revenue Agency (CRA) has implemented rules to prevent tax avoidance through income splitting. These rules, known as Tax on Split Income (TOSI), aim to eliminate the potential tax benefits of this strategy when it’s used improperly.
What is Income Splitting and Why Do Businesses Use It?
Income splitting involves transferring income from a higher-income family member (such as a business owner) to a lower-income family member (such as a spouse or child). The goal is to reduce the overall tax burden of the family by leveraging the fact that Canada’s tax system applies progressive tax rates, meaning individuals with lower income are taxed at a lower rate.
For example, if a business owner is in a higher tax bracket, they may choose to pay dividends to their spouse or children who are in a lower tax bracket, thus lowering the overall tax liability of the family.
Before the introduction of TOSI, this strategy was commonly used in private corporations to shift income among family members and reduce the overall tax burden. However, the CRA has placed limitations on this strategy through the TOSI rules.
Understanding TOSI (Tax on Split Income)
TOSI is designed to apply the highest marginal tax rate to certain types of income received by family members, effectively neutralizing the tax benefits that income splitting may offer. TOSI primarily targets income from private corporations, such as dividends and capital gains, that are distributed to family members who are not actively involved in the business.
While the rules are complex, they are outlined in the Income Tax Act and are strictly enforced by the CRA. TOSI applies specifically to income that is “split” with family members of the business owner, including spouses, children, and other relatives.
Key Provisions of TOSI
- Who Does TOSI Apply To?
TOSI applies to family members of the business owner, which may include:
- Spouses
- Children (both minor and adult)
- Other relatives
If these family members are receiving income (such as dividends) from the corporation, the income may be subject to TOSI, depending on the circumstances.
- Types of Income Affected
TOSI primarily targets income from private corporations. This includes:
- Dividends paid out of the corporation’s income.
- Capital gains from the sale of shares in the corporation.
If a business owner distributes these types of income to family members, TOSI rules can apply, resulting in the income being taxed at the highest marginal tax rate.
Exceptions to TOSI: When Does TOSI Not Apply?
While the TOSI rules are strict, there are several exceptions where TOSI does not apply. Understanding these exceptions is crucial for business owners who wish to continue to take advantage of income splitting within the bounds of the law.
- Reasonableness Test
If neither of the two exclusions below apply, then TOSI would apply to individuals for amounts that exceed a “reasonable return”.
If a family member is actively engaged in the business, they are entitled to a reasonable return for their contributions. For example, if an individual (25 or over) is working full-time in the family business and performing substantial work, the income they receive in the form of dividends or salary may not be subject to TOSI. The income must reflect the value of their contributions to the business.
This exception aims to prevent the CRA from applying TOSI to income paid to family members who are genuinely contributing to the business, rather than simply receiving income through passive ownership.
- Excluded Business
An excluded business refers to a situation where a family member has made significant contributions to the business. For example, if a family member has provided meaningful labor, capital, or expertise to the corporation, the income received from that business may not be subject to TOSI. The CRA looks at the nature of the contributions to determine whether they qualify as significant enough to exclude the income from TOSI. Access to this exemption does not require individuals to value their labour contributions, but instead they must “demonstrate an ongoing meaningful contribution to the business”.
- Excluded Shares
Capital gains earned from the sale of shares may be excluded from TOSI if the shares meet specific requirements. Shares that qualify as excluded shares under the Income Tax Act may allow the capital gains earned on their disposition to be free from TOSI taxation. This often applies to family members who are 25 or older and own at least ten percent (in terms of votes and value) of the outstanding shares of the corporation. To meet this requirement the business also cannot earn 90% or more of its income from the provision of services, cannot be a professional corporation, and substantially all of its income cannot come from a related business.
Why TOSI Matters for Business Owners
While the Tax on Split Income (TOSI) rules may seem restrictive, they are essential for maintaining fairness in the tax system by limiting income splitting strategies that could otherwise be used for tax avoidance. As a business owner, understanding TOSI is critical because it allows you to:
- Ensure Tax Compliance: By following TOSI rules when paying dividends to family members, you reduce the risk of penalties or higher taxes. Compliance helps you avoid costly mistakes while ensuring your tax filings are in line with CRA regulations.
- Optimize Compensation Strategies: With a clear understanding of TOSI, you can design a compensation plan that balances tax efficiency with compliance. This gives you the ability to maximize tax savings, while also staying within the legal framework of the Income Tax Act.
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Avoid Unnecessary Tax Liabilities: TOSI is designed to prevent the improper shifting of income to family members in lower tax brackets, which could otherwise reduce the overall tax liability of the family. Ensuring your family members are receiving dividends based on actual contributions, not just for tax-saving purposes, helps you avoid penalties and ensures you’re paying the appropriate amount of tax.
Considerations for Business Owners
As a business owner, you may want to pay dividends to family members who hold shares in your corporation. However, it’s important to carefully consider whether the dividends paid to family members could be subject to TOSI. Failing to comply with the TOSI rules can result in the income being taxed at the highest marginal rate, which could negate the intended tax benefits.
It is strongly advisable to work with a tax professional or CPA to:
- Determine if TOSI applies to your situation.
- Ensure that income splitting strategies are structured in compliance with the rules.
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Optimize compensation strategies in a tax-efficient way that minimizes personal and corporate tax liabilities.
Conclusion: Navigating the TOSI Rules
Incorporating your business and using income splitting can provide tax benefits, but it’s essential to understand the Tax on Split Income (TOSI) rules and how they apply to family members who receive income from your corporation. By staying informed about the rules and consulting with a tax professional, you can ensure that your income splitting strategies comply with the Canadian income tax act and maximize your family’s overall tax savings.
At Origin Accounting & Advisory, we specialize in helping business owners navigate the complexities of running a business in today’s ever changing economic environment. Contact us today to learn more about how we can help you optimize your compensation strategies while staying compliant with CRA regulations.
