The Tax on Split Income (TOSI) can severely penalize family businesses by taxing dividends paid to family members at the highest marginal tax rate. To successfully defend against a CRA audit, a tax lawyer can help you prove that your spouse or adult children meet an “excluded business” safe harbour, such as demonstrating they worked an average of 20 hours per week for the company.
Running a family business in Canada requires immense dedication, and historically, business owners relied on a strategy called “dividend sprinkling.” This allowed a corporation to pay dividends to a spouse or adult children who were in lower tax brackets, effectively lowering the overall household tax burden. However, the Canada Revenue Agency (CRA) has strictly cracked down on this practice. Today, if the CRA determines that a family member did not genuinely contribute to the business, they will apply the Tax on Split Income (TOSI) rules, taxing those dividends at the absolute highest marginal rate.
Facing a CRA TOSI audit can be incredibly stressful and financially devastating for small and medium-sized enterprises. 💰 These audits are highly fact-driven, meaning the CRA will scrutinize every detail of what your family members actually do for the company. Thankfully, the law provides specific “safe harbours” that, if proven, exempt those dividends from TOSI. Understanding how to organize your evidence and present a strong defence is absolutely crucial for protecting your family’s hard-earned income.
Step-by-Step Process in Canada: Defending a TOSI Audit
Whether your corporate headquarters are in Calgary, Toronto, or Vancouver, the federal TOSI rules apply uniformly across the country. Because these audits require interpreting complex sections of the Income Tax Act, consulting a Canadian tax lawyer or a specialized CPA early in the process is highly recommended.
Step 1: Receiving the Initial CRA Audit Letter
A TOSI dispute usually begins with a standard letter from the CRA requesting information about the dividends declared on your corporate T5 slips. The auditor will ask for an explanation of why the dividends paid to specific family members should not be subject to the TOSI rules. It is crucial not to ignore this letter or provide a rushed, informal response. Anything you say at this stage can be used to deny your safe harbour exemptions later on.
Step 2: Identifying the Correct Safe Harbour
Your legal and accounting team will review the facts to see which exemption fits best. The most common exemption is the “Excluded Business” safe harbour. This requires proving that the family member was actively engaged on a regular, continuous, and substantial basis in the business. Specifically, they must have worked an average of 20 hours per week during the year the dividend was paid, or in any five prior taxation years. Another option is the “Excluded Shares” exemption, which applies if the family member is age 25 or older, owns at least 10% of the shares by both votes and value of the corporation, and the corporation is not a professional corporation or services business.
Step 3: Gathering Substantial Documentary Evidence
The CRA will not simply take your word that your spouse worked 20 hours a week. 📝 You must provide concrete documentary evidence. This includes detailed timesheets, emails showing their involvement in daily operations, calendars mapping out client meetings, and records of them signing corporate cheques or negotiating with suppliers. The more paper trails you can provide showing their genuine labour contribution, the stronger your defence will be.
Step 4: Presenting the “Reasonable Return” Argument
If the family member does not meet the strict 20-hour rule, they may still be exempt if the dividend represents a “reasonable return” on their contribution to the business. You must prove that the dividend accurately reflects the labour they provided, the capital they invested, or the financial risks they assumed (such as co-signing a major business loan). A tax lawyer will help structure this argument by comparing their compensation to what an independent third party would receive for the exact same risk or work.
Step 5: Filing a Notice of Objection
If the CRA auditor disagrees with your evidence and issues a reassessment applying the highest tax rate, the fight is not over. For individual taxpayers, the deadline to file a formal Notice of Objection is the later of 90 days from the date of the Notice of Reassessment, or one year after the taxpayer’s filing-due date for that taxation year. This moves your file away from the original auditor and into the hands of a CRA Appeals Officer, providing a fresh opportunity for your law firm to negotiate a settlement or present a more robust legal argument.
How Much Does it Cost to Defend a TOSI Audit?
Fighting the CRA requires professional expertise, and the costs can vary based on the complexity of your family’s corporate structure.
| Professional Service | Estimated Cost (CAD) | What is Included |
|---|---|---|
| Tax Lawyer (Audit Response) | $2,500 – $5,000 | Drafting the initial legal response and compiling the safe harbour evidence. |
| Filing a Notice of Objection | $3,000 – $7,000 | Formal appeal preparation and negotiations with the CRA Appeals Division. |
| Tax Court of Canada Litigation | $15,000 – $40,000+ | Full legal representation if the dispute requires a formal trial. |
How Long Does the Process Take?
Dealing with the CRA is generally a lengthy endeavour. The initial audit phase typically takes 3 to 6 months to conclude. If you are reassessed and must file a Notice of Objection, it can take the CRA Appeals Division anywhere from 9 to 18 months just to assign an officer to your file. If the matter escalates to the Tax Court of Canada, expect the entire process to take 2 to 4 years.
Frequently Asked Questions (FAQ)
What exactly is the Tax on Split Income (TOSI)?
TOSI is an anti-avoidance rule that taxes certain types of income, such as dividends paid by a private corporation to family members, at the highest marginal personal tax rate, eliminating the benefit of income splitting.
Does the 20-hour work rule apply to minors?
No. The “Excluded Business” safe harbour based on working 20 hours per week only applies to adult family members (age 18 and older). Minors are generally subject to much stricter TOSI rules.
Can a spouse be exempt if they invested their own money?
Yes. If a spouse contributed their own capital or took on substantial financial risk for the business, they may qualify for an exemption under the “reasonable return” criteria, even if they do not physically work in the business.
Are professional corporations exempt from TOSI?
Generally, no. Professional corporations (like those for doctors, dentists, or lawyers) face stricter TOSI rules. For instance, the “Excluded Shares” safe harbour specifically cannot be used by professional corporations.
Should I hire a lawyer or an accountant for a TOSI audit?
While an accountant is crucial for tracking the numbers, a tax lawyer provides solicitor-client privilege and specializes in interpreting the Income Tax Act. Often, a collaborative approach between your CPA and a tax lawyer yields the best defence.
Leave a Reply