Maximizing The Small Business Deduction: Preventing Corporations from Being Associated

Barrett Tax Law

The Small Business Deduction.  The government giveth a wondrous gift, but if you’re not careful, they taketh back.

In Ontario, there are preferential tax rates that apply to a corporation’s profits when certain criteria are met. One of the more compelling circumstances that Canadian corporation can maximize their tax credits is through the Small Business Deduction (the “SBD”). While the application of the SBD is governed by section 125(1) of the Income Tax Act, a brief assessment of this deduction is provided below.

What is the Ontario Small-Business Deduction?

The Ontario SBD specifically refers to the reduction of corporate income tax rates on the first $500,000.00 of active business income for Canadian-Controlled Private Corporations (“CCPC”). Additionally, this amount also represents the annual limit of active business profits that can be claimed by a CCPC for the Small Business Deduction or shared between associated CCPC’s.

For CCPCs and associated corporations, the deduction was previously phased out for small businesses with more than 10 million dollars in taxable capital employed in Canada during the previous taxation year. Further, if taxable capital exceeded 15 million dollars in the previous year, the deduction was eliminated in its entirety.

As of late, more corporations can qualify for the Small Business Deduction.  For tax years beginning after April 6, 2022, The SBD will not be reduced to nil until a CCPC and its associated corporations have a combined taxable capital of 50 million dollars.

The amount of tax saved by applying the SBD to the first $500,000 of profits is dramatic.

The SBD is shared between associated companies.  This prevents abuse of the system whereby for example, rather than building a large corporation with millions in profit, all of which except the first $500,000 would be taxed at the regular corporate tax rate, one could instead build a variety of businesses each of which only earned $500,000 in profit, thereby multiplying the Small Business Deduction.

Different Ways Companies are Considered to be Associated

The rules outlining what causes corporations to be associated are found in subsection 256(1) of the Act.

The three general ways for corporations to be associated:

1. Direct / Indirect Control of a Corporation: one corporation controls the other
2. Common Control of Multiple Corporations: both corporations controlled by the same person / group of people
3. Control by Corporations by Related Parties (aka the 25% Rule): related individuals or groups of individuals each control a corporation, and one relative / group owns at least 25% percent of a non-specified class of shares of the other corporation.

The essence of what causes corporations to be associated boils down to the direct or indirect exercise of control held over two or more corporations.

Through the courts, this test of control has long been considered to be the right of control that rests in ownership of such a number of shares as carries with it the right of votes in the election of the board of directors.

This control test under 256(1) is applied on an annual basis and thus corporations which may be associated this tax year could potentially not be associated next tax year.

Conclusion

Given that associated corporations must share the Small Business Deduction, and given the tax difference on the first $500,000 of income between a corporation entitled to the SBD vs. a corporation paying full taxes, it is vital to be able to avoid corporations being associated whenever possible.

Similarly it is important for small businesses seeking to claim the Small Business Deduction to keep up with the ever-changing tax landscape and take full advantage of the Act, such as the ability under certain circumstances to file an election under subsection 256(2) of the Income Tax Act (“the Act”) to cause corporations to not be considered to be associated, or to perform a corporate reorganization to achieve the same result.

Any good tax plan should address the issue of the Small Business Deduction and associated corporations.

If you need any help navigating the SBD or other tax planning, please contact one of our experienced tax lawyers at Barrett Tax Law at 1-866-278-8424 or clientcare@barretttaxlaw.com.