Does the TOSI reasonable return exclusion apply to family trusts?
TAX ALERT |
In technical interpretation 2019-0814161E5, the Canada Revenue Agency (CRA) considered whether a dividend allocated by a family trust to an individual would be a ‘reasonable return’ under the tax on split income (TOSI) rules. If so, the dividend would be an ‘excluded amount’ and the TOSI rules would not apply.
Relevant terms explained
Prior to 2018, income splitting rules generally only applied to individuals who were under the age of 18. As described in our previous Tax Alerts, the TOSI rules now tax at the highest marginal rate any ‘split income’ earned by a ‘specified individual’ (including adults) in a particular year unless the income meets the excluded amount definition.
The excluded amount definition provides several exclusions from the TOSI rules, some of which are bright-line tests, including the ‘excluded business’ exclusion. These bright-line exclusions are intended to be proxies for situations that, from a policy perspective, should be excluded from TOSI but do not meet the ‘reasonable return’ test to exempt amounts from TOSI. Whether an amount received is a reasonable return depends on the facts of each case, including the work the individual performed, the property the individual contributed to support the business and the risk the individual assumed.
The excluded business exclusion relates to distributions from a specified individual’s excluded business, provided the specified individual is at least 17 years old. A business is an excluded business of a specified individual if the individual has been actively engaged in the business on a regular, continuous and substantial basis either in that year or in any one of the five previous years. Whether this condition can be satisfied is a question of fact and will depend on the facts and circumstances of each case as discussed in a previous RSM Tax Alert. In general, this condition would be satisfied if the individual worked in the business an average of at least 20 hours per week during the portion of the year in which the business operates. Records such as timesheets, schedules, and payrolls may be sufficient to support the number of hours the individual worked.
CRA view 2019-0814161E5
The relevant facts were:
- Spouse A and his/her spouse, Spouse B, are both residents of Canada and over 24 years old.
- Spouse A and Spouse B have a joint bank account in both their names.
- Spouse A used the funds from the joint account to form Opco.
- Spouse A has always been actively involved on a regular, continuous and substantial basis with Opco’s business, while Spouse B has never been involved in or contributed to Opco’s business.
- When Opco has had financial difficulty, Spouse A used the cash from the joint account to make loans to Opco. Opco has repaid all the loans it received from Spouse A.
- Opco pays taxable dividends to its parent company, Holdco, and Holdco pays taxable dividends to its sole shareholder, Family Trust.
- Family Trust in turn designates the taxable dividends equally to its two beneficiaries, Spouse A and Spouse B.
- The relevant legal structure is illustrated below.
The CRA determined that because Spouse A and Spouse B are specified individuals, TOSI would apply to taxable dividends allocated by Family Trust to Spouse A and Spouse B, unless the dividends satisfied the excluded amount definition.
The CRA concluded that the excluded business exclusion of the excluded amount definition applies to Spouse A because Spouse A had been actively engaged in the business on regular, continuous and substantial basis either in that year or in any one of the five previous years. Consequently, taxable dividends allocated by Family Trust to Spouse A are not subject to TOSI. However, taxable dividends allocated to Spouse B constitute split income and would be subject to TOSI, unless the ‘reasonable return’ exclusion applies.
- The reasonable return exclusion depends on the particular facts and circumstances including:
- The work the individual performed in support of the related business,
- The property the individual contributed directly or indirectly in support of the related business,
- The risks the individual assumed in respect of the related business,
- The total of all amounts that were paid or that became payable, directly or indirectly, by any person or partnership to, or for the benefit of, the individual in respect of the related business, and
- Such other factors as may be relevant.
In the present case, Spouse B could take the position that he/she loaned amounts to Opco because the loaned funds originated from a joint account. Thus, although only Spouse A was active in the business, Spouse B could argue that he/she indirectly contributed funds to the business therefore supporting Spouse B’s higher reasonable return therefrom.
However, the CRA clarified that a single factor might not be decisive on its own. In particular, the legal form of these transactions does not automatically lead to the conclusion that Spouse B had any role or input in making the loan to Opco. To determine whether an amount received by Spouse B is a reasonable return for TOSI purposes, a review of all the facts and circumstances is required; a single fact that suggests that an indirect contribution of funds was made to the business by Spouse B is not sufficient. Absent additional facts and circumstances, the CRA did not conclude on whether the reasonable return exclusion would be met for Spouse B. The CRA stated that, in this case, extrapolating that a dividend was a reasonable return based on a single factor could frustrate the purpose of the TOSI rules.
Sufficient appropriate evidence
The reasonable return determination is based on the facts and circumstances of each case. As no single factor determines the issue on its own, it is possible for an individual who is not actively involved in the family business to rely on the reasonable return exclusion to avoid the application of the TOSI rules. However, when attempting to rely on this exclusion, it may be prudent for taxpayers to establish as many factors as possible to support the reasonableness of a dividend.