Application of excluded shares exception and partnerships
INSIGHT ARTICLE |
In the technical interpretation, 2019-0813021E5, the Canada Revenue Agency (CRA) considered whether shares of corporations were members of a partnership would qualify as ‘excluded shares’. If so, the income from, and capital gains from the disposition of, such shares would be excluded from the application of the tax on split income (TOSI) rules.
Refresher – Excluded shares under TOSI
Under the TOSI rules, a ‘specified individual’ is subject to tax at the top marginal rate on any ‘split income’. A specified individual is an individual (other than a trust) resident in Canada at year-end. A specified individual's split income includes taxable dividends from, and capital gains from the disposition of, shares unless the dividends or capital gains are ‘excluded amounts’. The relevant exclusion for the current CRA technical interpretation provides that income from, and taxable capital gains from the disposition of, excluded shares are not subject to the TOSI rules.
Shares qualify as excluded shares if the specified individual that owns the shares is at least 24 years old, and the following three criteria are met:
- Less than 90 per cent of the corporation's business income is from the provision of services and the corporation is not a professional corporation.
- The specified individual owns at least 10 percent of the corporation's voting shares and at least 10 per cent of the fair market value of the corporation's issued shares.
- All or 1. substantially all of the corporation’s income is not derived, directly or indirectly, from one or more ‘related businesses’ in respect of the specified individual other than a business of the corporation. Put another way, this third criterion requires the corporation derive all or substantially all of its income from its own business and not from some other business that is a related business in respect of the specified individual. A related business in respect of the specified individual is generally one in which a ‘source individual’ is involved at any time during the year. A source individual is an individual resident in Canada that is related to the specified individual.
CRA view on 2019-0813021E5: TOSI and excluded shares
The relevant facts were as follows:
- Partnership AB carried on an active business in Canada and did not earn income from the provision of services.
- Partnerco A and Partnerco B (collectively Partnercos) were corporations that were not professional corporations. The Partnercos' only source of income was partnership income they received based on their interests in Partnership AB.
- Mrs. A and Mrs. B. were specified individuals. Mr. A was the spouse of Mrs. A and Mr. B was the spouse of Mrs. B. Both Mr. A and Mr. B were source individuals to their respective spouses. Each of these individuals was over 25 years old.
A visual representation of this legal structure is illustrated below.
Application of the excluded shares test to the facts
CRA was asked whether the shares that Mrs. A and Mrs. B held in Partnerco A and Partnerco B, respectively, were excluded shares. The taxpayer did not ask about, and the CRA did not comment on, whether the first two criteria in the excluded shares test set out above were satisfied. The question was whether the third criterion was satisfied.
The CRA clarified the business of Partnership AB constituted a related business in respect of both Mrs. A and Mrs. B (specified individuals) because Mr. A and Mr. B (source individuals) had indirect ownership interests in Partnership AB. As such, 100 per cent of the Partnercos’ income was derived directly from a related business in respect of Mrs. A and Mrs. B – the business of Partnership AB.
The next question was whether Partnership AB’s business constituted the same business as the Partnercos’ business. If so, the Partnercos’ income would, in fact, be from the Partnercos’ business and the Partnerco shares would satisfy the third element of the excluded shares test, notwithstanding that the business of Partnership AB was a related business in respect of Mrs. A and Mrs. B.
CRA confirmed that Partnership AB’s business was also the Partnercos’ business. This was due to the legal nature of the partnership relationship: partners agree to carry on business in common and, as a result, each partner is considered to carry on the partnership’s business. As partners of Partnership AB, the Partnercos were considered to carry on Partnership AB’s business and, therefore, earned 100 percent of their income from their own business.
CRA concluded that, provided the other two criteria in the excluded shares test were satisfied, Mrs. A’s and Mrs. B’s shares in the Partnercos were excluded shares and, therefore, the TOSI rules would not apply to Mrs. A’s and Mrs. B’s income from, and capital gains from the disposition of, the shares of the Partnercos. The CRA also expressed that the answer would not change if specified individuals were related (siblings).
We recommend you revisit partnership structures in light of TOSI. TOSI rules continue to evolve and partnerships add another layer of complexity to the analysis. The governing partnership laws establish the relationship between the relevant parties. This determination is critical to the application of the TOSI exceptions to specific partnership fact patterns.