TOSI – Tax On Split Income – the brain child that is going to tax the wealthy, and not the middle-class (and those working hard to join it).

In Episode 18 of my podcast, Brainstorming (+tax), we looked at the new Tax On Split Income rules, and brainstorm the idea: what if we were unreasonable on purpose?

Over the past year, a lot of emphasis has been placed on how only “reasonable” amounts of dividends can be paid to related shareholders.

So where is “reasonable” defined in the Income Tax Act?

Truth is, it isn’t, which makes it that much harder to comply or prove you are being “reasonable”.

In fact, the closest thing you can come to is in Section 67 that states:

“In computing income, no deduction shall be made in respect of an outlay or expense in respect of which any amount is otherwise deductible under this Act, except to the extent that the outlay or expense was reasonable in the circumstances”

Translation – if it looks unreasonable, then you cannot deduct it for tax.

This provision only disallows the deduction for tax purposes, it does not remove the fact that it still may be income to the recipient on the other side of the transaction.

So what does this mean?

It means that if I was going to pay a $100,000 wage to my spouse that is not active in my accounting firm it is extremely likely that the CRA would not allow the deduction in my corporation, and so I would not save the 12,000 of small business corporate income tax (or $27,000 of high rate) income tax the deduction would have given me.

Sounds like we should make sure we avoid this transaction doesn’t it?

But let’s brainstorm.

If I am a small business making less than $500,000 of profit in a year, and I want to pay my inactive spouse a dividend, in Alberta, she is going to pay roughly 41.6% on every dollar I allocate to her under the new Tax On Split Income rules.

If she is already in the highest tax bracket, then there is no issue, because it is the same rate either way. In fact the real impact is on those that are not in the highest tax brackets.

So what happens if instead of giving her a $100,000 dividend, I decide to pay her an unreasonable salary of $100,000 instead?

Now before we go any further, we must keep in mind that there may be other payroll taxes and the CPP to consider in these calculations which could change your results, but you will see that at lower amounts, this becomes less of a concern, and more of a plan.

So in Alberta if I paid my inactive spouse that has no other income, a $100,000 dividend would cost $41,600 in taxes. However, if I paid her a wage, she would only pay $24,600 in taxes.

What would I lose?

Assuming that the $100,000 is not deductible, and I am a small business, I would not get the deduction and lose the $12,000 in savings that the deduction could have given me.

But do we care?

Keep in mind, even by losing that deduction, dividends are not deductible either, so the tax inside the corporation is the same either way. The real difference then, is a Tax On Split Income Dividend vs the tax on the Unreasonable Wages.

In this Alberta small business example, the difference is $17,000 before factoring in CPP requirements.

Now I’ve done the math for every province, and it appears to work for almost every situation where the active spouse is already in a high tax bracket situation.

Every single province shows a benefit of doing this in either the small business, or the large corporation that has no small business deduction.

What we have to look at, however, is the balance between having the ACTIVE taxpayer receive a dividend based on their tax brackets, vs the inactive taxpayer receiving an unreasonable salary as well as any related payroll costs and compliance costs (those pesky accountants).

Now will the CRA or Finance look for other ways to close this possibility down?

Will they try to argue that there is somehow a “shareholder benefit” by having something not deductible to a corporation?

What about our friend the General Anti Avoidance Rule?

While I personally think those are both a bit of a stretch, it definitely seems to be something to think and be aware about in your specific circumstances.

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Cory G. Litzenberger, CPA, CMA, CFP, C.Mgr is the President & Founder of CGL Strategic Business & Tax Advisors; you can find out more about Cory’s biography at http://www.CGLtax.ca/Litzenberger-Cory.html