Published: January 13, 2021
Last Updated: February 21, 2022
Introduction: Active vs. Passive Income
Operating a business through a corporation can lead to significant deferral advantages over time. Those who choose to operate their business through a corporation can take advantage of the Small Business Deduction on “active business income” earned in a corporation and pay a much reduced rate of corporate tax until income is ultimately distributed to the shareholders.
However, there are certain pitfalls that can reduce the benefits of operating a business through a corporation. The distinction between “active” and “passive” business income in the Tax Act comes as a surprise to most taxpayers who have never learned of this very important difference in characterization under the Tax Act. “Passive” business income can be understood as income derived from property, meaning dividends, interest and some rents. “Active” income is related to business activities that are considered more hands-on, such as retail sales or professional services.
Despite the fact that the management of a rental operation may take up a large amount of the owner’s time, and thus feel anything but “passive”, the Income Tax Act is very clear that rents on real property are properly categorized as “passive” sources of income. The understanding of this distinction, the rules and the exceptions built in to the Tax Act are a key part of proper tax guidance in this area.
Rental Income Earned in a Corporation
It is sometimes the case that when a corporation operates a business that earns rents that it also earns income from other sources. Where there is a blend of these two types of income, the taxpayer must track these amounts separately and will be denied the Small Business Deduction on rental receipts, leading to a higher amount of taxes payable each year on that source of revenue.
While this does raise compliance costs for the taxpayer-corporation, they are still able to take advantage of the generous deferral on the active business income earned. It is when a rental operation begins to grow, and new investment properties are purchased that things become more complicated.
The ”Specified Investment Business”
Subsection 125(7) of the Tax Act contains a definition for a “specified investment business”. Where a corporation earns income principally from passive sources such as rents, it is deemed to be a SIB and cannot claim the small business deduction on any of its income, active or passive. The definition is not entirely precise, but the Courts have interpreted the wording “principally” to mean about 50% or more when used in the Tax Act.
Not surprisingly, this leads to some very shocked taxpayers and business owner-operators who do not receive tax guidance from an expert Canadian tax lawyer. In the above example of a small business owner who earns active income alongside the passive income of say a rental condominium, the elimination of the small business deduction can not only reduce tax efficiency but also seriously hinder the ability of the owner-operator to reinvest capital over time. Needless to say careful planning is required in these circumstances.
Exceptions to the Specified Investment Business Rule
Thankfully, there are some exceptions that, if proper tax planning is undertaken with the assistance of a knowledgeable Canadian tax lawyer, can allow the taxpayer to utilize their Small Business Deduction on rental operations.
For example, the definition of Specified Investment Business includes an exception that if more than five full-time employees are required to run the rental operation, then the corporation will be entitled to claim the Small Business Deduction. Similarly, if there is an associated corporation that provides services to the corporation that supports its rental business, there are scenarios where an experienced Canadian tax lawyer can plan out a structure that will allow both to claim the Small Business Deduction.
Another exception is what is known as the “temporary income surge”; if for example for a single period a corporation that earns mostly active business income earns rents or other passive income in a large amount temporarily, say due to restructuring, it will likely not meet the threshold as a specified investment business. In these circumstances, subsection 125(7) is not activated, allowing the application of the Small Business Deduction to the active income earned in the period.
Associated corporations that pay rent to one another to earn active business income will also be able to share the Small Business Deduction on the basis that the underlying character of the rental payments is active business. For example, when one corporation earns active business income, and pays rent to an associated corporation for office space, the associated corporation will be able to claim the Small Business Deduction on that rental income. This is to provide taxpayers the ability to structure their operations for business law purposes without creating any deleterious tax effects.
Canadian Tax Lawyer’s Pro Tax Tips on Specified Investment Business
As experienced Canadian tax lawyers, the problem of SIBs has been one we have tackled many times. Often, clients come to us having received incomplete or poor advice on their corporate structure, leading to tax compliance and inefficiency problems.
Our goal with these clients is to review and maximize tax savings, and to provide advice that can optimize tax savings, and claw back any amounts that may have been reassessed improperly.
As an example, where an owner-operator operates more than one business, which include active and passive income, an optimum structure could include a pair of associated corporations, one which rents commercial property to arms’-length tenants, but also provides office space to the active business. In this scenario, a restructuring could allow the owner to claim the Small Business Deduction on all of the active business income, and “quarantine” the passive income in the second corporation. However there is inefficiency as the rental corporation may be a specified investment business, leading to any rents paid by the active business corporation to be disqualified despite the characterization allowance discussed above. In this type of scenario, it is possible that a third corporation may be required to maximize tax efficiency while still maintaining civil liability protections.
As you can see from the above example, tax planning is very fact specific and will vary for every different business situation.
Contact our experienced Canadian tax lawyers today if you need tax guidance to optimize your tax structure or have questions, concerns or are being audited by the CRA to find out how we can help you move forward.
"This article provides information of a general nature only. It is only current at the posting date. It is not updated and it may no longer be current. It does not provide legal advice nor can it or should it be relied upon. All tax situations are specific to their facts and will differ from the situations in the articles. If you have specific legal questions you should consult a lawyer."
If a rental property is held in a corporation there are multiple factors that have to be considered in determining the tax rate. The General Corporate Rate is 38% Federal and 11.50% Provincial (Ontario). Therefore we have a combined General Corporate Rate of 49.50%. However, not all corporations pay this rate because there are tax breaks offered by the federal and provincial governments. The federal government offers a 10% abatement which brings the tax rate down by 10% to 28%. We also have the Small Business Deduction of 17% and the General rate reduction of 13%. To receive preferred tax rates, the corporation has to meet certain conditions.
The federal rate is 38% and is applicable in all provinces. However, the provincial tax varies from province to province. The provincial tax on rental income in Ontario, for example, is 11.50%. However, these rates aren’t applicable to all corporations because both the federal and provincial governments offer tax breaks. The setup of your corporation will determine the corporate tax rate and the tax credits it will qualify for.
The cost to incorporate in Ontario is $360 if you incorporate in person or by mail. You also may incorporate online through a service provider under contract with the Ontario Ministry of Government and Consumer Services.
When earning a rental income, you should disclose this income in your income tax return. If you have a partner in the rental business, you need to declare your portion only. This income is taxed at your marginal rate.
It is important to declare your rental income on your tax return. On the other hand, for co-owner in property, you should only report the portion of your income.
You will have a rental loss if your rental expenses is more than what you are earning. Uncollectible rent is the one that you can deduct from your gross rentol income.