This is the third instalment in a series of articles examining the draft legislation and explanatory notes on Canada’s new income-splitting rules, issued by the Department of Finance on December 13, 2017 and which are to be effective as of January 1, 2018. This instalment will explore what the new rules will mean for partnerships in Canada.
Please see our first article in the series for an overview of the new income-splitting rules. You may also refer to our follow-up article which explores the possibility of restructuring and the importance of the related business concept.
The new Tax on Split Income ("TOSI")
TOSI expands on what was known as the “kiddie tax”, previously applied to children under the age of 18 years. Income caught under these rules was taxed at the top marginal rate, negating access by minor children to graduated rates of tax, access to the credit for the basic personal exemption and numerous other tax credits. In an expansion of the kiddie tax, the government now proposes to apply the TOSI in respect of amounts received by “specified individuals”, both minors and adults, from a “related business” where a “source individual” is involved.
Source individuals, specified individuals and related business
A specified individual, a source individual and a related business are the necessary components where TOSI rules apply to partnerships.
A “specified individual”[i] is meant to be the low rate taxpayer to whom the high rate taxpayer is directing income. In this article, we will refer to the specified individual as the low rate taxpayer, although the definition does not in fact require a specified individual to be a low rate taxpayer.
A “source individual” with respect to a specified individual is an individual (other than a trust) who at any time in the year is resident in Canada and related to the specified individual. In this article, we will refer to the source individual as the related person.
A “related business” in respect of a low rate taxpayer includes a business carried on by a partnership or a corporation where a related person is at any time in the year actively engaged on a regular basis in the activities of the partnership or corporation and is earning income from the business. If there is no related business, then there is no tax on split income. It is income from a “related business” which is subject to the TOSI rules.
A related business is also deemed to include a business of a particular partnership where a related person in respect of the low rate taxpayer has an interest in the particular partnership (no matter how small the interest). This definition does not require the related person to be actively involved in the partnership in question. Let’s call this the partnership ownership rule. This differs from the definition of a related business in the context of a corporation. A business carried on by a corporation will only be a related business if the related person owns 10% or more of the fair market value of the corporation, either through share ownership or ownership of property that derives its values from such shares.
A case study under the new rules
In order to illustrate the application of the new TOSI rules to partnerships, consider the following hypothetical situation. Susan is a CPA and a 5% partner in a professional accounting practice (the “Accounting Partnership”). A separate partnership (the “Consulting Partnership”) has been set up to provide consulting services directly to the clients of the Accounting Partnership. Susan does not provide any services to the Consulting Partnership and the Consulting Partnership does not provide any services to the Accounting Partnership.
Susan sets up a family trust (the “S Family Trust”) which has Susan’s two adult children as beneficiaries (but not Susan) and this trust is a 5% partner of the Consulting Partnership. Up until 2018, 5% of the income of the Consulting Partnership has been allocated and paid to the S Family Trust, which in turn has allocated and paid this income to Susan’s children who are low rate taxpayers. Both of Susan’s children are in full time attendance at university and have never worked for either the Consulting Partnership or the Accounting Partnership.
The question is whether the application of the new TOSI rules will no longer allow the Consulting Partnership income to be allocated to Susan’s children at low rates of tax.
Partnership ownership rule
A partnership interest in the Consulting Partnership is owned by the S Family trust. If more than one member of Susan’s immediate family is a beneficiary of the S Family trust, it appears that the Consulting Partnership business would be a related business in respect of each such family member. The partnership ownership rule states that if a related person in respect of the low rate taxpayer has an “interest” in a partnership, the partnership business is a related business. Either one of Susan’s children who are both related to each other has an interest (albeit an indirect one) in the particular partnership through the S Family Trust.
The partnership ownership rule provides that if two related persons, such as siblings, become partners in the same partnership, any business income from that partnership will be income from a related business. The definition of related business does not in fact require the specified individual to be a low rate taxpayer.
Even though the income may come from a related business, it should be remembered that such income can still fall under the definition of “excluded amount” which is not subject to TOSI; for an example, see the section on the excluded business exemption found a little later in this article.
If anyone related to the low rate taxpayer, including Susan or either of Susan’s adult children, holds any shareholder interest in the general partner of the partnership in question, that may be sufficient to make the partnership ownership rule apply.
In terms of defining an “interest” in a partnership, there is discussion as to whether this means an ownership interest or an economic interest. If the child’s interest in the partnership is owned by an interposed trust, the income tax law will normally not attribute the ownership interest to the child although it will attribute the economic interest to the child. This point of law needs to be clarified in order to determine whether the interposition of a trust will block related business status in respect of a trust beneficiary. This appears to be contrary to the policy behind the proposed rules.
If the S Family trust had only one beneficiary or if the trust were able to roll out the Consulting Partnership unit to one beneficiary of the S Family Trust, i.e. one of Susan’s adult children, the business carried on by the partnership would no longer be a related business because the partnership ownership rule would no longer apply and because Susan and her children are not actively engaged in the business activities of the Consulting Partnership.
Once the business carried on by the partnership is no longer a related business, the income from the business carried on by the partnership would not be caught by the interpretation of “split income” as discussed in the next section of this article.
The definition of split income expands the notion of partnership income subject to the TOSI rules. The definition includes partnership income which “can reasonably be considered to be income derived directly or indirectly from one or more related businesses in respect of the individual.” This is a concept which does not limit itself to the business of the partnership but examines the businesses of the clients of the partnership.
The income derived by the Consulting Partnership does not come from the Accounting Partnership since the clients of the Accounting Partnership are billed directly by the Consulting Partnership. What if the Consulting Partnership provided consulting services to the clients of the Accounting Partnership but instead of billing the clients directly it billed the Accounting Partnership which then invoiced its clients? What if the Consulting Partnership instead of providing consulting services to arm’s length third parties, provided administrative services to the Accounting Partnership?
The legislative provisions which exist prior to the amendments capture income derived from the provision of property or services by a partnership or trust to or in support of a business carried on by:
- a person related to the individual;
- a corporation in which a person related to the individual has an interest of 10% or more; or
- a professional corporation in which a person related to the individual is a shareholder.
Pursuant to this wording, it is clear that services provided by the Consulting Partnership to the Accounting Partnership, whether consulting services or administrative services, would be caught. The Accounting Partnership’s business is in part carried on by Susan who is related to her adult children.
A distinction could be made between “income derived from the provision of property or services by a partnership to a related business” (wording in the current legislation) as opposed to “income derived directly or indirectly from one or more related businesses in respect of the individual for the year” (wording in the draft legislation).
It is not so clear under the draft wording whether services provided by the Consulting Partnership to the Accounting Partnership, would be caught.
It is clearly the intention of the government to capture income paid by the Accounting Partnership to the Consulting Partnership but it is not clear that the proposed wording is sufficient. Ordinarily, the government should be amending the wording to avoid any uncertainty.
If the draft legislation is sufficient to catch services provided by the Consulting Partnership to the Accounting Partnership, then the following example may lead to a surprising result. Suppose an office supply company sells office supplies to the Consulting Partnership, which in turn provides those office supplies to the Accounting Partnership with a 15% mark-up. Suppose someone related to a partner of the Accounting Partnership is a 5% shareholder of the office supply company but is not personally engaged in the company’s business. Does that mean that any dividend received by that shareholder of the office supply company is split-income subject to income tax at the top-rate because such income is “income derived directly or indirectly from one or more related businesses (the Accounting Partnership) in respect of the individual for the year?”
There are TOSI exemptions which are available in respect of income from partnerships, the most important of which would be income from an “excluded business.” This exemption extends to a low rate taxpayer who is actively engaged on a regular, continuous and substantial basis in the activities of the business generally in either the taxation year in question or any 5 prior taxation years. This exemption would not apply to Susan’s adult children since they were never involved in the activities of the partnership in question.
The TOSI partnership rules are not as simple as they first appear and there is room for analysis. All partnership structures which allow for allocation of income to lower income partners directly or through trusts should be reviewed. In scenarios similar to the example mentioned above, the business of the consulting or administrative partnership should be restructured, if possible, to provide services directly to the clients of the professional partnership and not to the professional partnership with only one relevant low income person having an interest in the partnership.