The “kiddie tax” was introduced in 2000 to deter income splitting with minor children by enforcing taxation at the highest marginal tax rate on the income received and denying certain personal tax credits. In recent years, new legislation expanded the tax on split income (TOSI), extending beyond minor children to include certain adults as well.

The updated TOSI regime affects a broad range of Canadians, but there are a number of available exclusions that should be considered when tax planning for income splitting. Two such exclusions, excluded business and excluded shares, are discussed below, along with some recently released guidance from the Canada Revenue Agency (CRA).

Excluded business

Income derived from an excluded business of the individual for the year is exempt from TOSI with no upper limit.¹ An excluded business is one in which the individual is actively engaged in the activities of the business on a regular, continuous and substantial basis in either the taxation year or any five prior tax years.

This fact-based test also contains a bright-line test to help determine when an individual is actively engaged in the activities of the business on a regular, continuous and substantial basis. The bright-line test is met where a specified individual has worked in the business at least an average of 20 hours per week during the portion of the year in which the business operates.

While the 20-hour-week rule is intended to mitigate the inherent ambiguity of the definition, it is not necessarily required for the excluded business exemption to be met. Other factors may be considered in determining whether a specified individual is actively engaged in the activities of the business on a regular, continuous and substantial basis, including the nature of the involvement contemplated based on the work and energy devoted to the business, and the detailed labour requirements of the business.²

Where this exemption has been met, it is not relevant whether the income received by the specified individual is reasonable or not. For example, a part-time receptionist who is also a specified individual and who receives a $150,000 dividend for 20 hours of work per week is not subject to TOSI³.

The CRA released a technical interpretation in early 2019 elaborating on the use of the excluded business exemption and confirming that “any five prior tax years” need not be continuous years and may occur prior to the effective date of the TOSI amendments on January 1, 2018. In addition, there is no requirement that the specified individual be related to the source individual at the time such qualifying activities are performed.⁴

The Department of Finance has supported these views in the explanatory notes accompanying section 120.4 of the Income Tax Act. The intention of this exclusion is to ensure that individuals who make significant contributions of labour to a business over a period of time will continue to be exempt from TOSI upon retirement or reduced involvement in the business.

Continuity through generations

The continuity provision under subsection 120.4(1.1)(b)(ii) allows shares inherited by a specified individual (e.g. an inactive spouse) as a consequence of the death of the source individual to retain their excluded business status to the extent that the source individual was entitled to the excluded business exemption. Consequently, if that particular person (the inactive spouse) dies and the children inherit the shares, they will also retain excluded business status by the same provision.⁵This continuity rule can prove to be tricky, so please consult with your Baker Tilly advisor if relying on this rule.

Excluded shares

Individuals aged 24 before the year of income distribution can earn unlimited income from, or generate taxable capital gains on, excluded shares without the application of TOSI. Excluded shares must be owned directly by a specified individual and must meet the following three conditions:

1. Less than 90 per cent of the business income of the corporation for the last taxation year was from the provision of services (gross business test), and the corporation is not a professional corporation.
2. Immediately before that time, the specified individual owns shares of the corporation that give the holder 10 per cent or more in votes and value.
3. All or substantially all⁶ of the income of the corporation for the last taxation year 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.

Defining income

In the interpretation of business income set out in paragraph (a) above, the exclusion applies not only to entities carrying on an active business, but also to those carrying on a business where the principal purpose is to derive income from property. Where a corporation only has income from property, the context in which that income is earned must be considered in determining whether a business is being carried on. The Income Tax Act defines “business” as an undertaking of any kind whatsoever. The Supreme Court of Canada has stated that there is an inherent assumption that the activities of a corporation are undertaken for the purpose of earning income.⁷

In light of the foregoing elements, an investment business or income from rental property may be considered to be carrying on a business. If a corporation carries on a business earning income from property, the shares could qualify as excluded shares.⁸ If there is no business carried on and thus no business income, the gross business test is not met.

In reference to paragraph (c) above, the CRA considers “income” to be gross income rather than net income or profit after expenses. Further, income is generally inclusive as an amount that would come into income for tax purposes. As such, taxable capital gains are included in income without omitting the offset of any allowable capital losses.⁹

Gross business test

The gross business test outlined in paragraph (a) above requires a calculation of the percentage of sales from services out of gross business income. If the result is greater than 90 per cent, the shares of the corporation will not qualify as excluded shares. The classification of income and taxation years under this test may vary by situation:

• The result of the test may vary from one year to another. Example: In 2018, the income from services as a percentage of business income could be 95 per cent, resulting in shares not being excluded shares for the subsequent year. However, the income from services may represent 85 per cent in 2019, resulting in shares being excluded shares for 2020 and not subject to TOSI (assuming other conditions in paragraphs (b) and (c) are met).
• A corporation’s first year of operations is 2018 and that current year’s gross income is used for the test. Example: In 2018, more than 90 per cent of the business income is derived from provision of services. Therefore, the shares would not qualify as excluded shares for 2018 nor 2019.
• Incidental goods used or consumed in the provision of services would be deemed income from services. Example: cleaning supplies used in providing cleaning services, despite being listed separately on the invoice or invoiced separately, would still be considered incidental to services.
• Income from construction businesses, often comprised of labour and materials, is treated as a mix of income from both services and non-services. The sale of materials would be excluded from the calculation of income from services in favour of satisfying the gross business test.

When navigating the complex rules of new legislation, it is imperative to understand supplementary interpretations and regulatory views to maximize tax planning opportunities. If the TOSI regime is applicable to your tax situation, your Baker Tilly advisor can help in discussing the opportunities and implementing an effective plan to meet the needs of you and your family.