Clients using sophisticated tax strategies to maximize access to the small business deduction (SBD) will be disappointed with two changes in this year’s federal budget.
The first is a change that closes a loophole in the association rules for corporations. To illustrate, consider the following example.
Opco is owned 50%/50% by Holdco A and Holdco B. Holdco A is owned by Marsha and Holdco B is owned by William, who are siblings.
Under this scenario, tax rules say all three companies are associated, which means all three have to share a single SBD, explains David Steinberg, co-leader of EY’s Private Mid-Market practice in Toronto. But there’s a rule that says if Opco files a special election, it can forfeit its SBD, which would then allow Holdco A and Holdco B to each get their own SBD. In that case, Steinberg says, you would go from one SBD shared by all three companies, to two SBDs—one for Holdco A, one for Holdco B.
From the government’s point of view, so far, so good. Here’s where the perceived abuse comes in.
Say Opco pays $400,000 of loan interest to Holdco A and $400,000 of loan interest to Holdco B. Normally, that interest income would be subject to a high rate of tax, notes Steinberg. “But under the association rules, there’s a deeming rule that deems the interest to be active [business income] if it’s received from an associated company. And that deeming rule still continued even if you made that special election not to be associated with Opco,” i.e., the special election that forfeited Opco’s SBD.
The net result: $800,000 of passive income is converted into active business income that qualifies for the small business deduction.
Steinberg explains that this year’s budget ends this practice by saying that if Opco makes the election to forfeit its SBD and become disassociated from Holdco A and Holdco B, then Marsha and William are no longer able to invoke the provision that allows them to deem the $400,000 in interest they each get as active business income eligible for the SBD.
So, post-budget, it’s still possible to elect to forfeit Opco’s SBD, resulting in a separate SBD for each of Holdco A and Holdco B; as of March 22, 2016, if Marsha and William make this election, they are no longer able to use it in combination with the deeming provision that converts interest income from Opco into active income eligible for the SBD.
Multiplying the SBD
The second change is less an alteration of the current rules than a tightening of their drafting to prevent a practice that thwarts the law’s original intention.
Each small business should be entitled to one SBD, notes Dave Walsh, leader, Tax Services practice, BDO Canada in Ottawa. In their current form, the rules contain a loophole that allows a single business to be structured in a way that multiplies its access to the SBD.
Say you have a small law firm, XYZ Legal Services, that’s structured as a partnership, and there are three partners. Walsh explains that currently, each partner could set up her own professional corporation on the side, with each corporation entitled to its own SBD. The three corporations then provide services to the partnership, and the income generated by those services goes into the side corporations as active business income.
The spirit of the law is that XYZ Legal Services should get one SBD, which would then be shared by the three partners. But thanks to the loophole, the partners are able to structure the business so that each partner gets her own SBD via the professional corporation they each set up on the side. This structure has been used by legal, accounting and other partnerships.
“The abuse,” says Steinberg, “is avoiding what’s called specified partnership income; partnerships were intended only to get one small business deduction. Now, they’re doubling up, tripling up, or quadrupling up, depending on how many partners you have.” The budget ends this practice of multiplying the SBD. So, if the partners see greater advantage in staying together as a single business, they’ll need to be content with a single, shared SBD. If having one SBD each is more important to them than the benefits of combining their services under one banner, they’ll need to go their separate ways.
Steinberg adds that the loophole also existed—and is being closed by the Liberals—in cases where the business was structured as a corporation rather than a partnership. In this scenario, the business owners would still set up side corporations, as in the previous example, except in this case the side corporations would be billing a corporation rather than a partnership for services rendered.