On December 13, 2017 the Department of Finance released revised income splitting rules. The updated rules introduced a number of exclusions from the current Tax on Split Income (TOSI) rules.
The revised rules now allow reasonable amounts received from a related business to be excluded from TOSI, as long as certain criteria are met. If clients fail to meet any of the exclusions, a solution is to take a close look at the reasonable return tests to determine if amounts received - either partially or fully - are considered to be a reasonable amount given the number of tests outlined by the Department of Finance.
Meeting any one of the exclusions allows clients to avoid top tax rates on certain amounts received from a related business.
The following is a list of the available exclusions. As a general rule, an excluded amount applies to individuals who receive amounts from a related business and meet at least one of the following criteria:
- Work in the business and meet specific bright line tests (excluded business)
- Are at minimum, a 10% individual shareholder (in terms of votes and value) of non-service and non-professional corporations who meet specific conditions (excluded shares)
- Are deemed to dispose of their shares as a result of death
- Sell qualified property eligible for the Lifetime Capital Gains Exemption
- Receive amounts as a result of a marriage breakdown or divorce
- Are the spouse of a business owner over age 65 who made contributions to the business (retirement property)
- Are between ages 18 to 24 and do not receive amounts in excess of the either the Safe Harbour Capital Return (the prescribed rate) or the reasonable return on Arm’s Length Capital
- Inherit property from a parent or another individual and meet certain conditions
Property inheritance is very important to an advisor because it helps develop a succession plan for the business and should be taken into consideration when creating an estate plan for clients. A document published by the Department of Finance (The Technical Backgrounder) was designed to provide taxpayers with a high-level overview of the rules, but focuses on the inherited property exclusion.
It suggests, very broadly, that “the person inheriting the property will generally not face a less favourable treatment than the deceased.” A deeper look into the rules reveal more details on the inherited property exclusion and specifically when TOSI would (and would not) apply.
Existing legislation already provides an exclusion from TOSI for minors when property is inherited because of a death. The legislation ensures that top tax rates would not apply in the following scenarios:
- the income or gain from property acquired is from the death of a parent
- the income or gain from property acquired is due to the death of any other person as long as the individual is a full-time post-secondary student or qualifies for the disability tax credit
The new legislation extends these rules to those age 18 years old until the end of year in which they reach 24 years of age.
In addition to the extension of the existing rules, the government provided supplemental exclusions for individuals age 18 and older, who inherit property from a deceased individual; these are referred to as the continuity rules. These rule were designed to ensure that the individual who inherits the property is not exposed to TOSI and is not subjected to top marginal tax rates if, in fact, the deceased also avoided TOSI.
The new rules provide very specific scenarios where the continuity scenario would apply to the individual inheriting the property.
The first exclusion is applicable if the deceased avoided TOSI by virtue of meeting the reasonable return criteria. The reasonable return criteria is available to those over the age of 24 and measures the individual’s relative contributions to the business based on a number of factors including (but not limited to) labour contributions, capital contributions and risk assumed in support of the business.
If the deceased met these criteria and avoided TOSI, the continuity rule would apply to the beneficiary and ensure TOSI would not apply to that individual. The key here is that the factors relevant in determining whether an amount is reasonable is based on the contributions made by the deceased during their lifetime, not the beneficiary.
An additional deeming rule, states that the individual inheriting the property must be at least 25 years of age, as long as the deceased would have been at least 25 years of age in the year of death. This rule applies specifically where the deceased met either the reasonableness criteria or the excluded share criteria. It ensures that if the beneficiary is between the ages of 18 and 24, they will be deemed to be at least 25 years old for purposes of determining whether TOSI applies. In essence, the beneficiary inherits the same tax treatment as the deceased.
This rule is beneficial because those under the age of 24 are generally not otherwise eligible for the excluded share exclusion and have much stricter reasonableness criteria that is otherwise avoided with this rule.
The other scenario where the continuity rule applies is when the beneficiary inherits property from a deceased person, who avoided TOSI on amounts received from the business exclusion. This exclusion applies if the deceased was actively engaged in the business on a regular, continuous and substantial basis in any five previous taxation years.
Similar to the rule above, the continuity rule continues to the beneficiary and considers that individual to have also been engaged in the business on a regular, continuous and substantial basis in any five previous taxation years. This continuity rule ensures that the beneficiary will not be subject to TOSI on amounts received from the business in the future.
Finally, a special rule applies to spouses or common law partners. If the inheriting spouse receives an amount that would have been an excluded amount if they were received by the deceased spouse, then it will also be an excluded amount for the surviving spouse or partner. The key to this rule is there is no age requirement for either spouse to meet this exclusion.
The inherited property exclusion is an important tax and estate planning rule that business owners may want to take advantage of as part of a succession plan. Advisors need to be aware that these rules are not applicable in all cases where the deceased avoided TOSI during their lifetime. The rules and exclusions are somewhat limited but make an effort to ensure the next generation is not subject to TOSI, if applicable.