Written by Trista Gallant | Buckberger Baerg LLP
Much has been written and talked about with respect to the “Tax on Split Income” (“TOSI”) changes. As taxpayers and practitioners, we have been through a year and a half with these new rules applying and many (most) of us are still uncertain about the application of TOSI in certain circumstances. Canada Revenue Agency (CRA) has been continuously providing clarifications and addressing questions around these relatively new rules as they prove difficult to interpret in some situations.
Oversimplified, TOSI may apply when a shareholder receives dividends or interest, or realizes a capital gain, from a private corporation, and a related person is actively engaged in the corporation’s business or holds at least 10% of its value.
Representatives from the CRA answered questions posed by the Society of Trust and Estate Practitioners Canada (STEP Canada) at the society’s annual conference in June of 2019. The official CRA answers have not yet been released, however, a few of the notable responses in respect of the TOSI “deeming” rules in 120.4(1.1) as they apply to inherited property are discussed below.
Inherited shares held through a trust by spouse or children
The rules in 120.4(1.1)(c) tell us that TOSI does not apply to split income received by a taxpayer if they have a spouse (or common-law partner) who is age 65 or older, or is deceased, and the amounts received would have been an “excluded amount” to the spouse if the spouse had received it themselves.
In Question 5 posed to the CRA, STEP Canada requested confirmation of this TOSI exemption where the spouse age 65+ or deceased qualifies for the excluded shares exemption (which includes the requirement of holding the shares personally), while the other or surviving spouse holds their shares as a beneficiary of a trust.
The CRA confirmed that generally, the exemption would apply and allow the spouse to receive the income through a trust exempt from TOSI and added their usual disclaimer “Where artificial transactions are undertaken to achieve a similar but inappropriate result, the GAAR [general anti-avoidance rule] could be applicable.”
Interestingly enough the same analysis does not apply when adult children receive the shares from a deceased parent and hold them through a trust. In Tax Window file 2018-0777361E5 an individual passes away and leaves voting preferred shares representing 10% votes and value to an Estate (Trust) in which the three adult children are the only beneficiaries. The three children also own common shares held personally each representing 10% of votes and value of the company.
Paragraph 120.4(1.1)(b) provides a continuity rule for inherited property and effectively allows the beneficiary to be deemed to have made the same contributions to the business as the deceased when applying the reasonable return and excluded business exemptions. As for the excluded shares component, it deems the beneficiary to have reached the age of 24, so that the excluded shares exemption may apply if shares are owned directly, but is not as generous as the rules for spouses in 120.4(1.1) (c).
CRA confirmed that the original owner (now deceased) must have been actively engaged in the business (or made contributions entitled to a reasonable return) in order to allow the beneficiaries to be deemed to be actively engaged or to have made the contributions of the deceased. The shares held by the trust would not qualify for the excluded shares exemption to the children even though they were excluded shares to the deceased individual. The common shares held by the beneficiaries directly would be considered excluded shares and would qualify (provided the company met the other requirements of the excluded shares definition).
Tracing ownership and attributes of shares after death
Questions 6(a) and (b) from the STEP Canada June 2019 conference, considered two slightly different scenarios in which adult children would receive shares of an Opco as an inheritance where one parent was active in the business and the other was not.
(Both of these situations presume the children are over 24, otherwise they would be included in the definition of “excluded amount” paragraph (a) until age 24 as they received the shares as an inheritance from a parent).
In question 6(a) the owner and spouse own all the shares of a services business and only the owner is actively engaged in the business. When the active owner dies, those company shares are gifted through the will to the non-active spouse. The deeming rule in 120.4(1.1)(b) provides that subsequent distributions from the corporation to the non-active spouse wouldn’t be considered split income as the business would be now be an excluded business to the spouse.
STEP Canada’s question was whether the shares would also be TOSI-exempt when the non-active spouse dies and the shares are then gifted to the children. Would the children be deemed to have made the same contributions as the person from whom they received the shares (the person who didn’t make the contributions) or would they been deemed indirectly to have received the shares as a consequence of the death of the active owner (the first parent to die)? CRA held that the children would be deemed to have made the same contributions as the active parent even though they did not receive the shares directly as a consequence of the death of that person.
“It is the CRA’s view that the effect of a previous application of the deeming rule in 120.4 1.1(b)(ii) could extend to a subsequent acquisition of property as a consequence of the death of another individual.”
This is good news as it is difficult if not impossible to get to this conclusion with only a direct reading of the deeming rule in 120.4(1.1)(b)(ii).
The second part of the question 6(b) addressed what would happen in the situation (same facts as 6(a)) where the active owner and non-active spouse have each willed one-half of their shares to each of two children, and the non-active spouse dies first.
The CRA responded that, while the shares that the children inherit from the non-active spouse would be subject to TOSI, once the active business owner dies, all of the inherited shares would be exempt, starting in the tax year that the children inherit the active business owner’s shares. This is because the Opco would now be considered an excluded business to each of the children and all amounts received from that business would be exempt from TOSI regardless of which shares the income or gain was received from.
The above clarifications from CRA are certainly appreciated and much needed in order to provide guidance to tax practitioners. It is anticipated that CRA will continue to provide their position with respect to how the rules would apply in specific circumstances, as there is certainly still confusion around some of these rules.