This article is part of a series dealing with draft legislation released for comment by the Department of Finance on July 29th.
New limits proposed for the small business deduction (SBD) are raising concerns about the broad discretion granted to the minister to override existing tax rules.
The SBD results in a preferential federal tax rate of 10.5 per cent on the first $500,000 of active business income earned by a Canadian-controlled private corporation (CCPC). Section 125 of the Income Tax Act (Canada) (ITA) sets out the circumstances in which the SBD is available, and also includes rules intended to limit the ability of taxpayers to multiply the benefit of the SBD. Over time, various corporate and partnership structures evolved which were not subject to these limitations.
In Budget 2016, the Government of Canada proposed enacting new rules to further limit the use of the SBD in the name of enhancing domestic tax integrity. The new rules would specifically target active business income earned by CCPCs through partnerships and corporations in which the CCPC or a shareholder of a CCPC held a direct or indirect interest.
This article discusses noticeable concerns raised by the 2016 Legislative Proposals. We encourage the Department of Finance to address these concerns before the draft legislation is passed into law.
A remarkable feature of the 2016 Legislative Proposals is the conferral of a broad discretion on the Minister to determine "specified corporate income", which is a key element of the SBD. In particular, the new definition in subsection 125(7) states that "specified corporate income" may be an amount the Minister determines to be reasonable in the circumstances. Since the new rules have yet to be implemented, it is unclear how aggressively the Minister will use this new discretionary power to override the usual calculation of specified corporate income set out in the ITA.
Although detailed explanatory notes were provided to accompany the 2016 Legislative Proposals, no explanation for granting this discretionary power was given. The notes relating to the new definition "specified corporate income" just state that the purpose of this addition is to "address structures that avoid the specified partnership income rules and to prevent the inappropriate multiplication of the small business deduction." With this broad mandate, the discretion granted to the Minister may end up being used as essentially another new anti-avoidance provision, in addition to proposed subsection 125(9) discussed below, thereby creating further uncertainty for taxpayers.
Proposed subsection 125(9) is a new anti-avoidance rule applicable to the SBD. The new rule may apply where a corporation earns active business income from providing services or property to a person who holds a direct or indirect interest in a particular partnership or corporation. That active business income will not be eligible for the SBD if one of the reasons for the provision of the services or property to that person, instead of to the particular partnership or corporation, is to avoid the application of the rules limiting the use of the SBD contained in subparagraphs 125(1)(a)(ii) or (ii.1).
Given the potentially broad interpretation of "indirect interest", this new anti-avoidance rule could apply to a very wide range of situations.
References in the 2016 Legislative Proposals to parties holding an "indirect interest" in a partnership or corporation are not completely clear and this will give rise to uncertainty. For example, does an "indirect interest" refer to an indirect interest via an agent or nominee, or does it have a broader meaning, such as the economic interest through an intermediary holding company, or the interest of (i) a creditor of a corporation or partnership, (ii) a holder of stock options or phantom equity or interest in a corporation or partnership, (iii) a guarantor of debt of a partnership or corporation, or (iv) a beneficiary of a trust that is a member of a partnership or a shareholder of a corporation?
Although this issue is not addressed in the explanatory notes, third party commentary on the 2016 Legislative Proposals leans towards the more inclusive interpretation. Although there is a dearth of CRA views on other sections of the ITA which incorporate the phrase "direct or indirect interest", commentary on the interpretation of "direct interest" in paragraph 55(3)(a) and "direct or indirect interest" in subparagraph 88(1)(c.2)(iii) similarly supports a broader interpretation. See, for instance, the report of the CBA/CICA Joint Committee on Taxation in response to the December 21, 2012 technical amendments of subparagraph 88(1)(c.2)(iii).
Substantially all (i.e., 90%) Arm's Length Test
As an example of the broad potential application of the new SBD rules, consider a situation in which a corporation owned by a sister (SisterCo) provides services to a small number of clients, one of which is a company owned by her brother (BrotherCo). The income earned by SisterCo from providing services to BrotherCo constitutes only 11% of the "income from an active business of the corporation for the year" for the purpose of subparagraph (a)(i) of the definition "specified corporate income" in subsection 125(7).
Because the owners of SisterCo and BrotherCo do not deal at arm's length and SisterCo provides services to BrotherCo, the arrangement will be caught by new clause (a)(i)(B) of the definition "specified corporate income". As a result, SisterCo will be precluded from claiming the SBD on income earned from BrotherCo, except to the extent that BrotherCo assigns a portion of its business limit to SisterCo under subsection 125(3.2). We suspect that the tax consequences of this scenario were not intended by the Department of Finance.
This example also raises another issue, namely how is the income from an active business of the corporation determined for this purpose? In light of the definition "income of the corporation for the year from an active business" in subsection 125(7) and the definition of income from business in subsection 9(1), "income" in this context could be interpreted as referring to "net income" or "profit". However, this is not clear and may be the subject of some debate in applying the new rules.
The 2016 Legislative Proposals have taken aim at preventing taxpayer's from multiplying the SBD for multiple CCPCs or partnerships that provide services or property to associated parties. Structures that previously gave rise to the SBD – and which had been approved in rulings issued by the CRA – will need to be rethought and retooled. Finally and most importantly, the new rules are very broad, include significant elements of uncertainty and discretion, and could apply to a myriad of business arrangements that were contemplated neither by the Department of Finance or taxpayers.
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.