Current combined personal tax rates are higher than corporate rates, so there is an inherent tax incentive for business owners to incorporate. Federally, the general corporate tax rate is 15%, while the small business tax rate for a Canadian-controlled private corporation (CCPC) is 10.5% on active business income not exceeding $500,000. This reduction is due to the small business deduction (SBD).
When two incorporated businesses are associated for tax purposes, they must share the small business limit. Similarly, when a CCPC is a member of a partnership, the CCPC is only entitled to its proportional share of the SBD, based on its share of active business income of the partnership allocated to it.
For instance, assume there are five professional corporations that are members of a partnership. The partnership has active income of $1 million for a tax year. If Corporation X is allocated 20% of the active income of the partnership ($200,000), at most $100,000 of that income (20% of the $500,000 SBD) can be classified under the SBD.
Certain group structures (primarily used by professionals) have been designed to get around these SBD rules.
What used to be permitted under the small business deduction
- Albert, an individual, is a member of a partnership.
- Albert is a shareholder of PCCorp, which is a CCPC.
- The partnership pays PCCorp as an independent contractor for services to the partnership.
- PCCorp can claim a small business deduction in respect of its active business income earned from the partnership. Although Albert is a member of the partnership, PCCorp is not, and under the old rules, the full small business deduction was available to PCCorp.
Another example of what used to be allowed under the SBD
- BCorp is owned by Belinda, an individual.
- BCorp provides services or property (either directly or indirectly) to Corporation C.
- Belinda, BCorp, and a person not dealing at arm’s length with either Belinda or BCorp, have direct or indirect interests in Corporation C. But, the two corporations, BCorp and Corporation C, were not considered associated for tax purposes. Under the old rules, BCorp and Corporation C each paid 10.5% tax (federally) on their first $500,000 of active business income, for a total of $1 million that would be taxed at 10.5%.
Proposed amendments announced in the 2016 Federal Budget, and released on July 29, 2016, restrict the multiplication of the SBD in corporate structures like those mentioned above.
Under the proposed amendments:
- A CCPC will be deemed to be a member of a partnership throughout a taxation year, and its income will be deemed to be partnership income and subject to its allocation of the SBD. So, Albert’s PCCorp would share the $500,000 SBD.
- Income of a CCPC from the provision of services or property to a corporation not dealing at arm’s length with the CCPC, also known as specified corporate income, will not be eligible for the SBD. So, BCorp and Corporation C would share the $500,000 SBD.
- Exceptions will apply where all or substantially all income earned by the CCPC comes from providing services or property to arm’s length corporations.
These proposed amendments deal a blow to some tax planning for CCPCs for taxation years starting after March 21, 2016.
Benefits of a corporation
Despite the rule changes, there are still benefits to having a separate corporation (including a professional corporation). They include:
- Tax deferral. The maximum tax deferral for an Ontario resident, for example, would be 27.03% on active business income (53.53% personal tax rate versus 26.50% corporate tax rate). Tax saved can then be reinvested in the corporation to earn investment income.
- Income splitting with spouses and adult children through share ownership by family members (only available for certain professionals).
- Flexibility of remuneration. Corporations allow owners to receive salary or dividends. Also, it is generally less expensive to fund costs such as life and health insurance with after-tax corporate income.
- Asset protection. Corporations limit general liability (exceptions include liabilities to the extent of personal guarantees, and professional liability for professional corporations).
Given the proposed amendments, it is necessary to examine any corporate structure that may be affected and determine whether it makes sense to restructure. For example, corporations providing services could be wound up or a partnership could convert its business operations to a cost-sharing arrangement. However, the loss of a small business deduction must be weighed against other potential benefits and costs of maintaining or modifying a corporate structure.
Your tax on $500,000 in active business income (Ontario rates)
|Combined tax rate||Tax payable|
|Within the small business limit||15.0%||$75,000|
|At the general tax rate||26.5%||$132,500|
By Stephanie Dietz, CPA, CA, CFP. She specializes in tax and estate planning at Stephanie Dietz Professional Corporation. firstname.lastname@example.org