Canada

CRA clarifies scope of ‘excluded shares’ exception for TOSI

TAX ALERT  | 

In Jan. 2018, the opportunities for income splitting were tightened through the introduction of the tax on split income (TOSI) rules. The CRA recently added to the growing body of interpretative guidance by clarifying the meaning of ‘excluded shares’ in the ‘excluded amount’ exception to the TOSI rules.

‘Excluded amounts’, ‘excluded shares’ and capital gains

As described in our previous Tax Alert, under the TOSI rules, generally a ‘specified individual’ will be subject to tax at the top marginal rate on any ‘split income’. Split income includes any income or taxable capital gains arising from a related business in which a ‘source individual’ to the specified individual is engaged. Split income excludes excluded amounts which are intended to be safe harbour provisions for situations where the specified individual earns a reasonable return and that do not raise any policy concerns.

Among other things, an excluded amount includes income from, or a taxable capital gain from the disposition of, excluded shares of the individual. Excluded shares are shares of individuals 25 or older that meet the following three criteria: first, they must be shares of a corporation where less than 90 per cent of the business income was from the provision of services and the corporation is not a professional corporation; second, the shareholder owns shares with 10 per cent or more of the votes and have a fair market value equal to 10 per cent or more of all issued shares; and finally, all or substantially all of the income of the corporation is income that is not derived, directly or indirectly, from one or more other ‘related businesses’ in respect of the specified individual. A related business in respect of the specified individual is generally one in which an immediate family member (spouse, parent, child or sibling) is involved at any time during the year.

Whether capital gains qualify as ‘income’ for paragraph (c) of the ‘excluded share’ definition

Recently the CRA commented on whether capital gains are to be considered ‘income’ under paragraph (c) of the definition of excluded shares in subsection 120.4(1) of the Income Tax Act (ITA). This refers to the third criterion of the excluded shares definition described above where all or substantially all of the corporation’s income is not derived, directly or indirectly, from one or more other related businesses in respect of the specified individual.

The CRA confirmed that, as previously discussed in Question 5 of the 2018 CRA Roundtable of the STEP Conference in 2018-0743961C6, for the purposes of the definition of excluded shares in paragraph (c) of the definition of excluded shares in subsection 120.4(1), income means gross income and not net income or profit after expenses. This definition captures essentially all income that comes into the business for taxation purposes, including the taxable portion of capital gains from the disposition of property.

The CRA further went on to address whether capital losses should be factored into the determination of the gross capital gains amount for purposes of income in paragraph (c) of the definition of excluded shares in subsection 120.4(1). The CRA noted that under paragraph 3(b) of the ITA, the computation of taxable capital gains for purposes of determining a taxpayer’s Part I income inherently nets out allowable capital losses. However, as income under paragraph (c) of the definition of excluded shares refers to the gross amount, capital losses should not be deducted. Thus, the CRA rejected a paragraph 3(b) net calculation method for purposes of paragraph (c) of the definition of excluded shares in subsection 120.4(1) because that would be “akin to computing net gains (net income) from the disposition of property” and not gross gains.

Complex rules, exclusions and different approaches

The TOSI charging rules as well as the numerous applicable exceptions are nuanced and difficult to navigate. Where exclusions exist, a careful analysis is recommended due to the specific policies underlying the TOSI regime. In light of the stated intent to consider a taxpayer’s gross income under paragraph (c) of the definition of excluded shares, even well-understood concepts such as income can take on different meanings under the TOSI rules as opposed to other contexts.

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