Small Business Deduction Planning
Among other drastic measures, the 2016 Federal Budget will result in many of our clients having to review their corporate structures. Some changes will be possible, but the bottom line is that our clients’ taxes will be going up.
There are proposed amendments to the Income Tax Act (the "Act") designed to reduce or eliminate the multiplication of the Small Business Deduction (SBD) among affiliated companies. Please note that when I refer to "affiliated" companies, I mean it in the ordinary sense, not in the technical tax sense.
Although the new rules were not passed in the most recent Budget Implementation Act, I am advised by the Department of Finance that the rules will be enacted and that there will be another Budget Implementation Act later this summer or in the early fall.
Current Rules – Small Business Deduction
SBD is really a tax credit, rather than a deduction. It reduces the corporate income tax rate applying to the first $500,000 per year of qualifying active business income of a Canadian- controlled private corporation (CCPC).
A group of associated corporations must share the Small Business Limit (SBL) of $500,000. There are technical rules to determine whether corporations are associated, but, in simplified terms, associated corporations generally have common control, or control by related parties including cross ownership.
If a husband and wife each has a company, if there is no cross ownership, they would not be associated, and each is entitled to claim its own SBD, resulting in up to $500,000 each of active business income taxed at the low rate. Even if husband’s company is billing wife’s company for services, both companies would still be entitled to its own SBD.
Under the current rules, which will change effective at the beginning of the 2017 fiscal year, corporate partners in a partnership can only claim their pro-rata share of the Small Business Limit. The partnership income that is allocated to each corporate partner is referred to as Specified Partnership Income (SPI) and each partner is only entitled to claim the SBD in respect of its proportionate share of the SPI. In a common example, if two dentists each had a professional corporation operating in a partnership generating $500,000 of active business income, each would only be entitled to claim the SBD in respect of 50% of the $500,000 SBL, i.e. $250,000, in respect of income from that partnership. If one of the corporate partners received less than $250,000 from the partnership, then that amount would be the maximum amount that would qualify for the low rate of tax. If each of the professional corporations had other sources of active business income, they would still be entitled to claim the SBD in
respect of that other income.
Under the rules that will come into force in the 2017 fiscal period, the concept of SPI will be extended to any CCPC that:
Is not otherwise a member of the partnership;
Provides services or property to the partnership;
A member of the partnership does not deal at arm’s length with the CCPC, or a shareholder of the CCPC; and
The CCPC does not derive more than 90% of its ABI is from providing services or property to arm’s length persons other than the partnership.
So, for example, if we consider our dental corporations, if any ocompany owned by the dentists or any of their family members are billing fees for services to the Partnership (no matter how legitimate those services and related fees might be!), those fees would be caught by the new rules.
The CCPC is not otherwise a member of the partnership
The CCPC provides services t the partnership
A member of the partnership (Yachad Ltd.) does not deal at arm’s length with the CCPC
The only determining question will be whether the CCPC derives more than 90% of its ABI from providing services or property to arm’s length parties other than the partnership.
Assuming that the income of the CCPC is caught by the new rules, initially the ABI earned by the CCPC does not qualify for the low rate of tax. However, the partner connected with that CCPC can assign its SPI to the CCPC. To continue the example, Dr. A could assign her share of the SPI to her dental professional corporation and that income, or a portion of it, would qualify for the low rate of tax. The maximum amount that would qualify would be the amount of the fees or the Dr. A’s percentage share of the partnership income.
In short, a corporation providing services to a partnership in which a non-arm’s length party has an interest, will be treated as a member of the partnership and any income received, including income from the provision of goods or services, will be treated as SPI and be subject to pro-ration.
It should be noted that the rules would still allow multiple partnerships to be used and if the CCPC is providing services to more than one partnership, it is the aggregate of the SPI from each partnership that is subject to pro-ration.
As mentioned above, the SBD reduces the corporate income tax rate applying to the first $500,000 per year of qualifying active business income of a Canadian-controlled private corporation (CCPC).
A group of associated corporations must share the Small Business Limit (SBL) of $500,000.
Again, looking at our dentists, if they are not related or there is no cross ownership, the dental corporations would not be associated. Accordingly, each is entitled to the SBD in respect of its first $500,000 of ABI annually.
The new rules will not change that, except to the extent of inter-company fees between companies in affiliated groups or having "common interests".
A new concept is being introduced, "specified corporate income", which is:
Income from the provision of services or property directly or indirectly to another a private corporation, where the CCPC, one of its shareholders, or a person not dealing at arm's length with the shareholder, holds a direct or indirect interest in the private corporation receiving the services.
Again, it does not apply if all or substantially all of the CCPC's ABI is earned from providing services or property to arm's length persons other than the private corporation.
Using our dentists as an example, assume that, instead of a partnership, Dr. A and Dr. B are shareholders in a dental corporation ("DentalCo"). Dr. A’s husband owns an accounting company (let’s call it "AccountCo") that provides accounting services to DentalCo. Because the shareholders of AccountCo do not deal at arm’s length with Dr. A, who has a direct or indirect ownership interest in DentalCo, the inter-company fees charged by AccountCo will be specified corporate income. Even if the fees are completely legitimate and the same as would be charged to any arm’s length party, they will be caught unless they represent less than 10% of AccountCo’s revenue.
Similar to the rules above dealing with partnerships, initially none of the income earned by AccountCo from DentalCo will qualify for the SBD. DentalCo could, however, assign a portion of its SBL to AccountCo. In this case, the ABI of AccountCo, in respect of its billings to DentalCo, which would qualify for the SBD will be the lesser of its actual income from those billings and the amount of the SBD assigned by DentalCo to AccountCo. There is an overriding limitation in the specified corporate income which gives the Minister of National Revenue a right to determine what amount would be reasonable for PGML to assign to Capri in the circumstances. This is potentially such a broad limitation that there is no way to even speculate as to its future application.
With respect to both corporate structures and partnerships, there is an exemption for related party fees if more than 90% of the CCPC’s income is derived from arm’s length third parties. So, if the related party billings are only a relatively small amount, these amounts will not be subject to the new rules.
There are technical rules that provide the mechanism for allocating the SBL or SPI to the CCPC providing the services. I will be happy to provide more detail about these technical rules if needed.
What can we do about it?
If CCPCs whether individual professional corporations or "affiliated" service providers like AccountCo are billing multiple partnerships, the income in respect of each partnership will be subject to pro-ration, but the pro-rated amounts can be aggregated in determining the SBD of the CCPCs.
The good news is that the new rules will, at least so far, not apply to co-tenancies, joint ventures or other types of associations that are not corporations or partnership. If a CCPC is billing an association of professionals corporations for services, commissions, etc. there is no pro-ration of income required and the full amount can continue to qualify for the SBD.
If our clients are prepared to consider changing their billing model so that each CCPC bills clients directly rather than billing the affiliated corporation or partnership, the income billed would not be subject to being pro-rated. Proper agreements would have to be executed to implement this, as you can be sure that it will be subject to scrutiny. This approach has often been taken in groups of affiliated professional corporations using a common "agency" company to act as agent for the professional corporations for billing and administrative purposes.
Assuming that nothing changes in terms of the structure of the billings, etc., the tax rate on a large portion of the billings from the CCPCs to the affiliated corporation or partnership will go to approximately 26.5% rather than 15%.
The impact of this change can be mitigated somewhat by changing our clients’ remuneration models.
If a large part of the income in the CCPCs will not qualify for the low rate of tax, our clients may wish to consider taking dividends rather than salary, or at least a combination of salary and dividends.
Remuneration planning will be the subject of an upcoming memo.