The Canada Revenue Agency (CRA) was recently asked their view on whether the “reasonable return” exception in would apply to preclude the application of the tax on split income (“TOSI”) rules.

An adult individual who is resident in Canada (“Spouse A”) incorporated a company (“Opco”) to operate a non-services business. Spouse A’s initial investment in Opco was in the form of common shares of Opco that Spouse A received as consideration for the cash subscription price. Sometime later, and during a period of financial difficulty, Spouse A made a cash loan to Opco. Opco later repaid the cash loan to Spouse A. In both cases, the cash that was used by Spouse A came from a joint account in the name of Spouse A and his/her spouse (“Spouse B”).

The common shares of Opco are now held by a holding company (“Holdco”). The common shares of Holdco are held by a discretionary family trust (Family Trust”) in which Spouse A is the sole trustee, and Spouse A and Spouse B are among the beneficiaries. When Opco is profitable, taxable dividends are paid from Opco to Holdco and then from Holdco to the Family Trust. The Family Trust designates this taxable dividend income equally to Spouse A and Spouse B.

Spouse A has always been actively involved on a regular, continuous and substantial basis in the business of Opco. However, Spouse B has never been involved in the business of Opco. Spouse A and Spouse B are both at least 24 years old.

Where the “excluded share” or “excluded business” safe harbour exceptions do not apply, the most appropriate test for determining whether the income of a specified individual from a related business should be excluded from split income should be based on whether the amount received is a reasonable return.

Although the cash used to fund Spouse A’s initial share investment in Opco and to make the loan to Opco was stated to be from cash that came from a joint account in the name of Spouse A and Spouse B, the CRA commented that the legal form of these transactions strongly suggests that Spouse B has not made any direct or indirect contribution of property to Opco. Furthermore, taking an overly broad interpretation that a specified individual has made an indirect financial contribution to a business such that the reasonable return would apply to prevent the amount from being split income would appear to frustrate the underlying tax policy of the TOSI rules.

Caution is to be exercised in applying the TOSI rules given the uncertainty in their application.