Trust Tax on Split Income Strategy (and Tax Concerns)
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To manage the Tax on Split Income (TOSI) within a Canadian trust, the primary strategy involves qualifying for specific bright-line exceptions that remove the income from the highest marginal tax rate. One of the most effective methods for trusts holding private corporation shares is the Excluded Business exception, which applies if a beneficiary (over the age of 18) is actively engaged in the business for at least 20 hours per week in the current year or any five prior years. Once this five-year test is met, the beneficiary is effectively green-lighted for life, allowing the trust to distribute dividends to them without triggering TOSI. Another vital strategy is the multiplication of the Lifetime Capital Gains Exemption; while TOSI generally targets dividends, capital gains from the sale of Qualified Small Business Corporation shares are often excluded from TOSI, allowing a trust to allocate these gains to multiple family members to shelter significant amounts of tax.
For beneficiaries who cannot meet the active involvement test, trusts often look to the Excluded Shares exception or the Reasonable Return test, though these are more restrictive. To qualify for the excluded shares exception, an individual must personally own at least 10% of the votes and value of the corporation, which can be problematic for trust structures where the trust, rather than the individual, holds the title. Consequently, if the 10% test cannot be met through the trust, the strategy may require a rollout of shares from the trust to the individual beneficiary before a dividend is paid. Additionally, for spouses of business owners who are aged 65 or older, a special exclusion exists where the spouse can receive TOSI-exempt income if the owner-spouse would have been exempt had they received it themselves.
Implementing these strategies carries significant tax risks, most notably the risk of miscalculating the 20-hour active engagement rule. The Canada Revenue Agency (CRA) requires rigorous documentation to prove a beneficiary’s involvement, and failing to provide such evidence can result in the income being re-characterized as split income taxable at the top rate. Furthermore, the Reasonableness Test is inherently subjective, as the CRA evaluates the reasonableness of a payment based on the beneficiary’s labor, capital contribution, and risks assumed. If the CRA deems a dividend distribution through a trust to be excessive relative to these factors, the excess portion will be subject to TOSI, potentially leading to unexpected tax liabilities and interest penalties.
Beyond TOSI itself, trusts must navigate attribution rules under Sections 74.1 to 74.5 of the Income Tax Act (Canada), which can override income-splitting efforts. Even if a distribution escapes TOSI, income can be attributed back to the person who originally contributed the property to the trust (usually the settlor or a lender) if the property was transferred for less than fair market value or if the trust is considered a reversionary trust under Section 75(2) of the Income Tax Act [more on attribution rules]. To mitigate this, a common approach is the prescribed-rate loan strategy, where a high-income individual lends money to the trust at the CRA’s official interest rate. This ensures that while the trust pays interest back to the lender, the remaining investment growth can be split among beneficiaries without falling prey to the attribution rules (more on prescribed-rate loan strategy).
Finally, the long-term viability of a trust strategy is threatened by the 21-Year Deemed Disposition Rule, which mandates that a trust is treated as having sold its assets at fair market value every 21 years. If a trust is used solely for TOSI management without a plan for this anniversary, it could trigger a massive, unfunded capital gains tax hit (more on tax-deferred roll-out strategy). Additionally, the CRA’s expanded trust reporting requirements (Schedule 15) now require much more transparency regarding "beneficial ownership," making it easier for tax authorities to audit the flow of funds. Effective implementation requires a delicate balance of active involvement tracking, careful adherence to loan interest payment deadlines (January 30th each year), and proactive planning for the eventual distribution of trust assets.
Contact our law firm today to learn how our legal team can help you plan for the future, including wills, trusts, powers of attorney, personal directives and other estate planning documents, or deal with the legal demands associated with the passing of a loved one. Contact our law firm at 403-400-4092 or via email at Chris@NeufeldLegal.com to schedule a confidential initial consultation.
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