What Is Tax on Split Income (TOSI)? — A Clear Guide

Tax on Split Income (TOSI) is a set of Canadian tax rules designed to limit certain forms of income sprinkling within families. In general, TOSI can apply when an individual receives certain types of income from a related business and the income does not qualify for one of the specific exclusions in the rules.

When TOSI applies, the affected income is generally taxed at the highest individual marginal tax rate rather than at the recipient's ordinary marginal rates. This can substantially reduce or eliminate the tax advantage that someone hoped to achieve by shifting income to a family member with a lower income.

TOSI is a specialized area of Canadian tax law, particularly when private corporations, family businesses, dividends, trusts, or significant investments are involved. The CRA's rules should be reviewed carefully before assuming that a payment to a family member is subject to, or exempt from, TOSI.

Why Does TOSI Exist?

TOSI is intended to prevent certain income-splitting arrangements in which income from a private business is shifted to family members who have not made a sufficient contribution to the business.

For example, suppose a business owner has a spouse or adult child who has little or no involvement in the business. Simply paying that family member dividends may not produce the expected tax savings. Depending on the circumstances, the dividend may be considered split income and TOSI may apply.

The rules are not intended to prevent legitimate compensation or every form of family financial planning. Instead, they contain a number of exclusions that recognize genuine contributions of labour, capital, business risk, ownership, and other circumstances.

Who Can Be Subject to TOSI?

TOSI can apply to a specified individual who receives certain types of split income from a related business and the income is not an excluded amount.

Split income can include certain taxable dividends from private corporations, certain partnership or trust income, and certain taxable capital gains connected with a related business. The detailed rules depend on the type of income and the recipient's age and circumstances.

TOSI rules also apply differently depending on whether the recipient is under 18, between 18 and 24, or 25 or older. As a result, simply saying that "dividends paid to family members are subject to TOSI" is not accurate. The specific facts have to be examined.

What Happens When TOSI Applies?

When an amount is subject to TOSI, it is generally taxed at the highest marginal individual tax rate. The special tax is reported on the individual's tax return using Form T1206, Tax on Split Income.

Some tax credits can still reduce the resulting tax. For example, the CRA identifies the disability tax credit, dividend tax credit, and foreign tax credit as credits that may be available against TOSI in appropriate circumstances.

The result is that income sprinkling can produce very different tax consequences from what someone might expect based solely on the recipient's normal marginal tax bracket.

Important TOSI Exclusions

TOSI is not an automatic tax on every payment between family members. The legislation contains several important exclusions. Some of the most relevant for adults include the following.

1. Income From an Excluded Business

An adult may be able to exclude income from a related business when they are actively engaged in the business on a regular, continuous, and substantial basis.

One important CRA bright-line test is an average of at least 20 hours per week during the portion of the year that the business operates. An individual can also qualify based on having been actively engaged in the business during at least five previous taxation years. The five years do not have to be consecutive.

Meeting the 20-hour test is not the only way to demonstrate active involvement. Where the bright-line test is not met, the facts and circumstances can still be relevant in determining whether the person was actively engaged in the business.

2. Reasonable Return

For individuals age 25 or older, a payment from a related business may qualify as an excluded amount if it represents a reasonable return based on the person's contributions to the business.

CRA guidance identifies factors such as:

• the work performed for the business;
• property or capital contributed to the business;
• risks assumed in connection with the business;
• previous amounts paid to the individual; and
• other relevant circumstances.

A payment being called a "reasonable salary" or "reasonable dividend" does not automatically make it exempt from TOSI. The underlying facts and the individual's contribution matter.

3. Excluded Shares

Certain income from excluded shares can qualify for an exclusion for an individual who is at least 25 years old.

The requirements are specific. Among other conditions, the individual generally must own at least 10% of the votes and value of the corporation, less than 90% of the corporation's business income can be from services, and the corporation cannot be a professional corporation carrying on one of the specified professional practices.

There are additional conditions, including rules dealing with income derived from related businesses. Therefore, simply owning shares in a family corporation does not automatically make the dividends exempt from TOSI.

4. Certain Inherited Property

Special TOSI rules can apply to property inherited from certain individuals. The rules recognize particular circumstances involving inherited property and can provide exclusions depending on the recipient's age, relationship to the deceased, and other facts.

Because the inheritance rules can be complicated, they should be reviewed based on the specific circumstances rather than treated as a general exemption for inherited investments.

Does TOSI Apply to Salary?

TOSI does not apply to salary or wages received by an individual. Salary is employment income rather than split income for TOSI purposes.

However, paying a family member a salary still requires appropriate consideration of the actual work performed and the normal tax and payroll rules. A salary arrangement should not be treated as a substitute for analyzing the broader tax consequences of a family business.

TOSI and Spouses

Spousal planning can be particularly confusing because several different Canadian tax concepts are sometimes described loosely as "income splitting."

TOSI primarily addresses certain income derived from related businesses. It is different from the rules that allow eligible pension income to be split between spouses or common-law partners.

Legitimate pension income splitting is not the same thing as income sprinkling from a private corporation. Eligible pension income can generally be allocated between spouses under the pension income splitting rules when the applicable CRA requirements are met. The TOSI rules should not be used as a reason to assume that ordinary eligible pension income splitting is prohibited.

CPP pension sharing is also a separate program administered through Service Canada and should not be confused with either TOSI or the CRA pension income splitting election.

Practical Examples

Example 1: Dividend to an Adult Child Who Does Not Work in the Business

Imagine that a parent owns a private corporation and pays a substantial dividend to an adult child who has no meaningful involvement in the company.

Depending on the circumstances, the dividend may be split income and TOSI may apply. The fact that the child has a much lower ordinary income-tax rate does not, by itself, guarantee a tax benefit.

Example 2: Adult Child Actively Working in the Business

Now assume the adult child works regularly in the family business and meets the requirements for the excluded-business rules.

The income may qualify for an exclusion from TOSI. Keeping good records of the individual's responsibilities and hours worked can be useful when establishing the nature and extent of their involvement.

Example 3: Capital Contributed to the Business

Consider an adult family member who contributes significant capital to a related business. Depending on the person's age and the source and nature of the capital, the TOSI rules may recognize a reasonable return on that contribution.

The tax result depends on the detailed TOSI rules and the facts. A large dividend cannot automatically be characterized as a reasonable return simply because the recipient invested some money in the company.

How to Reduce the Risk of a TOSI Problem

If you operate a family business or receive income from one, consider keeping detailed records that support the underlying arrangement.

• Document work performed: Keep records of responsibilities, schedules, hours, and other evidence of meaningful business involvement.
• Document capital contributions: Maintain records showing what capital was contributed and the associated ownership and financial risk.
• Separate salary from dividends: Salary and dividends have different tax characteristics and should not be treated interchangeably.
• Review share ownership: If relying on the excluded-share rules, verify the ownership, voting, value, and corporate-income requirements.
• Review the rules before paying dividends: A dividend that looks attractive from an ordinary marginal-rate perspective can have a very different result when TOSI is considered.
• Get professional advice when necessary: Corporate structures, reorganizations, trusts, and family-business arrangements can involve detailed rules that are difficult to evaluate using a simple tax calculator.

Where to Find the Official TOSI Rules

The Canada Revenue Agency provides detailed guidance on TOSI and income sprinkling. For individuals filing a tax return, CRA's guidance for line 40424 explains the federal tax on split income and provides definitions and examples.

CRA also provides Form T1206, Tax on Split Income, which is used to calculate TOSI when it applies.

Because the rules depend heavily on the recipient's age, the type of income, the source of the income, the person's involvement in the business, ownership, capital contributions, and other facts, the CRA guidance should be reviewed for the specific situation.

TOSI vs. Income Splitting: Why the Difference Matters

The terms income splitting and income sprinkling are sometimes used interchangeably, but they can describe very different tax strategies.

Income sprinkling generally refers to distributing business income among family members, often through dividends or other payments from a private corporation. TOSI is specifically designed to address certain arrangements of this type.

Pension income splitting, on the other hand, is a separate CRA provision that can allow eligible pension income to be allocated between spouses or common-law partners. It has its own eligibility requirements and election process.

Understanding which type of income-splitting strategy you are considering is therefore essential before deciding whether TOSI is relevant.

Fun Fact

The modern TOSI rules for adults were introduced as part of Canada's 2018 income-sprinkling changes. The rules use several concepts—including excluded businesses, excluded shares, reasonable returns, and arm's-length capital—to distinguish legitimate contributions from arrangements that may be subject to the special tax.

Wrap-Up

TOSI can make family-business income sprinkling much more complicated than simply paying dividends to a family member in a lower tax bracket.

At the same time, TOSI is not a blanket prohibition on paying family members. Genuine participation in a business, qualifying share ownership, capital contributions, reasonable returns, and other specific circumstances can result in exclusions.

If you are planning retirement and your income comes primarily from pensions, registered accounts, investments, or other retirement sources, TOSI may not be the issue you first expect. Understanding the distinction between TOSI, pension income splitting, CPP pension sharing, and ordinary investment income can help you evaluate the appropriate strategy.

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