The availability of the small business deduction (SBD) is one of the most favourable tax attributes for companies that qualify as Canadian-controlled private corporations (CCPCs). A CCPC that is earning “active business income” in Canada and is taxed in BC has its combined federal and provincial tax rate reduced from 26% to 13%, up to the $500,000 “business limit” shared with “associated corporations.” Recognizing this favourable tax treatment, corporate taxpayers have been creative in implementing business structures to multiply their access to the SBD.
Changes designed to eliminate multiplication of the SBD were initially proposed in the March 22, 2016 federal budget. Draft legislation for these changes was later released for consultation by the Department of Finance on July 29, 2016. The proposed SBD rules would be effective for corporate taxation years beginning on or after March 22, 2016.
The purpose of this article is not to walk through the changes made to section 125 of the Income Tax Act (the Act), but to focus on how the proposed tax rules would affect two business structures commonly used to multiply the SBD.
1. Using a partnership and “service corporation”
One of the most common methods used to multiply SBD is to place a partnership at the core of a corporate group. Under the “specified partnership income” rules, corporate partners share the $500,000 business limit based on the pro-rata allocation (to said partners) of the partnership’s income from an active business carried on in Canada.
Creative taxpayers have developed various structures so that the corporations they or their spouses own can receive income directly or indirectly derived from the partnership that is not considered specified partnership income. Typically, these non-partner corporations are called “service corporations” because they provide professional, administration, or management services—either to the incorporated partner or to the partnership itself. A service corporation is associated with the corporate partner, but it is not a partner of the partnership; as such, it potentially enables each partner to benefit from the full $500,000 business limit, rather than requiring partners to share the $500,000 business limit as a group.
These structures are set up for sound business reasons, and the Canada Revenue Agency (CRA) has issued numerous rulings to confirm that they’re permissible. Nevertheless, the definition of “specified partnership income” has been expanded in the draft legislation to eliminate this multiplication of the business limit. Under the proposed rules, a corporation that is a “designated member” would effectively have to share a portion of the business limit allocated by the partnership to a partner or corporate partner with which the designated member does not deal at arm’s length.
By definition, a “designated member” is a corporation that is not a member of the partnership, but either:
- One of its shareholders holds a direct or indirect interest in the partnership; or
- The corporation does not deal at arm’s length with a person who has a direct or indirect interest in the partnership, and it is not the case that all or substantially all of the corporation’s active business income for the year is derived from providing products or services to persons or other partnerships with which the corporation deals at arm’s length.
In short, this expanded definition of specified partnership income could have a significant impact, as many partners with service corporations would be caught under the definition of “designated member.”
2. Incorporating multiple CCPCs
Another way for business owners to multiply the business limit within a corporate group is to incorporate multiple corporations—that are CCPCs and intentionally not “associated”—to operate different aspects of the business. Properly structured, each corporation would be entitled to its own $500,000 business limit.
Consider a hypothetical corporation owned by a husband and wife involved in warehousing and trucking in BC. The corporation, Warehouse & Trucking Corp., has a contract with an arm’s-length national shipping company and generates $700,000 in taxable income from active business earned in Canada. If the corporation is not associated with any other corporations and is taxed in BC, it would pay 13% income tax on the first $500,000 of taxable income (amounting to $65,000) and 26% income tax on the remaining $200,000 of taxable income ($52,000), which would add up to $117,000 in income tax.
Now imagine instead that the husband owns and operates Warehouse Corp., which earns $300,000 in taxable income from active business, and the wife owns and operates Trucking Corp., which earns $400,000 in income from active business by charging trucking fees to Warehouse Corp. In this scenario, each corporation would have its own $500,000 business limit, which means that Warehouse Corp. would pay $39,000 in income tax and Trucking Corp. would pay $52,000, for a total of $91,000; this represents tax savings of $26,000 compared to the previous scenario. (Note, however, that reducing income tax cannot be one of the main reasons for structuring the business in this way; otherwise subsection 256(2.1) of the Actwould apply to negate the tax advantage.)
The proposed plan to eliminate the multiplication of the SBD using this method is to extend the SBD rules to fees earned between corporations. This would be accomplished by adding “specified corporate income” to the Act. By definition, “specified corporate income” is the sum of all the “active business income” earned in Canada by a particular corporation from the direct or indirect (in any manner) provision of services/property to a private corporation, if:
- The particular corporation (or one of its shareholders) or a person who does not deal at arm’s length with the corporation (or one of its shareholders), holds a direct or indirect interest in the private corporation; and
- It is not the case that the particular corporation earns all or substantially all of its active business income from persons (other than the private corporation) or partnerships with which it deals at arm’s length.
If the conditions above are met, the specified corporate income of the particular corporation that would be eligible for the SBD is the lesser of:
- The active business income earned by the particular corporation from the direct or indirect provision of services or property to the private corporation;
- The portion of the $500,000 business limit assigned to the particular corporation by the private corporation; and
- An amount determined by the Minister of National Revenue to be reasonable in the circumstances.
Using the latter of the two hypothetical scenarios described above, Trucking Corp. would be caught under this rule, as it would be the “particular corporation” providing services to Warehouse Corp., which is owned by the spouse of the shareholder of Trucking Corp.; in addition, Trucking Corp. does not provide services to third parties. Effectively, the fees earned by Trucking Corp. are producing taxable income that would not be eligible for the SBD unless Trucking Corp. was assigned a portion of the $500,000 business limit by Warehouse Corp.
The proposed rules related to SBD are very broad and to some extent undefined (i.e. direct or indirect interest). However, there may still be opportunities for certain arrangements that are not captured by the draft legislation. For example: joint ventures and cost-sharing arrangements.
Neither “partnership” nor “joint venture” is defined under the Act; however, a partnership is distinguished in the Act as it is considered a separate entity from its members. Income from a partnership is calculated at the partnership level, even though that income is allocated and taxed in the hands of its members. By contrast, a joint venture is not considered a separate entity for tax purposes, and its income is calculated and taxed via its members.
In theory, then, the proposed SBD rules should not affect the income earned from a joint venture, as it is not considered income allocated from a partnership or income earned from a private corporation. However, the difference between a joint venture and a partnership can be blurry, and taxpayers must be careful not to call an arrangement a joint venture when it is, in fact, acting as a partnership.
A cost-sharing arrangement is an agreement between participants to share common costs incurred in the operation of business—costs such as office rent, employee wages, and research and development expenses. Unlike a partnership or a joint venture, a cost-sharing arrangement has no element of profit to be allocated to its members. Since participants in such an arrangement do not carry on business in common, they should have their own revenue sources, and any revenue earned would not be shared among the participants. Therefore, the proposed SBD rules would not apply to them.
Several small corporations may be able to use a cost-sharing arrangement effectively. Bigger corporations, however—especially those operating across provinces—would find this arrangement impossible.
Time will tell…
Looking at the proposed legislation, it’s clear that the government intends for the new rules to have the broadest application possible to limit each economic group to a single $500,000 “business limit.” Arguably, the reach of the new rules could extend beyond this purview, as the draft legislation does not specify what percentage of ownership would constitute a “direct or indirect interest” in a corporation or partnership.
Effectively, entities that are completely dealing at arm’s length may be forced to share a single business limit under the new regime. All attention is now focused on how the proposed legislation might be amended further before it becomes enacted.
Edmund Chow is a senior manager of the tax group at Smythe LLP in Vancouver, where he specializes in tax compliance and advisory services for owner-managed businesses.