Each of three resident siblings (C-1, C-2 and C-3, all over 25) held an equal number of non-voting preferred shares of Investco, their father (M-1) held voting preferred shares of Investco, and three trusts for each sibling and their respective families (C-1 Trust, C-2 Trust and C-3 Trust) held an equal number of voting common shares of Investco with fair market values ("FMVs") equaling at least 10% of that of the Investco common shares.
In 2019, Opco (which did not carry on a services business) purchased for cancellation its shares held by Investco in consideration for an interest-bearing term note (the "Note"), after which, C-3 Trust held 80 out of the 100 non-voting common shares of Opco, as well as 80 voting preferred shares of Opco.
C-3 had worked more than 20 hours per week, for more than five years, as the general manager of Opco, whereas C-1 and C-2 had no involvement in its business. The directors of Investco were M-1 and C-1.
In 2019, in addition to the deemed dividend received by Investco from Opco, substantially all of Investco's revenues consisted of the interest on the Opco Note. In 2020, 85% and 15% of Investco's revenues were Note interest and investment income, respectively; and in 2021, these proportions were 75% and 25%, respectively. Investco held a portfolio of investments (managed by a broker) which it had acquired over the years from dividends received from Opco. It is assumed that Investco is carrying on an investments business.
Would the dividends received in 2020 and 2021 by Trust C-1, Trust C-2 and Trust C-3 on their Investco Common Shares and distributed, designated pursuant to s. 104(19), to their respective beneficiaries namely, C-1, C-2 and C-3 (the "Designated Amounts"), be subject to the tax on split income ("TOSI")?
Regarding the exclusion in s. (e)(i) for income from property not derived from a related business in respect of the specified individual, CRA stated that, assuming that the dividends were paid out of Investco's investment income cash flow, “the Designated Amounts would not be considered to be derived directly or indirectly from Opco's business, consistent with our position that ‘second generation’ income would generally not be considered to be an amount derived directly or indirectly from the original business,” but that on the indicated assumption as to Investco’s business, the Designated Amounts would be considered to be derived, directly or indirectly, from Investco's business.
Regarding whether Investco's business would be a "related business" in respect of C-1, C-2 and C-3 for the year. CRA indicated, regarding the “participation test” in s. (a)(ii) of that definition, that “prima facie, the mere fact of M-1 and C-1 acting as directors of Investco would not be sufficient in itself to consider that they were actively involved, on a regular basis, in the activities of Investco's business,” but that the “ownership test” in s. (c) of the definition might be satisfied depending on the FMV of the Investco preferred shares held by each of C-1, C-2 and C-3 and also given that the interests in the trusts represented property some or all of whose FMV was derived, directly or indirectly, from the shares of Investco. If, on this basis, Investco's business was a related business in respect of C-1, C-2 and C-3 for the relevant year, the Designated Amounts would not be excluded amounts pursuant to s. (e)(i) of "excluded amount" –whereas if the dividends were paid out of Investco's investment income and Investco's business was not a related business in respect of C-1, C-2 and C-3, the Designated Amounts could be excluded under s. (e)(i).
Alternatively, assuming that the dividends were funded with the Note interest, it might be reasonable to conclude that C-3 met the participation test and that, consequently, Opco would be a related business with respect to C-1 and C-2 for the years 2020 and 2021. No source individual in respect of C-3 would meet the participation test in s. (a)(ii) of “related business,” but source individuals in respect of C-3 (e.g., his spouse and children) could meet the ownership test in s. (c)(ii). However, those amounts could be excluded amounts under s. (e)(ii) of “excluded amount” and s. 120.4(1.1)(a), given C-3’s active involvement in the Opco business.
However, Designated Amounts allocated to C-1 and C-2 derived from such Note interest paid as dividends would be considered to be amounts derived, directly or indirectly, from a related business in respect of C-1 and C-2 for the year and would not be excluded pursuant to s. (e)(i) of "excluded amount" in subsection 120.4(1).
Would this answer change if, prior to the dividend payments, the Investco common shares held by the three trusts were distributed by them to their respective beneficiaries (C-1, C-2 and C-3) and the Investco voting preferred shares held by M-1 were redeemed?
After noting that Investco's business would then qualify as a "related business" with respect to each of C-1, C-2 and C-3 since a source individual with respect to each of them would satisfy the ownership test in s. (c)(ii) of “related business,” CRA noted that the Investco shares would not qualify as “excluded shares” - by virtue of not satisfying para. (c) of the definition - given that: for the 2020 year, substantially all of Investco's income for the preceding year (2019) was derived, directly or indirectly, from Opco's business, a related business in respect of C-1 and C-2; and for the 2021 year, 85% of Investco's income for 2020 was derived, directly or indirectly, from the business of Opco.
CRA went on to apply a similar analysis regarding whether the deemed dividends received by C-1, C-2 and C-3 on the redemption of the Investco preferred shares would be excluded under ss. (e)(i) or (ii), or (g)(i), of “excluded share.”