indicatorTax and Protection

Income splitting? Know the TOSI rules first

By Josh Proulx, JD, BComm 5 March 2024 10 min read

Historically, one of the more common tax planning strategies for business owners was to take advantage of “income splitting” or “income sprinkling.” This involves moving taxable income from a higher-income-earning family member to a lower-income-earning family member. When done correctly, this planning reduces the family’s overall tax exposure by taking advantage of the lower-income earner’s tax brackets.

In this article, we describe how the tax on split income (TOSI) rules affect a business owner’s ability to pay dividends to their family. This includes a brief description of these rules, together with some of the most common exceptions to escape them. If you are considering paying dividends to your family, you should consult with a tax advisor in advance to avoid the punitive tax results of the TOSI rules. If they apply to the dividend, it can be a costly mistake.

Please note that the information in this article is simplified and may omit important details. This article is not intended to be comprehensive and does not attempt to interpret these rules for any particular situation. You must seek advice from your own tax advisor to understand how these rules apply in your own circumstances.


Splitting income through a corporation

The tax on split income rules came into effect in 2018. Before that time, it was common for a business owner to take advantage of their corporation as a method of splitting income with their family. Rather than paying funds to themselves, business owners would commonly make payments to family members, to have the income taxed at the recipient’s tax rate, instead.

In some cases, this would have involved paying salary or wages to those family members. This was not always possible, though, since salaries must be considered “reasonable” to avoid negative tax consequences in the corporation. Instead, many business owners would simply pay corporate dividends to family members, which did not have this same reasonableness requirement. This enabled business owners to split income easily amongst their family in almost any proportion, simply by making those family members into shareholders and distributing dividends.1

In 2018, the federal government implemented the TOSI rules as a way to combat this type of planning. These TOSI rules introduced strict requirements for taking advantage of income splitting through corporate dividends (among many other things). If those requirements are not met, there can be severe tax consequences. While income splitting is still possible under the TOSI system, it is no longer as straightforward as it once was. It is now exceedingly important to seek tax advice before paying a dividend out of a corporation.


The tax on split income rules

Income splitting strategies were heavily restricted in 2018 after the TOSI rules came into effect. The TOSI rules are a broad, sweeping change that affected most private business owners. It is especially impactful to corporations in which an idle or inactive family member holds shares.


What are the TOSI rules?

The TOSI rules were intended to prevent business owners from accessing unintended tax benefits by using a private company to split income with related persons, unless those related persons are sufficiently involved in the business. Under the TOSI rules, any time a person receives certain types of income, they are treated as if they received “split income”, unless an exception applies.

Split income is taxed at the highest marginal tax rate, regardless of the recipient’s true tax bracket. A broad range of income types can be considered split income, but for the purposes of this article, the most important is dividends from a private corporation. If a family member receives a dividend from a private company and cannot avoid the TOSI rules, the dividend could be taxed at rates as high as 42.31% (in Alberta at 2024 rates).


What exceptions are available from the TOSI rules?

The TOSI rules are complex. There is a broad range of exceptions to avoid the application of these rules. We will describe a few of the most common exceptions in a simplified manner here, but this is not a comprehensive list. 

These exceptions can appear deceptively simple. Even when a dividend seems like it clearly ought to fit within an exception, you should still consult with your tax advisor in advance, to ensure it actually applies. The rules are very difficult to interpret and have several pitfalls that can catch you by surprise if you are not well advised by a tax professional. The cost of inadvertently stepping into the TOSI rules can be very high.

1. The age 65 (“pension splitting”) exception

The TOSI rules generally apply to dividends paid to a business owner’s spouse or common-law partner. Unless an exception is available, any dividends paid to a business owner’s spouse would normally be taxed at the highest marginal tax rate. The age 65 exception can help avoid the TOSI rules for dividends paid to a spouse or common-law partner.

The age 65 exception is available only if two requirements are met. First, the business owner must have reached the calendar year in which they expect to turn 65 years old. Second, that business owner must be able to receive a dividend without TOSI applying to them. If both of these requirements are met, that business owner’s spouse can receive dividends without the TOSI rules applying, to the same extent that the active business owner can.

Note that this does not require the dividend recipient to be 65 years of age. Instead, it is their spouse—the active business owner—that must have reached age 64 before the year began. This means that it is possible to split income with a younger spouse, as long as the older spouse meets the requirements and could have received a TOSI-exempt dividend.

2. The active worker (“excluded business”) exception

The TOSI rules are not intended to apply to people who are deeply involved in the business’s activities. Instead, the focus of these rules is to prevent income splitting with uninvolved family members. The active worker exception is designed to ensure dividends can be paid to actively involved family members.

Under this exception, a person can receive dividends from a business as long as they reached age 17 before the calendar year began and they are “actively engaged on a regular, continuous and substantial basis in the activities of the business.”

It can be difficult to interpret the meaning of that phrase. At a bare minimum, a person is deemed to meet this exception if they work an average of at least 20 hours per week in the business in either the current year or in any five previous years. Once they meet that requirement in any five previous years, they will be able to benefit from the active worker exception thereafter, even if they no longer work for the business. This is particularly useful for family businesses, where the business owner’s children may work part-time for many years before beginning their own careers.

It is important not to take this exception (or any exception to TOSI) for granted. While it may appear obvious in some cases that a family member has met this 20-hour-per-week requirement, it can be surprisingly difficult to interpret. Furthermore, it is generally the dividend recipient’s responsibility to prove they met the exception, which can be difficult if the company does not keep good records of family members’ work hours. As with all TOSI exceptions, it is vital to confirm with your tax advisor whether this exception is available in your circumstances before committing to pay a dividend.

3. The business owner (“excluded shares”) exception

Involvement in a business does not always require active labour. In the right situation, it may be possible to avoid the TOSI rules exclusively by holding shares directly in the operating company. This is a particularly narrow exception with many surprising limitations, so it is important to discuss with your tax advisor if you intend to plan into it.

For a shareholder to be exempt from TOSI under the excluded shares exception, they must meet four requirements:

  1. the dividend recipient must have reached age 24 before the beginning of the calendar year;
  2. the dividend recipient must own shares directly in the operating business that entitle them to 10% or more of the voting rights over the company and that are worth 10% or more of the total share equity in the company;
  3. the business cannot be a professional corporation and must earn at least 10% of its business income from something other than the provision of services; and
  4. the company must earn substantially all of its income from something other than businesses in which a person related to the dividend recipient is involved.

For example, imagine a business owner was a shareholder of a company that sells construction equipment entirely to unrelated third parties. Since the business earns its income from unrelated businesses, is not a professional corporation, and earns at least 10% of its business income from something other than the provision of services, it may be possible to arrange to split income with family members by arranging for those family members to own 10% or more of the company’s voting shares, provided those shares are worth 10% or more of the total share equity in the company.

Please note that these requirements are much more complex than they appear above. If a person were to hold their interest in a company indirectly (e.g., through a holding company or family trust), this exception may no longer apply. This exception generally requires careful structuring with a tax advisor in order to meet all of the requirements. There are several surprising pitfalls that can prevent a person from accessing this exception, which are not outlined here.

4. The related business exception

The purpose of the TOSI rules is generally intended to prevent a person from splitting income from a business among their family. For the rules to apply, there must be a “business” in existence for the year. In many cases, a business owner reaches a stage in life where they choose to wind down all of their operations or sell each of their businesses to a third party. For tax years that begin after that time, there may no longer be a business in existence for the year. In such a case, it is sometimes possible to arrange to split income while avoiding the TOSI rules.

Practically, this means that the TOSI rules apply very differently once a business owner has chosen to retire. Where a business owner has ceased to operate any business, but continues to hold passive investments within a holding company, for example, it is sometimes possible to split the income from those investments with family members without the TOSI rules affecting that split income. This is only possible to the extent the investment activity does not constitute a “business” for tax purposes.

This exception is especially challenging to rely on with any degree of confidence. While the CRA has shown some level of support for income splitting in this kind of scenario, it is only possible in narrow circumstances. Again, it is vital for your tax advisor to review your situation and confirm whether TOSI would apply to any attempt to split income from a company, even after you have ceased business operations or sold your business.

Seek advice before income splitting

Since the introduction of the TOSI rules, it has become much more difficult for business owners to split income through a corporation. However, this does not mean that income splitting is no longer an available strategy in Canada. Instead, it means that a greater degree of diligence is required in order to plan intentionally for the exceptions to the TOSI rules.

These rules and their exceptions are complex. The exceptions described above have been heavily simplified for the sake of brevity. In reality, there may be many cases where an exception appears to apply to a particular dividend, but the TOSI rules still affect it.

Due to the complexity of interpreting the exceptions, it is worthwhile to consult with your tax advisor to understand whether income splitting through corporate dividends is possible or advisable in your circumstances. While income splitting remains a possibility through corporations with proper structure and in the right circumstances, the cost of stepping inadvertently into the TOSI rules can be very high.

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