27 November 2018 CTF Roundtable Q. 9, 2018-0779981C6 - TOSI–Excluded Amount - Non-Related Bus. Exception

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: Application of the excluded share and related business exclusions.

Position: General comments provided.

Reasons: See comments.

2018 CTF Annual Conference
CRA Roundtable

Question 9: TOSI – Excluded Amount and the Non-Related Business Exception

Under the definition of “excluded amount” in subparagraph 120.4(1)(e)(i), an amount will not be split income of a specified individual who has attained the age of 17 years before a taxation year in circumstances where it is not derived directly or indirectly from a “related business” in respect of the individual for the year. Similarly, under subparagraph 120.4(1)(g)(i) of the definition of “excluded amount”, an amount will be excluded from split income if it can be considered income from “excluded shares”. Can the CRA clarify its position on the excluded shares and related business exclusions in the context of the following hypothetical scenarios?

Scenario 1:

Mr. A and his spouse, Mrs. A, are both over 25 years old and are resident in Canada. Each own 50% of the shares of ACo, which in the past had carried on a business (the “Old Business”) in which Mrs. A had been actively engaged on a regular, continuous and substantial basis for at least five prior taxation years. Mr. A was never involved in or contributed to the Old Business. ACo disposed of the Old Business two years ago, and ACo’s sole activity since then has been the investment of the sale proceeds and the historical retained earnings from the Old Business. In the current year, ACo declared a taxable dividend to Mr. A and Mrs. A.

Questions

(A) If ACo’s investment activities constituted a business during ACo’s last taxation year and generated positive gross revenue during that year, can the CRA confirm that Mr. A’s and Mrs. A’s shares in ACo constitute “excluded shares” in the current year?

(B) In the case where ACo’s investment activities did not constitute a business, can the CRA confirm that the dividend declared in favour of both Mr. A and Mrs. A will not be considered split income given that the dividend is not derived directly or indirectly from a related business in respect of the individuals for the year? More specifically, can the CRA confirm that even if the dividend is considered to be derived directly or indirectly from the historical retained earnings of the Old Business or from the proceeds of disposition of the Old Business, it is not deriving it from a related business “for the year”?

CRA response to scenario 1(A)

Generally, yes. The definition of “excluded shares” is set out in subsection 120.4(1). In general, shares of the capital stock of a corporation owned by a specified individual will be excluded shares if the conditions set out in paragraphs (a) to (c) of the definition are satisfied.

Under the requirements set out in paragraph (a), it must be the case that less than 90% of the business income of the corporation for its last taxation year was from the provision of services and that the corporation is not a professional corporation. In the present situation, considering that ACo is not a professional corporation and under the assumption that ACo carries on a business which income, for the last taxation year, was solely derived from property and not from the provision of services, the conditions set out in paragraph (a) would indeed be satisfied.

Furthermore, both Mr. A and Mrs. A have the requisite share ownership to satisfy the votes and fair market value tests set out in paragraph (b) of the definition.

Finally, considering the particular facts of the current hypothetical scenario, ACo’s income for the last taxation year would not be derived, directly or indirectly, from one or more other related business in relation to Mr. A or Mrs. A other than the business of Aco. Accordingly, paragraph (c) would also be satisfied.

Based on the foregoing, the shares of ACo held by Mr. A and Mrs. A would constitute “excluded shares”. As such, the taxable dividend received from ACo would be considered an “excluded amount” pursuant to subparagraph 120.4(1)(g)(i) of the definition. Both Mr. A and Mrs. A would accordingly not be subject to tax on split income in relation to the dividend received.

CRA response to scenario 1(B)

Generally, yes. The dividend will be considered an “excluded amount” since it was not derived from a related business in respect of the individuals for the year.

More specifically, subparagraph (e)(i) of the “excluded amount” definition in subsection 120.4(1) provides that an amount that is not derived directly or indirectly from a "related business” in respect of the individual for the year is an excluded amount. Accordingly, it must first be determined whether the amount was derived directly or indirectly from a related business and, secondly, whether such amount was from a related business in respect of the individual for the year. Should both tests be satisfied, the amount so derived would not be excluded from split income under subparagraph (e)(i).

Derived directly or indirectly from a business

The expression “derived directly or indirectly from a business” is not specifically defined in the Act. The courts have repeatedly concluded that the expression “derived from” can have a broad meaning. (footnote 1) This expression, together with the words “directly or indirectly”, denotes that the phrase was meant to have a broad interpretation.

In addition, it is to be noted that paragraph 120.4(1.1)(d) specifies that, for greater certainty, the expression “derived directly or indirectly from a business” is meant to include, under subparagraph (i), an amount that arises in connection with the ownership or disposition of an interest in the person or partnership carrying on the business, and, under subparagraph (ii), an amount derived from an amount described in subparagraph (i). In effect, paragraph 120.4(1.1)(d) preserves the nature of an amount as being derived directly or indirectly from a related business even in circumstances where the related business has been disposed of.

Consequently, it is our view that the expression “derived directly or indirectly from a business” can be broadly construed and that absent additional facts and circumstances, the dividend received by Mr. A and Mrs. A would be considered to be derived directly or indirectly from a related business, being the Old Business, notwithstanding that the dividend was received in a year that is subsequent to the years in which the Old Business was carried on.

Amount from a related business in respect of the individual for the year

We are of the view that in circumstances, as here, where the Old Business has been wound up in a previous taxation year, and where it can be determined that the corporation does not have a related business in respect of the individual for a particular subsequent year, then a dividend received by an individual in that subsequent year will constitute an “excluded amount” under subparagraph (e)(i). In such instances, the dividend will not be considered to have been derived from a related business for the year because the business was not carried on in the particular year.

Based on the foregoing, the dividend received by Mr. A and Mrs. A from ACo would accordingly constitute an “excluded amount” and not be subject to tax on split income.

Notwithstanding the above, if it is determined that any transaction either alone or as part of a series has been undertaken primarily to obtain the “excluded amount” exemption under subparagraph 120.4(1)(e) in a manner that would frustrate the object, spirit and purpose of section 120.4, the CRA would seek to apply the GAAR.

Scenario 2

Mr. A and his spouse, Mrs. A, are both over 25 years old and are resident in Canada. Mrs. A is the sole shareholder of Opco. For all relevant years, Opco is not a professional corporation and carries on an operating business that is not a services business. Mr. A is the sole shareholder of Serviceco but is not actively engaged on a regular, continuous and substantial basis in the activities of Serviceco. In Year 1, Serviceco’s income was derived from the provision of services rendered to Opco. Serviceco does not pay any dividends to Mr. A in Year 1. In Year 2, Serviceco does not render any services and its activities for the year do not rise to a level that is sufficient for Serviceco to be considered to have a business for the year.

Question

Can the CRA comment on whether, in circumstances where Serviceco’s Year 1 after-tax income is paid as a dividend to Mr. A in Year 2, such dividend would constitute an “excluded amount” pursuant to subparagraph (e)(i) of the definition?

CRA response

For the reasons set out below, the dividend received by Mr. A in Year 2 would not constitute an “excluded amount” and would, absent any other consideration, be considered split income of Mr. A for the year.

As previously mentioned, for purposes of applying the related business exception in subparagraph (e)(i) of the “excluded amount” definition in subsection 120.4(1), it must first be determined whether the amount was derived directly or indirectly from a related business and, secondly, whether such amount was from a related business in respect of the individual for the year. Should both tests be satisfied, the amount so derived would not be excluded from split income under subparagraph (e)(i).

Derived directly or indirectly from a business

The income earned by Serviceco in Year 1 was derived from the provision of services to, or in support of, Opco’s business and will as such be deemed to be an amount derived directly or indirectly from Opco’s business pursuant to clause 120.4(1.1)(d)(i)(A). Furthermore, it is the case that the dividend paid in Year 2 has been derived from the provision of services to Opco in Year 1 such that, pursuant to subparagraph 120.4(1.1)(d)(ii), the dividend so received would also be deemed to be derived directly or indirectly from Opco’s business.

Considering that, in accordance with subparagraph 251(2)(a), Mrs. A and Mr. A are related to one another, Mrs. A is therefore a “source individual” in respect of Mr. A as defined in subsection 120.4(1). Since Mrs. A owns all of the shares of Opco, the business of Opco will constitute a related business in respect of Mr. A pursuant to paragraph (c) of the “related business” definition in subsection 120.4(1). Accordingly, the dividend received by Mr. A from Serviceco in Year 2 will be considered to be derived directly or indirectly from a related business.

Amount from a related business in respect of the individual for the year

In circumstances where, as here, the related business continues to operate in the year, it is CRA’s view that there will be a related business in respect of the individual for that year. In the present hypothetical scenario, Opco continued to operate its business in Year 2. Accordingly, Opco’s business will constitute a related business, in respect of Mr. A, for Year 2. The current situation can be contrasted with scenario 1(B) where the related business was wound up in a preceding taxation year.

Based on the foregoing, the dividend received by Mr. A in Year 2 would accordingly not constitute an “excluded amount” under subparagraph 120.4(1)(e)(i).

P. Bilodeau
2018-077998
November 27, 2018

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 For instance, the phrase "derived from" has been broadly interpreted by the Supreme Court in the case of MNR v. Hollinger North Shore Exploration Co. Ltd., 63 DTC 1031.