Income Splitting and the TOSI Rules

Income splitting is the practice of shifting income from a higher-income family member to a lower-income one so that the income is taxed in the lower earner's hands, at a lower marginal rate. For decades it was one of the most common goals of private-company tax planning in Canada. Since 2018, however, the tax on split income (commonly called TOSI) has dramatically narrowed what works. When TOSI applies, the affected amount is taxed at the highest marginal tax rate, removing the benefit of moving income to a lower-bracket family member.

The rules live in section 120.4 of the Income Tax Act, and they are dense. They start from a broad definition of "split income" that captures many amounts received from a private business connected to a family member, and then carve back out a series of excluded amounts that are not subject to the highest-rate tax. Whether a dividend, a share of partnership income, or interest escapes TOSI usually turns on which exception, if any, applies. This page explains how the regime works, which exceptions matter, and where genuine income-splitting opportunities remain. It is general information about the law, not legal advice for your situation.

What the tax on split income is

TOSI is a special tax that applies to certain income a "specified individual" receives that is treated as split income. Where it applies, the split income is effectively taxed at the highest federal and provincial marginal rates, and the usual progressive brackets and most personal credits do not shelter it. The practical result is that paying a dividend to a low-bracket spouse or adult child produces no rate advantage if the amount is caught.

The regime originally applied only to minors, and was widely known as the "kiddie tax." Effective for the 2018 and later tax years, the federal government greatly expanded it to capture amounts paid to adult family members as well, unless an exception is met. That expansion made TOSI a central concern for almost every Canadian family that operates a business through a corporation, partnership, or trust.

Several concepts drive the analysis. A specified individual is generally a Canadian-resident individual connected to a person carrying on or owning the business, and a source individual is, broadly, the related person from whose business the income flows. Split income itself captures categories such as taxable dividends and shareholder benefits from private corporations, certain partnership and trust income derived from a related business, and certain interest on debt of a private corporation. Because the definitions are broad, the real work is usually in the exceptions.

Split income and the excluded amount

The structure of section 120.4 is to define split income broadly and then to remove from it any amount that qualifies as an excluded amount. An excluded amount is not subject to TOSI. Most TOSI planning is, in substance, an effort to bring an amount within one of these exclusions and to document that it qualifies.

The main exclusions, each discussed below, are the excluded business, excluded shares, the reasonable return on contributions, and a set of age-based rules, including treatment of certain amounts for individuals who have reached 65 and amounts connected to a retired or deceased spouse. There are also exclusions for certain taxable capital gains and for income from property acquired through the breakdown of a marriage or common-law partnership. The availability of each exclusion depends on precise, fact-specific tests, and on the age of the individual receiving the income.

The excluded business exception and the 20-hour safe harbour

One of the most important carve-outs is for income from an excluded business. In general terms, an amount is an excluded amount, and therefore outside TOSI, if the individual was actively engaged on a regular, continuous and substantial basis in the activities of the business, either in the year or in any five previous taxation years. The idea is that a family member who genuinely works in the business should be able to be paid from it without the highest-rate tax applying to that income.

Because "regular, continuous and substantial" is inherently uncertain, the legislation provides a bright-line safe harbour: an individual is deemed to be actively engaged on a regular, continuous and substantial basis in a given year if they work in the business at least an average of 20 hours per week during the portion of the year in which the business operates. Meeting the 20-hour test in a year is the cleanest way to satisfy the excluded-business exception for that year, and the five-year look-back means that someone who met the test in earlier years can continue to qualify even after reducing their hours.

The safe harbour is exactly that, a safe harbour. A person who works fewer than 20 hours per week may still be actively engaged on a regular, continuous and substantial basis on the facts, but they lose the certainty the bright line provides, and the burden of showing genuine involvement falls on them. This is why contemporaneous records, such as timesheets, calendars, payroll records, and a description of duties, matter so much. Whether a particular family member's role qualifies is closely tied to broader decisions about how owners and their families draw compensation, which we address under owner-manager compensation.

Excluded shares

A second key exclusion is for income from excluded shares. Where an individual aged 25 or older owns excluded shares of a corporation, dividends and other income on those shares are generally excluded amounts, outside TOSI. To be excluded shares, the shares must meet several conditions at the same time, and all of them must be satisfied.

• The individual must own shares carrying at least 10 percent of the votes and 10 percent of the value of the corporation. This is often referred to as the 10-percent test.
• The corporation must earn less than 90 percent of its business income from the provision of services. This requirement effectively keeps most professional and service businesses outside the excluded-shares exception.
• The corporation must not be a professional corporation, such as one carrying on the practice of law, accounting, medicine, dentistry, or another profession to which that concept applies.
• Substantially all of the corporation's income must not be derived from another related business.

The interaction of these tests is significant. Because the exclusion is unavailable to professional corporations and to most service businesses, it tends to help owners of product, manufacturing, and certain trading businesses far more than owners of practices. Incorporated professionals, in particular, often cannot rely on excluded shares at all, which is why their family compensation planning requires its own analysis, discussed under tax planning for incorporated professionals.

The reasonable return test

Where neither the excluded-business nor the excluded-shares route is available, an amount may still be an excluded amount if it represents a reasonable return. For an individual who is 25 or older, an amount is excluded to the extent it is a reasonable return having regard to the relative contributions the individual has made to the business. The factors the legislation directs you to weigh include the work the individual performed, the property or capital the individual contributed, the risks the individual assumed, the total amounts paid to the individual, and any other relevant factors.

For individuals aged 18 to 24, the analysis is stricter. Rather than a full reasonable-return test, the rules generally limit the excluded amount to a reasonable return on capital the individual actually contributed, and where that capital was funded with money borrowed from, or property transferred by, a related person, the permitted return can be capped at a prescribed rate. A young adult cannot escape TOSI simply by pointing to capital that was, in substance, provided by a parent.

The reasonable-return analysis is the most judgment-laden part of the regime. There is no formula; it is a facts-and-circumstances inquiry, and the Canada Revenue Agency has indicated it will generally not second-guess a return that is genuinely reasonable. The flip side is that an amount described as a "reasonable return" without real contributions to support it is exposed, so building and documenting the record of work, capital, and risk is central to relying on this exclusion.

Age-based carve-outs: 65 and retirement

Section 120.4 contains important relief tied to age and retirement, designed to align TOSI with the rules that allow pension-style income splitting between spouses later in life.

The central rule is that an amount is an excluded amount for an individual if it would have been an excluded amount for their spouse or common-law partner had the spouse received it, where that spouse has reached 65 years of age in the year. In practice, once one spouse turns 65, dividends and similar amounts that are within the rules for that spouse can be shared with the other spouse without TOSI applying, broadly mirroring the policy behind pension splitting. There is also relief where amounts derive from a business in respect of which a spouse was actively engaged, and relief for amounts that come to a surviving spouse on death. The combined effect is that the regime is considerably more flexible for couples at and after age 65 than for younger families.

These provisions reward planning that looks ahead to retirement. A structure that constrains income splitting during a couple's working years may open up once a spouse reaches 65, and the design of share ownership and dividend policy should anticipate that shift.

Prescribed-rate loans as a remaining strategy

TOSI sharply limited the splitting of business income, but it did not repeal the attribution rules, and one well-established technique for splitting investment income remains available: the prescribed-rate loan. Ordinarily, if a higher-income spouse simply gives investment capital to a lower-income spouse, the attribution rules in the Income Tax Act tax the resulting income back in the hands of the transferor, defeating the split. The same concern applies to transfers to minor children.

The attribution rules contain an exception for a genuine loan that bears interest at no less than the prescribed rate. If the higher-income spouse lends money to the lower-income spouse (or to a family trust) at the CRA's prescribed rate, and the borrower pays the interest each year by January 30 of the following year, the investment income earned on the borrowed funds, above the interest cost, is taxed in the borrower's lower-bracket hands rather than attributed back. The prescribed rate that applies is the rate in effect when the loan is made, and it is locked in for the life of the loan, which is why loans established when the prescribed rate is low can be valuable for many years.

A prescribed-rate loan must be implemented carefully. The loan should be properly documented, interest must be paid on time every year, and missing an annual payment can taint the arrangement going forward. Because the strategy turns on the attribution rules rather than on a TOSI exclusion, it is often the most reliable way to move investment income within a family today, and it frequently forms part of a broader family trust and holding company strategy.

Family trusts after TOSI

A discretionary family trust was historically a flexible income-splitting vehicle: it could allocate dividends from an operating company among beneficiaries in lower tax brackets, including adult children and a spouse. TOSI changed the calculus, because income that flows through a trust to a beneficiary generally retains its character for TOSI purposes. If a dividend would be split income in a beneficiary's hands when received directly, routing it through a trust does not, by itself, change that result.

That does not make family trusts obsolete. Trusts continue to serve essential roles in multiplying the lifetime capital gains exemption on a future sale of the business, in implementing an estate freeze, in asset protection, and in succession. A trust can also hold the funds advanced under a prescribed-rate loan, and it can distribute to beneficiaries who genuinely qualify for a TOSI exclusion, such as a beneficiary who meets the excluded-business test or whose income is a reasonable return. The point is that the trust must be operated with the TOSI character-flow-through in mind, rather than treated as a way around the rules. We address the mechanics under family trust tax planning.

When TOSI problems tend to surface

In our experience, TOSI questions arise in recurring situations:

• Existing dividend-sprinkling structures. A corporation that paid dividends to a spouse or adult children before 2018 must reassess whether those dividends still escape TOSI under the post-2018 rules, and on what basis.
• Family members with reduced roles. A spouse or child who once worked full time in the business but has since stepped back must consider the five-year look-back and whether the excluded-business exception still applies.
• Professional and service corporations. Owners who cannot rely on excluded shares need a defensible reasonable-return or active-engagement basis for any amounts paid to family.
• CRA review. The Canada Revenue Agency reassesses on the basis that an amount is split income and that no exclusion applies, often focusing on the adequacy of documentation.

In each case, the outcome turns on facts: who received the income, their age, the nature of the business, their genuine contributions, and the quality of the records. The same dividend can be entirely outside TOSI or fully caught depending on details that are easy to miss.

How Barrett Tax Law approaches this

Our tax lawyers begin by mapping the family and the business. We identify who receives income from the company, how each person is related to the source of that income, and the character of every relevant amount, so that we can see what is potentially split income. From there, we work through the excluded-amount exceptions in order: whether anyone meets the excluded-business test (including the 20-hour safe harbour and the five-year look-back), whether the shares qualify as excluded shares, whether amounts can be supported as a reasonable return, and whether the age-based rules at and after 65 are available.

We also look at the planning that still works. Where investment income is involved, we consider whether a prescribed-rate loan is appropriate and how to document and administer it correctly. Where a family trust is in place or contemplated, we assess how TOSI affects distributions and how the trust continues to serve goals such as the capital gains exemption and succession. And where the Canada Revenue Agency has already reassessed on the basis of section 120.4, we develop the response through the objection and, if necessary, the appeal process, as part of our work on tax disputes and objections.

If you are reviewing how your family draws income from a business, planning a structure that involves a spouse, children, or a trust, or facing a reassessment that invokes the tax on split income, you are welcome to reach out for a free, confidential consultation to discuss your circumstances and the options available to you.