The small business deduction (SBD) reduces the corporate tax rate for qualifying businesses and therefore creates a greater deferral of tax than for business income taxed at the general corporate rate. As such, the SBD is one of the most common tax advantages available to Canadian-controlled private corporations (CCPCs).
The small business limit is currently $500,000 federally and in all provinces and territories except for Saskatchewan (where the limit it $600,000). In 2020, the combined corporate tax rate on income up to the small business limit is 14% or less in all jurisdictions—at least 12.5 percentage points lower than the general corporate tax rates, and as much as 19 percentage points lower in some jurisdictions. This allows for a significant tax deferral where active business income is retained in the company.
How passive investment income rules restrict small business deduction
The passive investment income rules limit access to the SBD, and apply to taxation years that begin after 2018. Specifically, CCPCs that earned investment income over a $50,000 threshold in the previous year are generally subject to a reduction in the amount of SBD that can be claimed for the current year.
Under the rules, the small business limit is reduced by $5 for every $1 of adjusted aggregate investment income (AAII) above the $50,000 threshold. Under this formula, the SBD will be eliminated when AAII reaches $150,000 in a given taxation year. Note that investment income is aggregated for all associated corporations for purposes of this threshold.
Generally, AAII includes investment income, such as interest, rent, royalties, portfolio dividends, dividends from foreign corporations that are not foreign affiliates, and taxable capital gains in excess of current-year allowable capital losses from the disposition of passive investments. Since AAII includes income net of expenses, it might make sense to consider the related expenses that were incurred to earn investment income. For example, interest expense, investment counsel fees, and a salary paid to the owner-manager incurred to earn investment income could reduce AAII, as long as the amounts are reasonable.
Ways to preserve access to the small business deduction
Because the SBD restriction is based on AAII earned in the previous year, annual planning may make sense in situations where the amount of AAII changes from year to year so that the following year's SBD can be managed. There are strategies to reduce investment income within your corporation while retaining investment funds within the company (as withdrawing the funds from the company will be taxable to you). Keep in mind that any such action to reduce investment income must make sense from an overall investment perspective and not just with a view to tax minimization.
Adjust your investment mix
For example, you could adjust the investment portfolio in your company to be more tax-efficient. One way to achieve this might be to hold more equity investments within your corporation rather than fixed income investments. This would be helpful because only 50% of the gains realized on the sale of shares would be taxable, whereas investment income earned on bonds is fully taxable. This means that only 50% of the gain on the sale of equities is included in AAII compared to 100% of the income earned on fixed income investments.
Invest in exempt life insurance policy
As an alternative, you could also consider investing excess funds in an exempt life insurance policy, because investment income earned within an exempt life insurance policy is not included in AAII. To learn more, read our article, Tax Q&A: Using Corporate-Owned Life Insurance to Accumulate Wealth.
Set up individual pension plan
Finally, you may also consider setting up an individual pension plan (IPP). The passive investment rules don't apply to these plans, which makes them an attractive retirement savings option for business owners.
An IPP is a defined benefit pension plan available to owners of incorporated businesses. Under an IPP, the benefits are set by reference to your salary, and contributions are made to build sufficient capital to fund a defined pension benefit. The contributions made by your company are tax deductible, and the investments inside the plan grow on a tax-deferred basis.
For eligible individuals, the use of an IPP can allow for greater contributions (which generally grow with age) when compared to a registered retirement savings plan (RRSP). Over time, the use of an IPP can produce substantial tax advantages over an RRSP. Additional benefits of an IPP may include the ability to make up for poor investment performance and higher retirement benefits.