Beware – Specified Corporate Income Rules

In British Columbia, the small business deduction enables Canadian controlled private corporations to pay tax at the rate of 13% on the first $500,000 of active business income.

Where the company is part of an associated group of companies, the $500,000 small business deduction must be shared by the associated group. Business income in excess of the small business deduction is taxed at the rate of 26%. As a result, the small business deduction results in an annual tax reduction of $65,000 to the company or associated group of companies.

The March 2016 federal budget contains proposals to limit the availability of the small business deduction to companies that earn “Specified Corporate Income.” While it is believed these proposals were targeted primarily at professionals and closely held corporate groups who had created structures that enabled them to access multiple small business deductions, a review of the draft legislation reveals these proposals have a much wider reach.

A company’s Specified Corporate Income is its income from the provision of property or services to another private corporation where the company, a shareholder of the company, or a person who does not deal at arm’s length with the company or one of its shareholders has a direct or indirect interest in that other private corporation.

A company will not have Specified Corporate Income if all or substantially all its business income is earned from arm’s length parties (other than the other private corporation). In other words, income from the other private corporation will be considered incidental if it represents less than 10% of the company’s total active business income.

For fiscal years beginning after March 21, 2016 a company’s Specified Corporate Income will not be eligible for the small business deduction, unless the other private corporation assigns a portion of its small business limit to the company. These new rules will result in extending the current requirement for associated companies to share the $500,000 small business deduction to companies that are not associated.

Examples of When New Specified Corporate Income Rules Apply

Example 1

Mr. A is a lawyer with a 15% equity interest in ABC Law Inc., an incorporated law firm. Mr. A provides professional services to ABC Law Inc. through his separate personal law corporation.

As Mr. A has an interest in ABC Law Inc., the income earned by his personal law corporation from ABC Lawyers Inc. will be Specified Corporate Income that will not be eligible for the small business tax rate unless ABC Law Inc. allocates part of its business limit to Mr. A’s personal law corporation.

Example 2

Mr. B owns a manufacturing company – RST Manufacturing Inc. Mrs. B (Mr. B’s wife) provides management and consulting services to RST Manufacturing Inc. through her company – Bee’s Consulting Inc. RST Manufacturing Inc. is the sole client of Bee’s Consulting Inc. The income earned by Bee’s Consulting Inc. from RST Manufacturing Inc. will be Specified Corporate Income, and not eligible for the small business tax rate unless RST Manufacturing Inc. assigns a portion of its business limit to Bee’s Consulting Inc.

Example 3

Mr. C owns a construction contracting company – C Contracting Ltd. One of the company’s customers is D Construction Co., which builds residential houses. D Construction Co. is owned by Mr. D. However, Mr. C and Mr. D are brothers, and as a result they are deemed not to deal with each other at arm’s length. Consequently, the income earned by C Contracting Ltd. from D Construction Co. will be Specified Corporate Income and will not be eligible for the small business tax rate unless it represents less than 10% of the company’s total income or D Construction Co. assigns a portion of its business limit to C Contracting Ltd.

The potential impact of these new Specified Corporate Income rules is quite far reaching. These rules can limit access to the small business deduction to companies engaged in normal business transactions. Companies will need to be aware of who they do business with and whether there are any direct or indirect ownership interests in the other company that might impact their ability to claim the small business deduction.

Bryan Hubbell, CPA, CGA is a Senior Tax Manager with Manning Elliott LLP. To contact Bryan for more information about how the new Specified Corporate Income rules may limit your ability to claim the small business deduction, please call him at 1-604-557-5759 or email him at bryan@manningelliott.com

The above content is believed to be accurate as of the date of posting. Canadian Tax laws are complex and are subject to frequent changes. Professional tax advice should be sought before implementing any tax planning. Manning Elliott LLP cannot accept any liability for the tax consequences that may result from acting based on the information contained therein.