The Tax on Split Income (TOSI) rules in Canada apply the highest marginal tax rate to dividends paid to family members. However, you can legally avoid this top-rate taxation by meeting specific exceptions, such as the “Excluded Business” rule (working 20 hours a week) or the retirement exception once the business founder turns 65.
For many years, Canadian small business owners utilized income splitting to lower their overall household tax burden. By paying dividends to family members in lower tax brackets, a family could save thousands of dollars annually. However, the Canada Revenue Agency (CRA) introduced strict federal Tax on Split Income (TOSI) rules that effectively stopped this practice by applying the highest marginal tax rate (often over 50%) to these payments. This massive shift in the law left many families across Canada scrambling to reorganize their corporate structures.
Fortunately, the federal government did not completely close the door on family businesses. 📍 There are specific safe harbours and Exceptions to the Tax on Split Income (TOSI) Rules in Canada that allow you to continue paying family members without triggering the punitive tax rate. Because these federal tax laws apply universally whether your corporation is based in Toronto, Calgary, or Vancouver, understanding the specific legal criteria is vital for any Canadian entrepreneur. If you are ever unsure about your corporate tax strategy, connecting with a local corporate accountant or tax lawyer from our directory can ensure your dividends remain compliant and tax-efficient.
Step-by-Step Process in Canada: Applying TOSI Exceptions
Navigating the TOSI rules requires a meticulous review of how your family members interact with your private corporation. Here is a step-by-step approach to identifying and applying the legal safe harbours provided by the CRA.
Step 1: Understand Who is an Excluded Individual
Before analyzing the business, you must determine if the family member receiving the dividend is subject to TOSI at all. Generally, TOSI targets specified individuals, which includes a spouse, children, or related family members of the business founder. If the person receiving the income is completely unrelated to the core business operator, TOSI may not apply. However, for most family-run enterprises in Canada, the recipient will be caught by the general rule unless an exception is met.
Step 2: Apply the Excluded Business Exception (The 20-Hour Rule)
This is the most common and powerful exception. If the family member is actively engaged in the business on a regular, continuous, and substantial basis, their income is exempt from TOSI. 🕐 The CRA offers a bright-line test: if the family member works an average of at least 20 hours per week during the part of the year the business operates, they qualify. Furthermore, if they met this 20-hour requirement in any five previous taxation years (they do not need to be consecutive), they qualify for this exception for the rest of their life.
Step 3: Evaluate the Excluded Shares Exception
If the family member does not work in the business, they might still avoid TOSI if they own “Excluded Shares.” To meet this strict exception, the family member must be at least 25 years old and directly own shares representing at least 10% of the votes and 10% of the value of the corporation. Additionally, the corporation must earn less than 90% of its income from providing services, and it cannot be a professional corporation (like those used by doctors, dentists, or lawyers). Crucially, this exception does not work in multi-tiered corporate structures; if a holding company (Holdco) receives dividends from an operating company (Opco) that is a related business, the Holdco shares will fail the “excluded shares” test, meaning you must restructure or rely on other exceptions like the 20-hour rule.
Step 4: Utilize the Retirement Exception
The Canadian government recognized that income splitting is a fundamental part of retirement planning. 👴 If the primary business owner (the person who made the major contributions to the business) turns 65 years old, they are permitted to split their corporate income with their spouse. If the income would be excluded from TOSI for the 65-year-old founder, it will also be excluded for their spouse, provided the spouse is at least 18 years old during the tax year (having attained age 17 before the tax year begins), regardless of their active involvement in the business.
Step 5: Document and Track Everything Meticulously
If you are relying on any of these exceptions, especially the 20-hour rule, the burden of proof is entirely on you. You must maintain detailed timesheets, payroll records, and written job descriptions for your family members. If the CRA initiates an audit and you cannot prove your spouse actually worked 20 hours a week at your Vancouver or Edmonton office, the CRA will retroactively apply the top marginal tax rate and issue massive penalties.
How Much Does it Cost to Ensure TOSI Compliance in Canada?
Restructuring your business to comply with TOSI is a complex legal and accounting task. Here are the estimated costs you might face in Canadian dollars (CAD):
| Corporate Tax Restructuring | $2,000 to $5,000 CAD to have a tax lawyer or CPA reorganize your share classes to meet the Excluded Shares exception. |
| Annual Tax Filing (T2 & T1) | $1,500 to $3,500 CAD annually for a professional accountant to properly file your corporate and personal returns with TOSI considerations. |
| TOSI Audit Defence | $3,000 to $10,000+ CAD if you are audited by the CRA and need legal representation to prove your family member meets an exception. |
How Long Does the Process Take?
Evaluating your corporate structure for TOSI compliance is an annual obligation. ⏱ You must assess whether a family member met an exception at the end of every single tax year before issuing a T5 dividend slip. If you need to formally restructure your corporation to give a family member 10% voting shares, the legal drafting and filing of the Articles of Amendment with the provincial or federal registry usually takes between 2 to 4 weeks. If the CRA decides to audit your TOSI claims, expect the review process to drag on for 6 to 12 months.
Frequently Asked Questions (FAQ)
Does TOSI apply to salaries paid to family members?
No. The Tax on Split Income rules generally target dividends, trust distributions, and partnership income. If you pay your spouse a standard T4 salary for work they actually performed, TOSI does not apply. However, the salary must be legally reasonable for the labour provided, or the CRA will deny the corporate expense deduction.
What happens if my child is under 18?
If the recipient is a minor (under 18 years of age), the rules are incredibly strict. The “Kiddie Tax” rules automatically apply the highest marginal tax rate to dividends paid to minors from a private family business, with virtually no exceptions available.
Can a service business use the Excluded Shares exception?
Generally, no. If your corporation generates 90% or more of its gross income from providing services (such as a consulting firm, marketing agency, or accounting practice), you are legally prohibited from using the Excluded Shares exception. You must rely on the 20-hour rule instead.
Do the 20 hours a week have to be tracked officially?
Yes! The CRA explicitly states that taxpayers must keep sufficient records to prove the hours worked. A simple verbal statement is not enough. You should use a digital time-tracking software or formal punch cards to protect yourself during a federal audit.
What is the reasonable return exception?
If a family member is between 18 and 24, they can receive a “safe harbour” return based on capital they actually invested into the business. If they are over 25, they can receive a dividend that represents a “reasonable return” based on their labour, capital contribution, and risk assumed, though this is heavily scrutinized by the CRA.
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