Tax on Split Income (TOSI):  Why Does the Federal Government Single Out Small and Medium-Sized Family-Owned Businesses that Provide Services?

Usually tax laws apply to everyone.  However, in 2017, the Federal Government introduced a special tax on dividends that treats family-owned private businesses that provide services more harshly than other businesses that sell goods.  The Federal Government said this new tax was to create “Tax Fairness for the Middle Class”.  But is it fair that the Federal Government imposes higher tax rates just because of what kind of business you are in?

I have practiced tax for over 30 years.  I have never seen another situation where, all other factors being equal, you are taxed differently simply because of the business you are in.

Our tax system has progressive rates which means that the more you make, the higher the rate of tax you pay.  This has been largely accepted in Canada as a matter of social policy and is fair.

We also understand that capital gains are taxed differently than dividends and dividends are taxed differently than salary.

But, if two individuals, both of the same age and circumstances, earn the same amount of the same type of income, we have always had a system that treated both individuals equally.  That was until 2017.

In 2017, the Federal Liberal Government introduced a very complicated tax on split income (TOSI) that changed this basic principle.

Under the new TOSI rules, some people will pay the regular rates of tax and some people will pay the highest possible rate even if they earn exactly the same amount.

Example:  Company A is a small family-owned business that builds houses and sells the finished houses to its customers.  It is considered to be selling something other than its services.  Now imagine that Company B is the same small family-owned business, but instead it builds houses for customers who hire the Company to build the houses.  It doesn’t sell houses.  It provides house building services.

Imagine both Company A and Company B make exactly the same profit in 2019, let’s say $250,000.  Unfortunately for the shareholders of Company B, they are subject to a much more stringent test than the shareholders of Company A (see paragraph (a) in the definition of “excluded shares” in s.120.4(1)).

The Federal Government said is was opposed to income splitting for fairness reasons.  But instead the law treats businesses that provide services more harshly than businesses that sell goods.

That is unless your business is large enough to have its shares traded on a stock exchange.  Then there are no rules preventing income splitting (see paragraph (a) in the definition of “split income” in s.120.4(1)).

So what is the Federal Government trying to achieve?  The “fairness” behind this tax change is very difficult to understand.  But the result is clear:  income splitting is ok if your family business is listed on a stock exchange but not ok if it is too small to be listed.  And if your family business is small, you are favoured if you sell goods rather than provide services.

Government data shows that small and medium-sized private businesses (SME’s) employ more Canadians than large publicly traded corporations.  The data also shows that businesses that provide services are the primary drivers of our current economic growth.  So what is behind this tax?  What does “Tax Fairness for the Middle Class” really mean?  Are small family-owned businesses not part of the middle class?

Let me know your thoughts.

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