A recent tax change that has gotten a lot of attention is the tax on split income, or “TOSI”. Through design or inadvertently, many trusts will be affected by these rules. Many family trusts were set up at least partially to split income to family members. Even when income splitting is not an express purpose of the trust, where a trust owns property that earns money from the work or investment of a person (“source individual”) who is related to a beneficiary, there is a risk TOSI may apply.
Things Trustees and their advisors should know about TOSI
1. TOSI doesn’t just apply to dividends
While dividends have gotten the most press, TOSI may apply to any income from a “related business”.
A related business is any business, whether operated personally or through a partnership, corporation or trust, where a source individual at any time during the year was “actively engaged on a regular basis in the activities” or in which he or she had a qualifying interest (for a corporation this is 10% or more). TOSI may apply to any dividends, shareholder benefits, capital gains, or interest derived from a related business.
This means trustees need to look carefully at any source of income and ensure it is not caught under the TOSI rules. I recommend starting with the assumption that TOSI applies to any income, unless you can find a reason why it should be excluded.
2. Beneficiaries of trusts cannot own “excluded shares” through a trust
One of the main exclusions to the TOSI rules is if the recipient owns “excluded shares”. Shares are excluded shares when an individual owns at least 10% of the shares of a corporation which meet specific criteria. Income earned on excluded shares, or gains earned on disposing of excluded shares, are not caught by TOSI.
Unfortunately, even if a trust owns shares that would otherwise be excluded shares, income allocated through the trust to a beneficiary on those shares owned by the trust will not qualify as shares “owned by the specified individual”, (and therefore not “excluded shares”) since the beneficiary and not the trust would be the specified individual.
This is a significant disadvantage of owning what otherwise might qualify as excluded shares through a family trust. In some cases, it may make sense to distribute shares owned by a trust to a beneficiary so they do qualify as excluded shares for that particular beneficiary.
3. Some exclusions from TOSI will still apply to allocations from trusts
There are, however, exclusions that will still apply to payments through a trust.
While capital gains from a related business are now generally caught by TOSI, capital gains that qualify for the capital gains exemption are specifically excluded, including for allocations from trusts.
A second exemption is that if the income derives from a business which is an “excluded business” for the beneficiary, then it will not be caught by TOSI.
A business will be an “excluded business” if the beneficiary was actively engaged on a regular, continuous and substantial basis in the activities of the business in either the taxation year or any prior five taxation years.
While “actively engaged” is not defined, if the beneficiary works at least an average of 20 hours per week in the business (while the business operates), the beneficiary will be deemed to be actively engaged.
Recent CRA publications and responses to questions at conferences have also suggested that passive investment income earned on the investment of income from a related business, is not itself necessarily income from that related business.
This suggests that, with the right structure, investment income earned on income itself caught by TOSI could be an excluded amount.
The new TOSI rules will make things more complicated for trustees and their advisors when it comes to allocating income to beneficiaries. Existing trusts should be re-examined to determine whether they should be restructured or their operations changed. Potential settlors, trustees and their advisors will need to more carefully consider whether setting up a new trust is the best option.
However, trusts will continue to be used for non-tax reasons where it is advisable to separate legal and beneficial ownership and, depending on individual circumstances, trust will continue to make sense in certain tax plans.