CRA indicates that a scheme to circumvent TOSI application to the reinvested earnings of a professional practice “technically” worked

2019-0819431E5 dealt with what appeared to be a scheme to get around the fact that shares of a professional corporation could not be “excluded shares” for purposes of the split-income (TOSI) rules (and also that spouses often are prohibited from holding voting shares of a professional corporation, as effectively required by para. (b) of the “excluded share” definition) even with respect to the investment income derived by the professional corporation from reinvestment of its earnings from the practice. A professional corporation (PC1) whose non-voting equity was held equally by a physician (Dr. A) and Spouse A (who had no involvement in the practice) applied its earnings to build up a large investment portfolio, which CRA noted very well might be an investment business. However: on December 30 of Year 1, PC1 ceased carrying on its medical services business; on December 31, Spouse A acquired 50% of Dr. A’s voting shares; and on January 1 of Year 2, Dr. A commenced carrying on the medical services business in a newly- incorporated professional corporation (PC2) with the same ownership as PC1 had prior to December 30.

CRA had found that the TOSI rules applied to dividends paid to Spouse A at the end of Year 1, but that they did not technically apply to dividends paid to Spouse A in Year 2 given that: (i) PC1 was no longer a professional or services business, and in the previous year (Year 1) it had derived less than 90% of its revenue from the medical practice (para. (a) of the excluded shares definition); (ii) Spouse A satisfied the 10% of votes-and-value test in para. (b) of that definition; and (iii) the test under para. (c) was by its terms to be applied to the results of the previous year (Year 1) and “all or substantially all of the income of PC1 is derived directly or indirectly from one or more related businesses (i.e., the medical services business and the investment business) in Year 1, and PC1 is still carrying on these businesses in Year 1.”

In a follow-up technical interpretation, CRA has now re-addressed Year 3 where, respecting the application of para. (c), it had previously stated that because “…any dividend paid by PC1 to Spouse A would be considered to be derived directly or indirectly from a 'related business' carried on by PC2 (and not PC1) in Year 2 and subsequent years,” the shares of PC1 held by Spouse A would not qualify as “excluded shares.”

CRA now acknowledges:

In the event that the income of PC1 for Year 2 and any subsequent year is income earned solely from its investment business, such income would not be considered to be derived directly or indirectly from the medical services business now carried on by PC2. This would be the case even though the historical retained earnings of PC1 that are used in PC1’s investment business were originally derived from its former medical services business. Accordingly, in those circumstances, we would consider all the conditions of the “excluded share” definition to be technically met for those years.

CRA went on to indicate that the transactions “appeared to be undertaken primarily to ensure that the shares of PC1 held by Spouse A would meet the definition of ‘excluded shares’,” and that GAAR could be engaged.

Neal Armstrong. Summary of 8 April 2020 External T.I. 2020-0839581E5 - "Excluded Shares" under s. 120.4(1) – excluded shares - (c).