TOSI Rules in 2025: Are You Still at Risk?

Canadian small business owners continue navigating the Tax on Split Income (TOSI) rules, entrenched since 2018 with no substantive changes through 2025. These provisions restrict income splitting in Canada by imposing top marginal rates up to 54% combined federal-provincial on certain family payments, erasing lower-bracket advantages. Exemptions exist, but documentation gaps and CRA audits expose many to reassessments, as recent court rulings underscore persistent grey areas.

For many owners, these risks compound existing compliance challenges – especially, when they are already questioning why professional tax preparation and accounting services matter when CRA scrutiny intensifies.

Multi-generational firms in manufacturing or retail often thrive within bounds, while service-heavy operations like clinics face steeper hurdles. This blog examines where most businesses get TOSI wrong in 2025, why CRA scrutiny is intensifying and how to protect family income from punitive reassessments.

What is Tax on Split Income?

TOSI levies the highest marginal rate, 33% federal plus provincial add-ons, hitting 53.5% in Ontario or 54% in Nova Scotia for 2025 on split income flowing to specified relatives from private corporations, partnerships, or trusts. Covered income includes taxable dividends, shareholder benefits (e.g., low-interest loans), partnership distributions and trust allocations linked to related businesses, sparing only reasonable salaries for actual services rendered.

Before 2018, owners routinely issued dividends to spouses or adult children without much scrutiny, tapping brackets from 14.5% federal on the first $57,375 earned in 2025 up to 26% on $57,376-$114,750. The expansion ensnared adults over 18, demanding proof of labour, capital, or risk contribution to avoid attribution back to the source. Codified in Income Tax Act section 120.4, TOSI fosters equity by blocking passive sprinkling yet burdens legitimate multi-generational firms, where children contribute seasonally or via oversight.

Consider a non-working spouse receiving a $50,000 dividend: TOSI triggers ~$27,000 tax (53.5% effective), dwarfing ~$10,000 in their standalone bracket (20% avg). Enforcement ramps via audits requiring timesheets, T4S, contracts and market salary benchmarks; shortfalls yield back-taxes across years, 10-50% gross negligence penalties and compounded 9% interest. CRA’s Folio S1-F5-C1 details reasonable tests, comparing family pay to unrelated peers via industry data like Statistics Canada wages.

Callout: Documents CRA Requests First in TOSI Audits

• Timesheets with client/project details (not just totals)
• T4 payroll slips and ROEs
• Service contracts/job descriptions
• Arm’s-length salary comparables (e.g., Glassdoor, StatsCan)

Pro tip: Digitize 7+ years; 80% audits settle on records alone

How Does Income Splitting Work in Canada?

Income splitting in Canada shifts earnings from high earners to lower-bracket kin, capitalizing on progressive taxation through dividends, loans, or trusts. How does the process of income splitting in Canada take place amid TOSI?

To answer that, many owners first need clarity onwhether they should incorporate their business at all before attempting income-splitting strategies

Pre-reform, incorporation:– 

enabled share issuance to family for flexible dividends, say, $100,000 to a stay-at-home spouse at a 20% effective rate versus the owner’s 50%, netting $30,000 savings annually. TOSI curtails this sharply. Viable workaround: prescribed-rate spousal loans at CRA’s Q1 2026 3% rate (down from Q4 2025’s 4%), where the lender attributes interest income, the borrower deducts against investment gains taxed at marginal rates.

Detailed math on $500,000 loan: – 

Annual interest $15,000 (lender taxes at 48% equals $7,200 liability); borrower invests in dividend stocks yielding 6% ($30,000), deducts $15,000 interest for net $15,000 taxable at 25% ($3,750), saving $3,450 net family-wide. Payments due January 30 via cheque or transfer, with investments segregated, no personal spending.

Trusts apportion income flexibly: –

But also snag TOSI on ineligible beneficiaries; the 21-day rule (ITA s.104(23)) enforces timely payouts to avoid 54% graduated trust rates post-2018 tightening. Salaries to genuine contributors are deducted corporately without TOSI, provided reasonably under ITA s.67, e.g., an admin role at $60,000 matching provincial medians, backed by job descriptions and performance reviews. Pension income splitting (up to 50%) endures unchanged for RRIFs, annuities in eligible couples.

TOSI Exemptions: Key Pathways Forward

Tosi rules exemptions hinge on ironclad evidence, with CRA probing regular, continuous, substantial involvement beyond raw hours via qualitative factors like decision-making. Primary shields, detailed:

1. Excluded Business (Active Engagement):–

Ages 18-24 (or older leveraging history) qualify, averaging 20 hours/week pro-rated, e.g., 520 hours for half-year retail or construction seasonal peaks. Breakthrough: Credits any 5 prior years, non-sequential; dividends exempt indefinitely post-exit if totally reasonable. Bakery case: Child logs 20+ hours ages 19-24 (summers full-time), pursues career; ages 25-28 $30,000 annual dividends TOSI-free, proven by T4S, schedules. Hazard: Recipient (not corp) proves burden via payroll, client emails, logs; verbal or reconstructed claims fail Tax Court.

2. Excluded Shares (Significant Ownership):–

Age 25+, direct (no intermediaries) ≥10% voting rights and FMV in non-professional corps deriving <90% revenue from services, manufacturing, wholesale, qualify; dentistry, consulting excluded. Substantially all (>90%) income from arm’s-length unrelated businesses; shared family ventures disqualify via related person tests.

3. Age 65+ Provision:–

Owners turning 65 split dividends/spousal business income (any recipient age) to the extent the owner is exempt, optimal for founders easing out, combining with CPP/OAS splits.

4. Supplementary Relief:–

Capital gains on qualified small business corporation (QSBC) shares (10+ years active), qualified farm/fishing property exempt entirely. Reasonable returns for passive holders benchmarked to risk-adjusted industry ROE (e.g., 8-12% for retail). Retired hold costs generating portfolio dividends often escape as non-business under the ITA definition.

No 2025 alterations per EY, KPMG, Thorsteinsson’s analyses; budgetary focus on capital gains inclusion hikes, AMT expansions.

Who is Eligible for Income Splitting in Canada?

Narrowly, immediately specified individuals’ spouses/common-law (incl. separated <90 days), children/grandchildren (under 25 emphasis), siblings/nieces/nephews (immediate only) receiving from related business entities. Exempt status gates access.

Spouses via loans/pensions unrestricted; adult children via labour/ownership rigorous. Non-residents ineligible post year-end; work/school abroad may qualify for residency.

Seniors 65+ lead with spousal latitude, adjustable yearly. Youth 18-24 with verifiable 20-hour contributions dominate dividend flows. 25+ direct owners in low-service corps unlock the shared path.

Service professionals (physicians, lawyers) pivot to salaries (67 test) or loans; dividends are absent exemptions. Farms/fishers gain disposition boosts.

Audit Traps and Enforcement Realities

Nuance proliferates: Tax Court weighs strategic oversight (e.g., marketing direction), qualifying sans punch-clocks if substantial. Reasonable dividends peg to multiples of 3-5x salary family operations, per CRA comparables database. 2025 probes intensify on remote/hybrid family payroll post-pandemic, plus T3 trust mismatches.

HVAC family illustration: $40,000 dividend idle adult child triggers $21,400 TOSI (53.5%), lacking prior 520-hour T4S flips to zero with proof. Farms leverage QSBC/QFFP disposition exemptions on sales; seasonal proration vindicated in appeals.

Loans excel at 3% (Q1 2026, post-dip), arbitrage 2-3% on equities, but CRA voids if funds mingle with personally segregated brokerage statements are mandatory. Trusts falter on phantom allocations, taxing at 54% if undistributed.

Actionable 2025 Compliance Steps

• Record Obsessively: Digital timesheets, T4S, service contracts, comparables; 7-10 year retention for audit windows.
• Strategic Incorporation: Time sole prop-to-corp conversions to capture child labour credits pre-shift.
• Loan Optimization: Execute by Dec 31 at 3%; model GICs/ETFs for 5-7% yields.
• Share Restructuring: Redeem/reissue direct 10% voting/FMV shares in eligible entities year-end.
• 65+ Roadmap: Stress-test owner exemptions; pair with spousal RRIF flows.

Pre-March T2, audit family T-slips; voluntary disclosure program caps penalties for unfiled TOSI.

Advanced Planning: Holdcos and Beyond

Holding companies post-opco wind-down enable passive splits: Investment income (dividends/interest) evades TOSI without active business nexus, per related business exception. Example: Sell opco shares QSBC-exempt, roll to holdco; family dividends from $200,000 portfolio taxed individually. Caveat: Avoid adventure in the nature of trade triggering business status.

Professional corps (PCCs) double-restricted: No shares exemption, salaries only. Doctors integrate loans with IPPs for enhanced deductions.

Provincial Nuances and 2026 Outlook

Rates vary: Alberta 42.31% TOSI top (2024 base), BC 53.5%; plan provincially. Q2 2026 prescribed rate likely rises to 4%+, narrowing loan windows, act Q1. No TOSI repeal in 2026 fiscal signals; capital gains focus dominates.

Persistent Risks in 2025

TOSI endures sans repeal signals in 2026 plans. Undocumented work, service-heavy models and indirect holdings (trusts/holdcos) invite top-rate shocks and multi-year adjustments. Compliant routes youth labour banking, senior splits, 3% loans preserve 20-30% family wealth.

Annual reviews with ITA 120.4 specialists, leveraging flowcharts like Moody’s TOSI diagrams, prove indispensable. In Canada’s steep tax regime, TOSI mastery delineates prosperous lineages from penalized ones, positioning firms accordingly.

Know exactly where you stand before CRA forms an opinion!

TOSI rules haven’t softened since 2018, but your approach can. SMR CPA brings battle-tested expertise, helping families claim excluded business credits, navigate share exemptions and deploy 3% loans that actually stick during audits. We’ve seen too many good businesses stung by missing timesheets or indirect holdings. You deserve better.

Count on us as your year-round tax allies, decoding CRA expectations so you keep more cash for growth. Drop SMR CPA a line today for your personalized TOSI roadmap. Turn uncertainty into confidence starting now.