Effect of New Income Splitting Rules on Holding Corporations

Most small businesses in Canada operate through corporations. Often times, the owner of the business/corporation owns shares of the operating corporation through a holding corporation. Using a holding corporation used to be pretty basic tax planning, but the new tax on split income (“TOSI”) rules may cause some issues with the basic holding corporation structure.

There are two main exceptions to the new TOSI rules that most business owners rely upon – the “excluded business” exception and the “excluded shares” exception. The excluded business exception is the 20-hour per week test that many people are familiar with – if a spouse works at least 20 hours per week in the business then the TOSI rules do not apply and there is no limit to the dividends that can be paid to that spouse.

Under the excluded shares exception, if the corporation is not a services business, the spouse owns at least 10% of the votes and value of the corporation, and less than 10% of the income of the corporation’s income comes from a related business, then there is no limit to the dividends that can be paid to the spouse. The problem is that the excluded shares rule may cause problems for traditional holding corporation structures since the holding corporation has to consider all income, including dividends received from the operating corporation. The income from the operating corporation may disqualify the holding corporation from the excluded share exception. Government commentary to date says that this requirement is intended to prevent splitting a service business into services and non-services parts using holding corporations or side-car corporations, but unfortunately it causes issues for non-service businesses using a traditional operating corporation-holding corporation structure.

If you are a business owner in this situation, you may be able get around this potential issue if you and your spouse hold the shares of the operating company personally rather than through a holding corporation; however, you should consult with a tax advisor to determine if advantages and problems or holding the shares of the operating corporation personally outweigh the advantages and risks of holding the shares indirectly through a holding corporation.