Key considerations on the new small business deduction denial rules

June 2017

NTL_Firm_08Jun17_Website_Small-Business_679x220.jpg

The small business deduction (SBD) is a key tax advantage for Canadian-controlled private corporations (CCPCs). Specifically, the SBD provides access to favourable small business income tax rates on eligible active business income up to a federal SBD limit of $500,000. For federal tax purposes, the small business rate is currently 10.5% versus the general corporate rate of 15%. The provinces and territories each provide their own small business and general corporate tax rates, which vary by jurisdiction.

With the benefit of reducing corporate tax, planning has been implemented to take advantage of the SBD using certain partnership and corporate structures with CCPCs. Various rules have been in place alongside the SBD rules which are intended to prevent the multiplication of the SBD in circumstances that the government does not consider appropriate. For example, associated corporations must share the SBD limit, rather than each such corporation being eligible to claim their own. Corporations are associated when there is common control of two or more corporations (for example, control by the same person or group of non-arm’s length persons). These rules will prevent one owner from conducting business activities in multiple corporations in order to access multiple SBDs. Essentially, there should be only one SBD for a single business or business activities conducted by the same owner. In addition to the association rules, there are anti-avoidance rules in place so that planning cannot be done to get around the association rules in order to access multiple SBDs.

Despite the various rules in place prior to 2016, planning using complex partnership and corporate structures was still being undertaken to multiply access to the SBD. As a result, in 2016 the government implemented additional complicated rules to stop planning deemed unacceptable by the government. These changes included expanding the specified partnership income (SPI) rules and introducing new specified corporate income (SCI) rules. However, as the wording of the new rules is quite broad, in particular for the SCI rules, business dealings between corporations each running a separate single business may find access to the SBD restricted or non-existent. In addition, the rules appear to restrict the SBD in situations where that may be inappropriate. 

Due to the complexities of the SBD changes introduced in 2016, this article will focus on those changes related to the new SCI rules. We will first provide an overview of these new rules, which are effective for taxation years that begin after March 21, 2016. We will then address some key issues to be aware of when applying the rules. 

The new SCI rules

Under the new SCI rules, active business income (ABI) earned by a CCPC from the provision of property or services (directly or indirectly, in any manner whatever) to a private corporation will be excluded from eligible ABI where certain conditions are met. This income effectively falls within the SCI category and it will not be eligible for the SBD unless a specific exception for associated corporations is met, or the private corporation is allowed (and willing) to assign part or all of its SBD limit to the CCPC. Note that income that is ineligible for the SBD under these rules will be taxed at the general corporate tax rate.

Let’s break down the rules further by taking a look at the conditions and the associated corporation exception. This will help provide a better understanding of the income that will potentially be caught and ineligible for the SBD.

What is the “income of concern”?

The tax rules set out that income from an active business for the year earned by a CCPC from the provision of property or services (directly or indirectly, in any manner whatever) to a private corporation may be ineligible for the SBD if:

  • At any time in the year, the corporation (or one of its shareholders) or a person who does not deal at arm’s length with the corporation (or one of its shareholders) holds a direct or indirect interest in the private corporation, and
  • All or substantially all of the corporation’s income for the year from an active business is not from the provision of property or services to:
    • Persons (other than the private corporation) with which the corporation deals at arm’s length, or
    • Partnerships with which the corporation deals at arm’s length, other than a partnership in which a person that does not deal at arm’s length with the corporation holds a direct or indirect interest.

In general terms, if all or substantially all of a corporation’s ABI is earned from arm’s length sources, these rules should not be a concern. However, if all of the conditions above are met, it will be necessary to determine if the income is ineligible for the SBD or if an exception applies.

What exceptions could apply to allow the SBD?

First, there is an exception for certain income earned by a CCPC from an associated corporation. In particular, the exception will apply where:

  • A CCPC is earning ABI from the provision of property or services to an associated corporation, and 
  • That associated corporation is deducting those amounts from its own income that is generally unrestricted ABI (there are complicated exceptions).

Where these conditions are met, the income will not be caught up in the computation of SCI and it will be eligible for the SBD. Of course, the SBD must be shared between the associated corporations. So, whether or not the income is eligible for the SBD will depend on how the SBD limit is allocated between the associated corporations — but this is not a new rule.

If the associated corporation exception does not apply, then the income of concern will be eligible for the SBD only to the extent of the amount that the private corporation is able (and willing) to assign of its SBD limit to the CCPC. In other words, the private corporation must assign all or a part of its SBD limit to the CCPC in order for the CCPC to claim the SBD in respect of the income of concern (or SCI). There are certain restrictions on the amount of SBD limit that can be assigned. Note, however, that the specific rules related to making an assignment of the SBD limit are beyond the scope of this article.

It is also important to know that there is one overriding limit built into these rules. The amount of SCI of the CCPC may be determined by the Minister based on what the Minister determines to be reasonable in the circumstances. This is effectively an anti-avoidance rule that provides the Minister with ultimate control over the SCI determination, likely to nullify planning used to escape the SCI rules and which the Minister deems inappropriate. However, this overriding limit leaves taxpayers with uncertainty as to their final determination of SCI, and this uncertainty may impact more than one corporation in a group where a SBD limit assignment is made.

Key issues of concern

As is evident from the discussion above, the new SCI rules are complex and very broad. The following discussion highlights a number of issues that have arisen concerning the application and interpretation of the rules.

Providing property or services, directly or indirectly – The starting point for determining whether the SCI rules apply is whether a CCPC is earning ABI from the provision of property (for example, a loan or real property) or services, directly or indirectly, in any matter whatever, to a private corporation. The wording “directly or indirectly, in any matter whatever”, makes this starting point quite broad. In particular, whether income is earned indirectly, in any manner whatever, means it is necessary to take a thoughtful look at sources of income to determine if income could be considered earned indirectly from a private corporation. It would be useful for the Canada Revenue Agency (CRA) to provide guidance to taxpayers on how broadly this term should be interpreted.

Direct or indirect interest condition – As set out in the rules above, when a CCPC (or one of its shareholders) or a person who does not deal at arm’s length with the CCPC (or one of its shareholders) holds a direct or indirect interest in the private corporation that is receiving the provision of property or services, the SCI rules may apply. One may generally assume that the reference to a direct or indirect interest refers to holding shares of the private corporation directly or through another entity. However, the phrase “direct or indirect interest” is not defined in the tax rules and there is no specific reference made to holding such an interest in the shares of the private corporation. As a result, there is a concern that this phrase could be interpreted broadly to include certain rights in the private corporation or possibly even a creditor’s interest. Whether the CRA would interpret the phrase in this way is not certain, and guidance would greatly help taxpayers and their advisors to properly apply the rules.

All or substantially all condition – As mentioned above, when a CCPC earns income from the provision of property or services to a private corporation, the SCI rules will not apply when all or substantially all of the CCPC’s active business for the year is from arm’s length sources. The CRA generally interprets the phrase “all or substantially all” to mean 90% or more. Therefore, the condition will generally be met if more than 10% of ABI from the provision of property or services is earned from any non-arm’s length persons, and not just the private corporation in question. If this is the case, income earned from the private corporation may be subject to the new SCI rules.

There are a number of issues with this condition. First, in order to determine if this condition is met, one needs to be able to differentiate income that is earned from non-arm’s length versus arm’s length sources. Under the tax rules, related persons deal at non-arm’s length, while it is a question of fact whether persons who are not related are non-arm’s length. In the latter case, the situation and business relationship will need to be considered where an arm’s length relationship is not clear, and this can create some uncertainty for purposes of applying the rules.  

Second, for purposes of determining whether the 90% threshold is met, it will be necessary to track non-arm’s length income from arm’s length income, which adds further compliance requirements for corporations dealing with the rules. A reference to income is generally understood to mean revenue net of expenses.

Lastly, from an overall perspective, a CCPC may earn income from a non-arm’s length business that is a totally separate business, but the rules could still restrict the SBD.

Sales to cooperatives in the farm and fishing industries – Under the current rules, there is an anomaly that could deny the SBD to corporations that sell to farm cooperatives (co-ops) where the corporation was a member. Similar issues exist for the fishing industry. The anomaly has arisen because the income tax rules deem a co-op to be a private corporation, and the corporation selling its goods to the co-op is typically a member. As a member, the corporation usually has an actual interest in the co-op or will be deemed to have an interest due to receiving patronage dividends. Under the SCI rules, if all or substantially all of the corporation’s active income is not from other arm’s length sources, the income from the co-op sales will not be eligible for the SBD. This issue was taken to the Department of Finance, and on March 5, 2017, a legislative amendment was proposed that will help address the issue. Based on the amendment, if certain conditions are met, income from the sale of farming products or fishing catches to an arm’s length farming or fishing co-op will not be subject to the new SCI rules. This change is to be effective for taxation years that begin after March 21, 2016.

Services provided to credit unions – Similar to co-operatives, credits unions are also deemed to be private corporations under the income tax rules. Therefore, a small business that is a member of a credit union and also provides services to a credit union could be denied the SBD on income earned from the credit union if 90% or more of the business’ income is not from other arm’s length sources. To date, there has been no proposed amendment to fix this particular issue.

Final thoughts

Based on this discussion and analysis, it is clear how broad the wording of the rules is, and the uncertainty such wording can create. The objective of the new SCI rules, along with the changes to the SPI rules, is to help ensure that a single business is eligible for a single SBD. However, uncertainty can make applying the rules difficult, and the far reach of the rules with non-arm’s length persons can make it a cumbersome task to determine whether the rules apply.

If your CCPC is earning ABI from the provision of property or services to a private corporation, contact your BDO advisor to determine whether the new SCI rules are a concern.


The information in this publication is current as of June 1, 2017.

This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.