When the tax on split income (TOSI) rules were expanded on December 13, 2017, the tax community knew that the rules would be difficult to apply because of their broad nature. In addition, the legislation contains several apparently unintended traps, many of which reveal themselves when partnerships are involved.
Assume, for example, that Father owns 0.0000001 percent of a publicly traded limited partnership (Public LP) that earns business income and annually allocates the business income to its limited partners. Father gifts his 19-year-old son $100,000 to invest in Public LP. Son already owns 0.0000001 percent of Public LP. Son has no other income sources;therefore, income from Public LP will otherwise not be subject to tax (because the income earned will likely be less than the basic personal amount), and the attribution rules will not apply. (Business income generally does not attribute, subject to subsection 96(1.8), and Son is not a minor.)
Is the business income that Father and Son earn from Public LP subject to the TOSI rules and thus potentially subject to tax at the highest marginal tax rate? For business income to be subject to the TOSI rules, the following criteria must be met:
- The individual (other than a trust) who receives the income in question must be a “specified individual.”
- The income in question must be “split income.”
- The income in question must not be an “excluded amount” with respect to the specified individual.
The criteria can be analyzed as follows.
First, each of Father and Son is a specified individual, because each is a non-trust individual who is resident in Canada at the end of the year.
Second, clause (b)(ii)(A) of the definition of “split income” in section 120.4 includes a portion of an amount (other than dividends from non-publicly traded corporations and income from certain shareholder benefit/loan provisions described in paragraph (a) of the definition) “included because of the application of paragraph 96(1)(f) . . . to the extent that the portion . . . can reasonably be considered to be income derived directly or indirectly from one or more related businesses in respect of the individual.”
Paragraph (b) of the definition of “related business” in section 120.4 includes a business of a particular partnership (here, Public LP) “if a source individual in respect of the specified individual at any time in the year has an interest—including directly or indirectly—in the particular partnership.”
Father and Son are “related persons,” and thus each is a “source individual” in respect of the other. As a result, from each of their perspectives, a source individual has an interest in Public LP. Therefore, the business income allocated from the partnership is split income. Absent one of the exclusions in the definition of “excluded amount,” the partnership income will be taxable at the highest marginal tax rate to each of Father and Son.
Third, several exclusions in the “excluded amount” definition attempt to ensure that income earned from investments that are generally arm’s-length will not be subject to the TOSI rules. The first, in subparagraph (e)(i) of the definition, applies to individuals over the age of 17 if the income “is not derived directly or indirectly from a related business in respect of the individual for the year.” As illustrated above, however, the income earned by each of Father and Son from Public LP is income derived from a related business in respect of each of Father and Son. Thus, this exclusion cannot be relied on.
An exclusion in paragraph (g) of the “excluded amount” definition applies when the individual is over the age of 24 in the year, and the amount is a “reasonable return” in respect of the individual. Subparagraphs (b)(ii), (iii), and (v) of the definition of “reasonable return” generally looks at the “property [that the individual] contributed, directly or indirectly, in support of the related business”; the “risks [the individual] assumed in respect of the related business”; and “such other factors as may be relevant” to the investment that generated the income. (Other criteria are noted in this exclusion, but they are not relevant here.)
Does Father’s purchase of the Public LP units on the open market satisfy this exclusion? Father has risked capital to make the investment and is earning a return thereon. Whether Father has made a “contribution” in respect of the business is a question of fact. If Father and Son have contributed nothing to Public LP’s business, can Father rely on this exclusion, given that his “contribution” to the business (nothing) is measured relative to Son’s contribution (also nothing)?
Because Son is only 19 years of age, he cannot rely on the “reasonable return” exclusion, and he will be unable to do so until the year in which he turns 25. In this case, there are two possible exclusions on which Son can rely. The amount realized must represent
- a reasonable return on arm’s-length capital, and/or
- a safe-harbour capital return (SHCR).
The details of the exclusion for a reasonable return on arm’s-length capital are beyond the scope of this article. However, because Father gifted the invested funds to Son, the amount realized in respect of the investment will not constitute a reasonable return on arm’s-length capital. Son will have to try to rely on the SHCR exclusion in order to avoid the TOSI rules.
Simply put, an SHCR will essentially permit Son to earn a return on his capital contributed ($100,000) equal to the highest prescribed rate in effect for a quarter in the year. Thus, Son can earn up to 2 percent on the FMV of property contributed by him in support of a related business, at the time it was contributed. However, Son purchased the Public LP units from a third party on the open market; he did not contribute the funds directly to Public LP. Does this purchase constitute “property contributed” by Son “in support of a related business”? Probably not, but this remains to be seen.
The outcome described above appears to be an unintended consequence of the labyrinthine TOSI rules. An adult child, investing gifted funds into a widely held and (in this case) publicly traded investment vehicle, in which no person related to him is actively engaged, or owns a material interest, can potentially be caught by the TOSI rules.
One cannot help but notice that if the funds had been used to purchase public company shares, or if the Public LP units had earned dividend income from public companies (rather than generating business income), the TOSI rules probably would not be applicable. Note, however, that this observation is based on a recent (and perhaps generous) interpretation published by the CRA (2018-0768831C6, October 5, 2018). An alternative reading with respect to the earning of public company dividends through a partnership that constitutes a related business is that such dividends could be subject to TOSI, and that the CRA’s interpretation—which automatically excludes from the TOSI rules, in all cases, public company dividends allocated from a partnership—is perhaps questionable.
Kraft Berger LLP
Article first published in Tax for the Owner-Manager
Volume 19, Number 2, April 2019
©2019, Canadian Tax Foundation