Earlier this year, the federal government approved legislation that restricts the small business deduction (SBD) available to Canadian-controlled private corporations (CCPCs). For tax years after 2018, access to the SBD now depends on passive investment income levels, as determined by adjusted aggregate investment income (AAII).
Where AAII exceeds $50,000 in the previous fiscal year, access to the SBD (10% to 17% depending on the province) drops by $5 for every $1 of AAII above $50,000. Access to the SBD is completely eliminated where AAII reaches $150,000.
This type of clawback isn’t new. As it stands, the SBD is clawed back for companies with taxable capital above $10 million, and eliminated at $15 million. In general terms, taxable capital comprises retained earnings plus non-trade liabilities; less loans with, and investments in, Canadian companies. It appears the policy behind this is that companies with substantial retained earnings or certain liabilities aren’t viewed as small and therefore shouldn’t benefit from the SBD.
The policy behind the new clawback rule doesn’t necessarily target only large companies, however: the SBD will be reduced where assets invested reach $1 million, assuming a modest 5% return. Thus, an understanding of AAII will be important for small-business owners to ensure they continue to benefit from the SBD.
The starting point for calculating AAII is aggregate investment income (AII) as defined in the Income Tax Act (ITA). Generally, a company’s AII is made up of:
- taxable capital gains, net of allowable capital losses from current or previous years;
- passive rental income;
- passive foreign income, including foreign accrual property income (FAPI); and
- losses from property.
However, when calculating AAII, the following income sources are excluded:
- dividends from connected corporations (dividends from non-connected corporations are included in AAII but not in AII) and
- taxable capital gains from business assets, including gains on qualified small business corporation shares.
Dividends from connected corporations
Where a corporate shareholder owns more than 10% of the votes and value of any class of shares of another corporation, that corporation is connected to the corporate shareholder. Dividends from connected corporations are excluded from AAII and therefore don’t impact the availability of the SBD for the associated group of companies.
This seems consistent from a policy perspective as it’s common for an operating company to pay a dividend to its holding company for creditor protection and other reasons. Since AAII is measured as an aggregate of all associated companies, it would be unfair to include these dividends in that calculation as they represent income from an investment in an active asset (i.e., the operating company) as opposed to a passive asset, such as publicly traded shares.
Gain on sale of active business assets
Similar to the policy of excluding connected corporation dividends, excluding gains from business assets encourages investment in small businesses. A significant aspect of operating a small business may include replacing assets and selling off old ones. Also, several business owners may sell their business assets as part of the business exit strategy. The government doesn’t want to penalize private companies when they sell these assets.
What can’t be used to reduce AAII
The following deductions can’t be used to reduce AAII:
- net capital losses from previous or subsequent years,
- deductions for charitable donations, and
- deductions for foreign accrual taxes.
Net capital losses from other years
Certain inclusions and deductions are defined in the ITA to determine net income. However, a taxpayer’s tax liability isn’t calculated on net income but rather on taxable income. In calculating taxable income, certain deductions are allowed pursuant to division C of the ITA.
In calculating AAII, certain deductions aren’t allowed, one of which is net capital losses from other years. These can be carried back three years or carried forward indefinitely to reduce net capital gains for the year to which they’re applied.
Although this option is still available to reduce a private company’s current-year taxable capital gains, only current-year net capital losses can be used to reduce AAII. Therefore, small-business owners wishing to continue benefiting from the SBD will need to manage capital gains and losses to ensure they occur during the same fiscal year.
In calculating AII and AAII, a deduction for losses from property is allowed. A loss from property occurs where expenses incurred to earn income from the property exceed income earned. A charitable donation isn’t considered an expense incurred for the purpose of earning income, but rather an act of charity for which corporations are allowed a separate deduction in calculating taxable income.
Foreign accrual tax (FAT)
There’s an interesting exclusion in the definition of AAII relating to foreign accrual tax (FAT) paid on foreign accrual property income (FAPI). Although FAPI is a complex topic and not something typically seen by the average small business, it’s not uncommon in a private company context, due to globalization and Canada’s proximity to the U.S.
Generally, where a Canadian taxpayer (including a Canadian private company) owns a foreign company, which is a controlled foreign affiliate (CFA), and the CFA earns passive income, the Canadian shareholder may have to include income (i.e., FAPI) from that CFA even if no dividends are received from it during the year. In addition, the Canadian shareholder is entitled to a deduction based on the amount of FAT paid by the CFA.
Often, due to how the FAT deduction is calculated, the FAPI inclusion is less than the FAT deduction such that the Canadian shareholder has little or no taxable income related to their investment in the CFA. However, in calculating AAII, the new rules don’t allow for a FAT deduction, so the full amount of FAPI is included in AAII.
While the concept of income or loss may seem simple from a business or accounting perspective, the definition of AAII is complex. A full and careful analysis of that definition is a starting point to protecting a corporation’s access to the SBD each year.
Jim Witty, CPA, CA, is vice-president, Tax, Retirement and Estate Planning at CI Investments.