Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Principal Issues: 1. Whether the TOSI rules will apply to a deemed dividend received by individuals on the redemption of their common shares in an investment holding company. 2. Whether TOSI will apply to a deemed dividend received by an estate and allocated to the beneficiaries.
Position: 1. Depends on the particular facts, but in this case probably not. 2. Depends on the particular facts.
Reasons: Meets technical requirements.
November 7, 2018
Re: Application of TOSI to deemed dividends
This is in response to your email dated September 6, 2018, where you requested our views on whether the tax on split income (“TOSI”) rules in section 120.4 Income Tax Act (Canada) (the “Act”) would apply to any of the deemed dividends described in the following hypothetical fact situation.
In 2018, an individual who was resident in Canada (“Deceased”) passed away and the Deceased’s estate (“Estate”) acquired all the voting preferred shares of a taxable Canadian corporation (“Investco”) for their fair market value (“FMV”) pursuant to subsection 70(5) of the Act. The preferred shares of Investco comprise more than 10% of the voting rights and FMV of Investco.
The Deceased’s three children, who are all over 24 years of age and Canadian residents, are the only beneficiaries of the Estate. Each of the Deceased’s adult children own common shares of Investco that also comprise more than 10% of the voting rights and FMV of Investco.
Investco has carried on an investment business for more than 30 years and earns interest and dividends from its investments. Investco’s investments were initially funded using the proceeds from the sale of the shares of an operating corporation the Deceased had owned more than 30 years ago.
The business of Investco is to be wound-up and all the shares of Investco are to be redeemed or repurchased by Investco resulting in each of the children and the Estate receiving a deemed dividend equal to the difference between the FMV and the paid-up capital of their respective shares. The Estate may allocate the dividend income to the children.
This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R8, Advance Income Tax Rulings and Technical Interpretations.
Under the TOSI rules in section 120.4, TOSI will apply to tax the “split income” of a “specified individual” at the highest marginal rate unless the amount is an “excluded amount,” as all terms are defined in subsection 120.4(1).
Specified individual/Source individual
The definition of “specified individual” in subsection 120.4(1) is broad and provides that an individual (other than a trust) will be a specified individual for a taxation year where the individual is resident in Canada (footnote 1) at the end of the year, and if the individual has not reached 17 years of age before the end of the year, the individual has a parent resident in Canada at any time in the year. The definition of “source individual” in subsection 120.4(1) is also fairly broad, and in respect of a specified individual for a taxation year, means an individual (other than a trust) who, at any time in the year, is resident in Canada and is related to the specified individual.
Based on the above definitions, the adult children of the Deceased, as well as the Deceased (for 2018), are specified individuals and source individuals.
Generally speaking, the definition of split income provides, inter alia, that split income of a specified individual will include taxable dividends received by the individual in respect of shares of the capital stock of a corporation (other than shares of a class listed on a designated stock exchange or shares of the capital stock of a mutual fund corporation) or an amount that is in respect of such taxable dividends allocated to the individual by a trust, pursuant to subsection 104(13). Therefore, if the deemed dividend income on the preferred shares owned by the Estate is allocated to the children, such income will be split income unless it is an excluded amount.
A “related business” is defined in subsection 120.4(1). For the purposes of this situation a related business will include under paragraph (c) of that definition, a business carried on by a corporation where a source individual, in respect of the specified individual, owns shares of the capital stock of the corporation or property that derives, directly or indirectly, all or part of its FMV from shares of that capital stock, and the total FMV of the shares and property described above, that is owned by the source individual, equals at least ten per cent of the FMV of the capital stock. When applying the TOSI rules, the business of Investco appears to be a related business in respect of the Deceased and the children.
The definition of “excluded amount” includes two “safe harbour” exclusions for certain adults to alleviate some of the compliance burden on taxpayers. The first safe harbour exclusion from TOSI is for income received by a “specified individual,” age 24 or over, from owning “excluded shares”. The second safe harbour exclusion from TOSI is for income received by a “specified individual,” age 17 or over, from an “excluded business.” In general, these safe harbour exclusions provide a bright line test and are intended to act as a proxy for situations that would have otherwise been a reasonable return and do not raise any policy concerns.
It appears from your correspondence that your primary concern is whether the shares of Investco would be “excluded shares” immediately before they are to be redeemed or repurchased by Investco. Accordingly, for the most part, we will concentrate our discussion on the first safe harbour exclusion.
The definition of “excluded shares” is set out in subsection 120.4(1). Shares of the capital stock of a corporation owned by an individual will be excluded shares of the individual if all the conditions set out in paragraphs (a) to (c) of the definition are met. A share owned by such a specified individual is an excluded share if:
(a) the following conditions are met:
i) less than 90% of the business income of the corporation for the last taxation year of the corporation that ends at or before that time (or, if no such taxation year exists, for the taxation year of the corporation that includes that time) was from the provision of services, and
ii) the corporation is not a professional corporation;
(b) immediately before that time, the specified individual owns shares of the capital stock of the corporation that:
i) give the holders thereof 10% or more of the votes that could be cast at an annual meeting of the shareholders of the corporation, and
ii) have a FMV of 10% or more of the FMV of all of the issued and outstanding shares of the capital stock of the corporation; and
(c) all or substantially all of the income of the corporation for the relevant taxation year in subparagraph (a)(i) is income that 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.
Based on our understanding of the facts, it appears that the conditions in (a) above would be met for Investco. Further, if immediately before the time the common shares of Investco are to be repurchased, the children each own more than 10% of the voting rights and value of Investco (“votes and value test”) represented by the common shares they own, the requirements set out in (b) above also would be met. However, with respect to the preferred shares of Investco owed by the Estate, while those shares also appear to satisfy the votes and value test, they do not satisfy the ownership requirement set out in (b) above. Finally, as set out in (c) above, the definition of excluded shares also requires, all or substantially all of the income of Investco, for the relevant year, to be income that is not derived, directly or indirectly from a related business of Investco, other than a business of Investco. If Investco’s only income for the last 30 years has been from carrying on its investment business, in our view, the requirement in (c) above should be satisfied.
Therefore, while the common shares of Investco owned by the children would appear to be excluded shares, the preferred shares of Investco, owned by the Estate, would not be excluded shares. Accordingly, any deemed dividends arising on the redemption of the preferred shares, if allocated to the children by the Estate, would be subject to TOSI unless another exception applies.
Pursuant to the definition of “excluded business” provided in subsection 120.4(1), where the children were actively engaged on a regular, continuous and substantial basis in the activities of the business carried on by Investco in either the relevant taxation year, or in any five prior taxation years, the dividend income received on their common shares and the dividend income allocated from the Estate, would be income derived directly or indirectly from an excluded business. It is a question of fact as to whether the children would be considered to meet the excluded business test with consideration given to the nature, and the labour requirements of Investco’s business.
Where the safe harbours found in the excluded share and excluded business exceptions do not apply, the general underlying rationale is that in such circumstances, the most appropriate test for determining whether the income of a specified individual from a related business should be excluded from split income will be based on the “reasonable return” test pursuant to the definition in subsection 120.4(1). The general test as to whether the amount received is a reasonable return is according to the specific facts and circumstances, including the work performed, the property contributed in support of the business, the risks assumed by the specified individual or a related individual, prior amounts received by them in respect of the business, and any other factor as may be relevant.
Paragraph 120.4(1.1)(b) provides a continuity rule for inherited property and applies to amounts that would, absent the application of this rule, be split income of a specified individual who has attained the age of 17 years before the year in respect of property that was acquired by, or for the benefit of, the specified individual as a consequence of the death of another person.
In such circumstances, subparagraph (i) of this paragraph would allow a specified individual to avoid the application of the TOSI to the extent that the amount, had it been received by the deceased person, would have been a “reasonable return” for the purposes of subparagraph (g)(ii) of the “excluded amount” definition.
Subparagraph (ii) of this paragraph would allow a specified individual to avoid the application of the TOSI to the extent that the amount, had it been received by the deceased person, would have been from an “excluded business” for the purposes of subparagraph (e)(ii) of the “excluded amount” definition. This continuity rule would apply because the deceased person was, or was deemed to be because of this paragraph, actively engaged on a regular, continuous and substantial basis in the activities of the related business throughout five previous taxation years.
We have not been provided with sufficient facts to determine whether the rule described in paragraph 120.4(1.1)(b) would apply in your circumstances.
Additional guidance on the TOSI rules can be found on the Canada Revenue Agency (CRA) website at: https://www.canada.ca/en/revenue-agency/programs/about-canada-revenue-ag....
We trust that these comments will be of assistance.
Michael Cooke, CPA, CA
Corporate Reorganizations Section II
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:
1 In the case where the individual passed away they must have been a Canadian resident immediately before death.
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