Changes to the Small Business Deduction: What Small Business Owners Need to Know01-Aug-17
By Mike Harris
On December 15, 2016, a number of changes to the small business deduction were proclaimed into law, effective for taxation years generally commencing after March 21, 2016. These amendments are intended to address a number of common tax structures which the Department of Finance found abusive, but may inadvertently impact a number of arrangements that were previously understood to be acceptable.
The Old Rules and Common Structures
Under the previous legislation (the “Old SBD Rules”), active business income (other than active business income earned through a partnership) was eligible for the small business deduction under to section 125 of the Income Tax Act (Canada) (the “ITA”). In contrast, active business income earned through a partnership was eligible for the small business deduction only if it was “specified partnership income”, a complex set of rules intended to ensure that the members of a partnership shared a single $500,000 small business deduction.
Corporations were required to share a single $500,000 small business deduction if they were “associated” for purposes of the ITA. Generally speaking, corporations that are under common control will be associated. Two corporations owned by related persons (such as a husband and wife, or parent and child) are also associated if there is a significant degree of cross-ownership of the shares of those corporations (i.e. the parent owns shares in the child’s corporation or vice versa). In situations where there is limited or no cross-ownership of shares, each of these related persons can own a corporation that is entitled to its own small business deduction.
The Issue and the New Rules
Because related persons can own corporations that are not associated with each other, and therefore each have their own $500,000 small business deduction, plans were developed to take advantage of this situation and multiply the small business deduction. Consider for example a husband and wife who each wholly own their own corporations, and the wife carries on an active business through her corporation (“WifeCo”). If the husband is an employee of WifeCo there would be only a single small business deduction available, in the hands of WifeCo. However, if the husband provides services to WifeCo through his own corporation (“HusbandCo”), this would be active business income and was eligible under the Old SBD Rules for the small business deduction. This meant that HusbandCo and WifeCo were able to access two separate $500,000 small business deductions, even though only a single “business” is actually being carried on.
The same result would be achieved if WifeCo was a partner in a partnership, and HusbandCo provided services directly to the partnership, or indirectly to the partnership by providing services to WifeCo.
Amended section 125 of the ITA (the “New SBD Rules”) restricts the types of income that will qualify for the small business deduction. The New SBD Rules potentially apply where:
- A corporation earns income by providing property or services to a private corporation (the “recipient corporation”), and the corporation, one of its shareholders, or someone not at arm’s length with the corporation or its shareholders, owns an interest in the recipient corporation; or
- A corporation earns income by providing property or services to a partnership, and one of the corporation’s shareholders, or someone not at arm’s length with the corporation or its shareholders, is a partner of the partnership.
The New SBD Rules prevent plans such as the HusbandCo/WifeCo examples above, as HusbandCo will generally be denied the small business deduction in respect of any income earned from providing property or services to WifeCo.
The Unintended Consequences
The New SBD Rules are broadly drafted and will apply in a number of situations that are not abusive. For example, consider a father who acts as a general contractor building residential homes through his wholly-owned corporation. His son is a framer who carries on a framing business through his wholly-owned corporation. The son’s corporation invoices the father’s corporation for work done on various jobs. This income earned by the son’s corporation is caught by the New SBD Rules and will not qualify for the small business deduction, because the father is a shareholder of the corporation receiving the framing services.
As another example, consider a husband and wife who own and operate a paving company through a corporation. The family are also members of the local cooperative and own a share in the cooperative (as required by the terms of the cooperative). If the cooperative hires this paving company to pave its parking lot, the income earned by the paving company is caught by these new rules and will be denied the small business deduction, as the husband and wife own an “interest” in the cooperative.
Because of the broad application of the New SBD Rules, any situation where property or services are provided to corporations or partnerships where someone not at arm’s length with the supplier (i.e. family, business partners, close friends) owns an interest in the recipient may potentially be caught.
An analysis of whether the New SBD Rules will apply in any given situation is complicated because there are exceptions to the New SBD Rules, and the question of whether two persons are at arm’s length will depend on the particular facts of that situation. McLennan Ross is well positioned to answer any questions that may arise as a result of the New SBD Rules, and to advise on whether previous planning remains effective. Please do not hesitate to contact Mike Harris or MaryAnne Loney should you have any questions or require any advice.