Small Business Deduction (SBD): Section 125 of Canada’s Income Tax Act—A Canadian Tax Lawyer’s Analysis
Introduction – Small Business Deduction (SBD)
Subsection 123(1) of Canada’s Income Tax Act sets the basic federal corporate tax rate—currently, 38 percent of a corporation’s taxable income. Subsection 124(1), however, reduces the federal rate by 10 percent on the amount of income that a corporation earned in a Canadian province. This 10 percent abatement provides relief for the corporation’s provincial or territorial tax burden. So, as a result of the basic federal rate and after the provincial abatement, a Canadian corporation’s general federal tax rate is 28 percent of its taxable income.
Yet for tax policy reasons certain corporations and types of income enjoy more favorable rates. Subsection 125(1) provides a “small business deduction” in certain limited circumstances. Simply put, a Canadian-controlled private corporation receives a 17 percent tax credit on the corporation’s active business income up to $500,000. As a result, a Canadian-controlled private corporation pays federal tax at a rate of 11 percent on the first $500,000 of its active business income.
Canadian provinces and territories offer a similar small business deduction. For instance, the Ontario small business deduction reduces the corporate income-tax rate to 4.5 percent on a Canadian-controlled private corporation’s active business income.
The phrase “small business deduction” or SBD is a misnomer. First, a deduction is claimed against income to reduce income; a credit is claimed against tax payable to reduce tax liability. So, the small business deduction is not a deduction; it is in fact a tax credit. Second, the small business deduction is not available to all businesses. Only certain incorporated businesses enjoy the tax credit. Finally, a corporation need not be small to benefit from the small business deduction. A qualifying corporation receives the full small business deduction tax credit until its “taxable capital employed in Canada” exceeds $10 million. At this point, the corporation’s small business deduction is reduced on a linear basis until the corporation’s taxable capital reaches $15 million. At that point the small business deduction tax credit is eliminated.
In order to qualify for the small business deduction (“SBD”) a corporation must be a Canadian-controlled private corporation (“CCPC”) earning active business income. In addition, associated corporations must share the SBD.
This article discusses all three of these crucial concepts in determining small business deduction tax credit: CCPCs, active business income, and associated corporations.
Canadian-Controlled Private Corporation
Subsection 125(7) defines a “Canadian-controlled private corporation.” Basically, a CCPC must satisfy three criteria:
- It must be a private corporation. Essentially, its shares cannot be listed on a designated stock exchange.
- It must be a Canadian corporation. Simply put, a Canadian corporation is one that is both resident and incorporated in Canada.
- It cannot be controlled by either a non-resident person, a public corporation, or any combination thereof.
Notably, despite its name, a Canadian-controlled private corporation need not be controlled by Canadian residents. For example, a Canadian resident own 50% of ACO, a private Canadian corporation. A public corporation owns the other 50% of ACO. Yet ACO is a CCPC since ACO isn’t controlled by non-residents, public corporations, or a combination of public corporations and non-residents.
The Income Tax Act also contains additional rules that buttress the CCPC definition. These rules deal with cases where a private Canadian corporation is subject to complex ownership structures.
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Active Business Income
To qualify for the small business deduction tax credit (SBD), a Canadian-controlled private corporation must earn “income… from an active business.” A corporation’s active business income generally includes the following:
- income from any business, other than a specified investment business or a personal service business;
- income “pertaining to or incident to” the corporation’s active business; and
- income from an adventure or concern in the nature of trade.
As a result, Canada’s Income Tax Act essentially presumes that a corporation earns active business income, unless that corporation carries on either a specified investment business or a personal service business.
Subsection 125(7) of the Canadian Income Tax Act defines a “specified investment business” or SIB as any business whose principal purpose is to derive income from property. For instance, a corporation that earns primarily interest, dividends, rent, or royalties might qualify as carrying on a specified investment business.
The subsection also lists four exceptions to a specified investment business (SIB):
- a business carried on by a credit union,
- a business of leasing property other than real or immovable property,
- a business that employs more than five full-time employees throughout the year, or
- a business using services from an associated corporation that would have otherwise required employing more than five full-time employees throughout the year.
Granted, the terminology of “specified investment business” seems somewhat inappropriate. It connotes that the corporation carried on a “business.” Of course, if this were so, the corporation could not have conducted a specified investment business.
A personal service business or PSB is often referred to asan incorporated employee. In particular, it is any business where, in the absence of the corporation, the individual who both provides the service and is the corporation’s “specified shareholder” would reasonably be regarded as an employee of the person to whom the services are provided.
By excluding personal service businesses from the benefit of the small business deduction, the Income Tax Act clearly demarcates between independent contractors and employees. The Tax Act intends for the small business deduction to reward—unsurprisingly—businesses. In other words, it is Parliament’s way of saying that an employee is not entitled to benefit from the SBD on the basis of that employee’s interjecting a corporation between the employee and employer.
Under Tax Act subsection 125(3), associated corporations must file an agreement to share the small business deduction. Otherwise, they all lose the small business deduction tax credit (SBD). This rule prevents an individual from running one business through several corporations in order to multiply his or her access to the SBD.
The Income Tax Act lists five cases where corporations are associated:
- One corporation controls the other.
- Both corporations were controlled by the same person or group of persons.
- Each corporation is controlled by a person. The person controlling one corporation is related to the person controlling the other corporation. And either of those two persons owns at least 25% of each corporation.
- One corporation is controlled by a person. And that person both (i) is related to each member of a group of persons that controls the other corporation and (ii) owns at least 25% of the other corporation.
- Each corporation is controlled by a related group. Each member of one related group is related to all the members of the other related group. And one or more persons who are members of both related groups own, in total, at least 25% of each corporation.
In addition, the Income Tax Act contains numerous related rules, which elaborate upon how these five should apply in specific circumstances. The rules governing associated corporations are complex and subject to numerous interpretative tax cases.
Tax Tips – small business deduction tax credit (SBD)
The small business deduction is one of many factors you should consider when deciding whether incorporating is right for you. While incorporating might permit your business to enjoy the SBD, it could also bring about a host of problems should you be unprepared, especially as regards associated corporations or activities that don’t qualify for the small business deduction tax credit (SBD). Furthermore, incorporating might preclude you from deducting your business expenses from other sources of personal income, such as employment income. Consult one of our expert Canadian tax lawyers for income tax planning about how to properly set up your business.