THE SMALL BUSINESS DEDUCTION
The so-called “small business deduction”, though generally called by that name, is actually a tax credit because it reduces the corporate tax rates.
Generally speaking, the small business deduction reduces the tax rate for CCPCs on the first $500,000 of their income from active business carried on in Canada. The apparent rationale is to promote entrepreneurship and help small corporations that may not have access to bank loans and other forms of financing.
The federal tax rate on business income is normally 15% for Canadian resident corporations. (There are some situations where a much higher rate applies, such as for an incorporated employee – a “personal services business”, discussed further below. There are also lower rates, such as a special reduced rate for a corporation involving in manufacturing zero-emission technology.)
The small business deduction reduces the 15% down to 9% federally. Each province then provides a parallel deduction, which varies by province. For example, in Ontario the combined federal and provincial small business rate is currently 12.2%, and in Alberta it is 11%.
A CCPC is a private corporation resident in Canada that is not controlled by non-residents or public corporations or a combination thereof. So, for example, if you are resident in Canada and own a private Canadian corporation that you control, it will be a CCPC. For these purposes, “control” generally means owning more than 50% of the voting shares in the corporation.
If you own, directly or indirectly more than one CCPC, the small business deduction must be shared amongst the corporations if they are “associated” with each other. The meaning of “associated” is fairly complex, but generally two corporations are associated if they are controlled by the same person or group of persons. They are also associated if one corporation controls the other.
So if the corporations are associated, you need to choose how to allocate the $500,000 amount.
I am the controlling shareholder of two CCPCs.
This taxation year, one CCPC has active business income of $500,000 and the other CCPC has active business income of $300,000.
I have various options. For example, I could allocate the entire $500,000 to the first corporation and it could benefit from the small business deduction for the whole amount.
But I might allocate $400,000 to the first corporation and $100,000 to the other corporation, and those amounts would benefit from the small business deduction.
The rationale for this associated corporation rule? The government does not want you to double up, triple up, and so on, if you own or control various CCPCs.
Phase-out of deduction with taxable capital over $10 million
Since the small business deduction is meant to apply to “small” businesses, there is a phase-out of the deduction when the CCPC has more than $10 million in taxable capital (a technical term in the Income Tax Act, but it generally includes things like share capital, retained earnings and debt issued by the CCPC).
For many years until this year, the small business deduction was phased out starting when the CCPC had taxable capital in excess of $10 million and was totally eliminated once its taxable capital was $15 million or more.
Under recent proposed changes, effective for taxation years beginning April 7, 2022 or later, there is a slower and more gradual phase-out. The deduction is still phased out starting when the CCPC has taxable capital over $10 million, but the phase-out occurs between that amount and $50 million of the CCPC’s taxable capital so it is less severe than the previous rules.
The Department of Finance provides the following examples:
- a CCPC with $30 million in taxable capital would have up to $250,000 of active business income eligible for the small business deduction, compared to $0 under current rules; and
- a CCPC with $12 million in taxable capital would have up to $475,000 of active business income eligible for the small business deduction, compared to $300,000 under current rules.
When the small business deduction is not available
There are a couple of exceptions where your CCPC is not eligible for the small business deduction even if you can show that is carrying on a business.
First, the deduction does not apply if your CCPC carries on a “personal service business”. Basically, this means that you or a related person, as an employee of the CCPC, provides services to a client or customer and, but for the existence of the CCPC, could be considered an employee of the client or customer. (This is also called an “incorporated employee”.) For example, if my CCPC has a services contract with one client only and I could otherwise be considered an employee of the client (based on court decisions, which we will discuss in a subsequent Letter), my CCPC might not be eligible for the small business deduction, but it all depends of the facts. There are a couple of exceptions – the main one applies if the CCPC employs in the relevant year more than 5 full-time employees. (As noted earlier, a personal services business is not only ineligible for the small business deduction – it actually pays a much higher federal corporate tax rate, 28% instead of 15%!)
The small business deduction also does not apply if your CCPC runs a “specified investment business”. In general terms, this can include a business the principal purpose of which is to derive income from property (e.g. interest, dividends, rents and royalties). An exception applies if the CCPC employs in the year more than 5 full-time employees. Of course, in many cases income from property is not a business in the first place, and would not be eligible for the small business deduction because it’s not “active business income”.
If your CCPC does not have more than 5 full-time employees and you are concerned about these rules, it is best to speak to your professional tax adviser.