Canada: Breaking Down Changes To The Small Business Deduction

In Canada, corporations may claim a small business deduction (SBD) on their corporate tax returns, effectively reducing the corporate tax rate on the first $500,0001 of taxable income from active business income (ABI). ABI does not include aggregate investment income.

Aggregate investment income (AII) includes:

  • taxable capital gains in excess of allowable capital losses (current, carried forward, carried back); and
  • property income (i.e. interest income, rental income, royalties, and dividends included in calculating taxable income).

All is calculated net of expenses. The Canada Revenue Agency (CRA) permits a reasonable allocation of direct and indirect expenses when determining All, including rental expenses, advisory and professional fees, etc.

For farms, maximizing ABI and minimizing AII is important given the much lower corporate tax rate associated with ABI subject to the small business deduction.2 It is important to know how to categorize various revenue sources that may be included in a farm operation's taxable income. Consider these examples:

  1. AII does not include AgriInvest income. The CRA advises that, when money is withdrawn from an AgriInvest account, the taxable portion is not considered investment income; rather it is a farm program payment and is included in the calculation of ABI.
  2. Income from the generation of electricity from solar panels or wind turbines is included in the calculation of AII.

These factors have increased relevance due to recent changes the Department of Finance has made reducing or eliminating access to the small business deduction (SBD) based on excess AII. The structure used by the Department of Finance to reduce or eliminate the SBD is called adjusted aggregate investment income (AAII). The AAII calculation starts with AII and makes the following adjustments to arrive at AAII:

  • Taxable capital gains and allowable capital losses resulting from the disposition of "active assets" are excluded. Active assets include assets primarily (generally, more than 50 per cent) used in an active business primarily (generally, more than 50 per cent) carried on in Canada by the CCPC or a related CCPC. An active asset also includes an investment in shares if the shares are of a connected corporation where the shares would qualify as QSBC shares under ITA 110.6(1).
  • Net capital losses are not to be deducted.
  • Dividends from non-connected corporations (e.g. portfolio dividends) are to be added.

Some highlights and key pieces of information of the new rules include:

  • For corporations with $50,000 or more AAII, the SBD will be "ground down." For each $1 of AAII over $50,000, there is a reduction in the SBD of $5. Thus, the SBD is fully ground down where a corporation has $150,000 or more of AAII.
  • The "grinding down" limits access to the small business deduction and its low corporate tax rate.
  • Taxable capital gains on the sale of active assets and incidental investment income on active assets is not part of the AAII calculation. The term "active asset" is specifically defined by the CRA. A common example is a taxable capital gain on the sale of land used in the farming operation, which would not be included in the AAII calculation.
  • These rules take effect and are applicable for year-ends beginning after December 31, 2018.
  • There is no grandfathering of "passive investments" as originally promised. AAII is calculated annually based on income generated from the investments held within an associated corporate group. As a result of the calculation, all investment income generated on investments held before and after December 31, 2018, factors into the AAII calculation. If you currently have an investment portfolio inside your corporation (or as part of an associated group) and the income generated from the investments (AAII) exceeds $50,000, the excess amount will reduce your SBD limit.

These changes could have a significant effect on the amount of tax that is paid inside your corporation going forward. Fortunately, there are some planning opportunities for reducing the amount of additional tax your corporation must pay:

  1. Ensure that there is a proper allocation of direct and indirect expenses against the AAII. Common expenses include advisory fees incurred to manage your investments. If you have rental income included in the calculation of AAII, ensure that all applicable expenses related to that rental property are deducted.
  2. Review your investment strategy and consider focusing more on capital appreciation rather than income-generating assets. This strategy defers the tax liability until the asset is sold and a capital gain is realized.
  3. Look for tax-efficient methods to extract the investment assets from your corporation. It may be beneficial to have the investments taxed in your personal name depending on your marginal personal tax rate.
  4. Consider paying a bonus to the owners of the company in order to reduce the amount of ABI that is subject to a higher tax rate due to the SBD being ground down as a result of AAII.

These new rules could have a significant effect on taxes that will be paid inside a corporation and ultimately the amount of cash available to grow your business. If you have passive investments inside your corporation, consider consulting with your accountant or tax professional for help in understanding and taking advantage of the planning opportunities that are available.

Footnotes

1. The business limit of all provinces and territories is now equal to the federal limit of $500,000, except Saskatchewan, which has an increased limit of $600,000 as of January 1, 2018, and Manitoba, where the limit stands at $450,000 (will increase to $500,000 effective January 1, 2019).

2. The corporate tax rate on ABI, subject to the small business deduction, ranges from 11.5 per cent to 17.25 per cent throughout the provinces. The corporate tax rate on AII throughout the provinces ranges from 50.17 per cent to 54.67 per cent.

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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