Canada: Elimination Of Small Business Tax Deferral

On March 22, 2016, the Minister of Finance, Honourable Bill Morneau, tabled Budget 2016. Budget 2016 contains numerous business income tax measures. However, for taxpayers who are members of partnerships or shareholders in certain corporate structures, the proposals to small business taxation are of particular interest.

Small Business Deduction

An Ontario corporation is subject to a general corporate income tax rate of 26.5% (15% federally plus 11.5% in Ontario). The small business deduction results in an Ontario Canadian-controlled private corporation (CCPC) with qualifying active business income (ABI) being subject to a combined corporate income tax rate of 15% (10.5% federally plus 4.5% in Ontario) on the first $500,000 of ABI each year. 

Comparatively, an Alberta corporation is subject to a general corporate income tax rate of 27% (15% federally plus 12% in Alberta). An Alberta CCPC with ABI is subject to a combined corporate income tax rate of 13.5% (10.5% federally plus 3% in Alberta) on the first $500,000 of ABI each year. 

The small business deduction is phased out on a straight-line basis for a CCPC and its associated corporations having between $10 million and $15 million of taxable capital employed in Canada.

Partnerships

Presently, for taxpayers who carry on business through a partnership, the specified partnership income rules in Canada's Income Tax Act effectively provide a notional $500,000 small business deduction for the partnership each year that is proportionately allocated to each partner based on the taxable income allocated to the partner for the year. Where the partner is an individual, the specified partnership income rules do not impact the calculation of the individual partner's personal income tax liability. However, where the partner is a CCPC, the specified partnership income rules limit the small business deduction that a CCPC can claim in respect of its income from the partnership to the lesser of the ABI that it receives from the partnership and its proportionate share of the notional $500,000 small business deduction.

Current Treatment

Exhibit A

For example, in Exhibit A, assume LLP has taxable income of $1,000,000. Also assume Mr. X and Mrs. Z provide contract services to LLP through their respective CCPCs and the taxable income allocated from LLP to each of the partners is as follows:

Mr. X - $100,000
Mrs. Z - $150,000
Y Co - $750,000

The application of the specified partnership income rules would allocate the notional $500,000 small business deduction as follows:

Mr. X - $50,000
Mrs. Z - $75,000
Y Co - $375,000

Mr. X and Mrs. Z are taxable on their $100,000 and $150,000 of allocated partnership income from LLP and pay personal income tax rates.

Assuming the only income X Co, Y Co and Z Co earn is from LLP, the following applies:

X Co is taxable on its $650,000 of income for providing services to LLP and pays Ontario corporate income taxes of $114,750 ($500,000 @ 15% plus $150,000 @ 26.5%).

Z Co is taxable on its $600,000 of income for providing services to LLP and pays Ontario corporate income taxes of $101,500 ($500,000 @ 15% plus $100,000 @ 26.5%).

Y Co is taxable on its $750,000 of allocated partnership income from LLP and pays Ontario corporate income taxes of $155,625 ($375,000 @ 15% plus $375,000 @ 26.5%). Note that the specified partnership income rules only provide Y Co with the ability to access a $375,000 small business deduction where X Co and Z Co each have a $500,000 small business deduction.

Proposed Treatment

Budget 2016 proposes to extend the specified partnership income rules to partnership structures in which a CCPC provides (directly or indirectly, in any manner whatever) services or property to a partnership during a taxation year of the CCPC where, at any time during the year, the CCPC or a shareholder of the CCPC is a member of the partnership or does not deal at arm's length with a member of the partnership.

Effectively, where an individual is a member of a partnership and that individual provides services to the partnership through their CCPC, Budget 2016 proposals will deem the CCPC to be a member of the partnership. The CCPC will then be subject to the specified partnership income rules as outlined earlier. Assuming the very same fact pattern from our example, Budget 2016 proposals will have the following impact:  

Mr. X and Mrs. Z will be taxable on their $100,000 and $150,000 of allocated partnership income from LLP and pay personal income tax rates.

Given Mr. X will be allocated a notional small business deduction of $50,000 from LLP, Mr. X will notionally allocate the $50,000 small business deduction to X Co. X Co is taxable on its $650,000 of income from providing services to LLP and pays Ontario corporate income taxes of $166,500 ($50,000 @ 15% plus $600,000 @ 26.5%).

Given Mrs. Z will be allocated a notional small business deduction of $75,000 from LLP, Mrs. Z will notionally allocate the $75,000 small business deduction to Z Co. Z Co is taxable on its $600,000 of income from providing services to LLP and pays Ontario corporate income taxes of $150,375 ($75,000 @ 15% plus $525,000 @ 26.5%).

Y Co is already an actual member of LLP. Therefore, there is no change in how Y Co is taxed under Budget 2016 proposals. Y Co is taxable on its $750,000 of allocated partnership income and pays Ontario corporate income taxes of $155,625 ($375,000 @ 15% plus $375,000 @ 26.5%).

Corporations

Budget 2016 also proposes amendments to Canada's Income Tax Act for structures similar to the above that use a private corporation (what we refer to as a master corporation) instead of a partnership. Specifically, Budget 2016 proposes that a CCPC's active business income for providing services or property (directly or indirectly, in any manner whatever) in its taxation year to a master corporation will be ineligible for the small business deduction where, at any time during the year, the CCPC, one of its shareholders or a person who does not deal at arm's length with such a shareholder has a direct or indirect interest in the master corporation.   

Summary

Bottom line: where applicable, Budget 2016 proposals will eliminate the small business tax deferral, which ranges from a low of 8.4% in Quebec to a high of 17.5% in Nova Scotia based on provincial or territorial residency.  

The proposals will apply to taxation years that begin on or after March 22, 2016.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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