All business owners aim to minimize their taxes payable in order to maximize the cash available to pay themselves, their employees and to invest in the future growth of their business. The small business deduction (SBD) is available to corporations that meet certain criteria to help them achieve this goal. It is important to understand the rules of this deduction so you can plan for your year-end tax filings.
Corporations that were Canadian-controlled private corporations (CCPC) throughout the year may be able to claim the SBD. The corporation must be a private corporation that was either incorporated in Canada or has been a resident of Canada since 1971. The corporation can not be controlled, either directly or indirectly, by non-residents or public corporations.
The SBD can be claimed on income earned from an active business carried on in Canada up to a maximum of $500,000 each year. This deduction reduces the basic federal rate on corporation income taxes to 9%. Small business rates ranging from 0% to 6% are available in each province and territory as well. The combined federal and provincial small business rate of 9% to 15% provides for significant tax savings compared to the combined general rates of 26% to 31.5%. The small business rates are applied to the lesser of the following: income from an active business carried on in Canada, taxable income and the corporation’s business limit.
Income from an active business carried on in Canada excludes foreign business income and property income such as dividends, interest, rents, royalties and capital gains. The business limit of up to $500,000 is shared amongst associated corporations and must be allocated accordingly on each associated corporation’s annual income tax return. The allocation is done on a calendar year basis between all corporations in an associated group that have a fiscal year-end within the calendar year. The association rules are complex, but corporations are generally associated if they are subject to common control by the same person or group of persons, whether directly or indirectly.
Two types of business are excluded from eligibility for the SBD: specified investment businesses and personal service businesses. The principal purpose of a specified investment business is to earn income from property. A personal service business is a business that provides services to another entity and these services would normally be provided by an employee. These individuals are considered incorporated employees. Income from these businesses generally does not qualify as active business income. However, there are exceptions such as if the corporation employs more than five full-time employees throughout the year or would be required to employ five full-time employees if not for services provided by an associated corporation and if a company receives rental income from an associated corporation that earns active business income.
There are many additional rules in place to prevent multiplication of the business limit. Special rules apply to the following types of income: specified corporate income, specified partnership income and specified farming or fishing income.
Specified corporate income is income that would otherwise be considered as income from an active business from providing property or services to another corporation but is not eligible for the SBD as the corporation, one of its shareholders or a non-arm’s length party holds a direct or indirect interest in the other corporation. For example, fees may be paid to another corporation which is owned by a shareholder of the corporation or the spouse of a shareholder. If all or substantially all of the other corporation’s income is earned from the corporation or other non-arm’s length sources, the income will not be eligible for the SBD. CRA generally interprets all or substantially all to be greater than 90%.
Members of a partnership must share the business limit based on their pro rata share of the partnership. The specified partnership income rules apply to designated members of a partnership. A designated member is a corporation that is not a member of the partnership but provides services to the partnership and the shareholder of the company is a member of the partnership or does not deal at arm’s length with a member of the partnership. As with specified corporate income, these rules apply if all or substantially all of the income of the designated member is earned from non-arm’s length sources.
Specified farming or fishing income is income earned by a corporation from the sale of farming products or fishing catches to another arm’s length corporation.
The business limit can also be reduced in certain situations. The first is if the taxable capital of the corporation, and all associated corporations, exceeds $10 million in the prior tax year. Taxable capital can be roughly calculated as the equity of the corporation plus all loans and advances to the corporation less certain investments in or loans to other corporations. The business limit is reduced on a pro rata basis until the taxable capital reaches $15 million, at which point the business limit is reduced to $nil. The business limit is also reduced if the aggregate investment income of the corporation, and all associated corporations, exceeds $50,000 in the prior tax year. The business limit is reduced on a pro rata basis until the aggregate investment income reaches $150,000, at which point the business limit is reduced to $nil.
The small business deduction can provide substantial tax savings. It is important to understand these rules and structure your business accordingly to ensure you reap the full benefits of this deduction.
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