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Changes to Small Business Deductions and Impact on Common Business Structures

12/12/2016


​​​​​On March 22, 2016, the Trudeau Liberal government tabled their first budget, which proposed significant changes to corporate taxation when income is earned in a partnership or revenue is received from another company.

A Small Business Deduction (SBD) is available on the first $500,000 of active business income earned in Canada by a Canadian Controlled Private Corporation. This SBD has an annual tax deferral of between $42,000 in Quebec to $72,500 in Saskatchewan.

table

The SBD is a deferral versus an outright tax savings, as when the individual shareholders receive dividends, the income subject to the small business deduction will have a higher rate on the dividend.

Associated corporations must share the SBD on an annual basis. The determination of associated corporations can be quite complex and should be determined with the assistance of your accountant.

In order to understand the significance of the changes, it is prudent to revisit the way things used to be.  Let’s consider the following sample structure:

flowchart 1

Old Rules

Specified Partnership Income is a not a new concept for Canadian corporations – essentially, all corporate partners of the same partnership share one SBD for the partnership income.

If the corporate partner also had active business income from other sources that were not the specified partnership income, it could access the excess SBD up to its $500,000 limit on this income. It would be required to share the excess with all other associated corporations.

In this sample structure, Partner 1 and Partner 2 are corporations that would have specified partnership income, and would each have access to $250,000 of the SBD on this income. Any excess income would be taxable at the general rates.

Mgmt Co. 1 would have access to a SBD on the income it receives from providing services to the Partnership, it would have access to a SBD on its income. This would be seen in a dental practice, for instance, where the hygiene company or a lab company would be owned by a spouse of the professional and provide services to the partnership.  Under this illustration, Mgmt Co. 1 was not associated to Partner 1, and could access a SBD of $500,000.

As Mgmt Co 2 and Partner 2 are both owned by the same person, they are associated and would share one $500,000 limit. Mgmt Co 2 provides services to Partner 2, thus income would be active business income from the associated corporation and Mgmt Co 2 would be able to shelter a further $250,000 of income from Partner 2 with the SBD.

New Rules

Under the proposed changes, specified partnership income has been significantly changed and a new concept of specified corporate income has been introduced.

Specified Partnership Income

One of the proposed changes adds a new concept, called the designated member. This would include a corporation who is not technically a partner of the partnership to be considered a partner where the corporation provides services to the partnership and the shareholder of the company is a member of the partnership or is non-arm’s length with a partner.  If the corporation earns more than 90% of its revenue from sources other than the partnership or other non-arm’s length corporations and partnerships, then it will not be considered a designated member of the partnership.

This amendment thwarts planning where either a partner or the spouse of the partner would set up a company to provide services to the partnership.  Now, this corporation would be considered a designated member and the income from the partnership would be considered to be specified partnership income and the small business deduction would not be available on this income.

Under the new rules, Mgmt Co 1 owned by Mr. A would be considered a designated member of the partnership and the income of this company would be considered specified partnership income unless this company had more than 90% of revenue from other sources. It would have to share the $500,000 limit from the partnership.

Specified Corporate Income

This is a completely new concept introduced by the 2016 budget. Essentially, if a company received income from another company (referred to herein as a ‘payer corporation’) and it or its shareholder deals at non-arm’s length with a shareholder of the payer corporation, then the income will be considered to be specified corporate income unless it earns less than 10% of its income from the payer corporation and the remaining income is from external sources.

This amendment thwarts any kind of planning where one company earns active revenue from another company that it is not associated with, but has some kind of relationship with, whether it is a common shareholder or is related to a common shareholder. That income will not be eligible for the SBD unless the payer corporation assigns part of its $500,000 business limit to this company.

In the illustration, the income in Mgmt Co 2 would be specified corporate income from Partner 2, and Partner 2 would be required to allocate a portion of its SBD to Mgmt Co 2.

Most practitioners believe this amendment was intended to deal mainly with professionals, who earn their income from a partnership and pay a fee to a non-associated company, which would claim the SBD based on the comments made during the 2015 election campaign. However, this has caught a plethora of other structures that were quite benign previously.

For instance, imagine this scenario:

The partnership has a fairly large staff, but Ms A and Ms B have decided to not hire a full time HR manager to deal with personnel, and instead have contracted this service to a company owned by Ms A’s sibling.  If the HR Consulting Services company has more than 10% of its revenue from the Partnership, this company would be a designated member of the partnership and its income from the partnership would be specified partnership income, sharing part of the $500,000 limit from the partnership.

flowchart 2

This structure did not intend to multiply access to the small business deduction and has a punitive result under the new legislation.

Joint Ventures

Interestingly, the proposed rules are silent with respect to using a Joint Venture. If dentist or medical professionals entered into a cost sharing arrangement instead of a partnership, it appears that they would each access their own SBD on the income.

Takeaways from the Proposed Legislation

These new rules are very complex and are causing companies to lose access to the SBD even though they are non-tax motivated. It will be very important on a go-forward basis to have a very strong understanding of the rules, the structures, and how we can arrange our affairs. One of the takeaways is that whenever you are doing business with family or anyone that is related to a shareholder or partner, there is a high potential for the loss of the SBD.

This legislation applies to years that begin after budget day 2016. Thus, it will apply to a year ended April 30, 2017 and after.

For more information, contact Kim Drever, CPA, CA, Regional Tax Leader, Peace Region at 780.831.1700 or kim.drever@mnp.ca