The small business deduction reduces the corporate tax rate for qualifying businesses and therefore, as mentioned, creates a greater deferral of tax than business income taxed at the general corporate tax rate. The small business deduction reduces both federal and provincial taxes. It is available to CCPCs on their active business income up to a set threshold — the small business limit. The small business limit is currently $500,000 federally and in all provinces and territories except for Saskatchewan (where the limit it $600,000). The combined corporate tax rate on income up to the small business limit is less than 12.2% in all jurisdictions — much lower than the general corporate tax rates (see chart at the bottom of the page).
A CCPC is a Canadian corporation that is not controlled by public corporations, non-residents, corporations with a class of shares listed on a designated stock exchange, or any combination of these. If you are a Canadian resident and you incorporate your business federally or provincially, the company will be a CCPC. Note that an election can be made for a corporation to not be a CCPC which is relevant for the eligible dividend rules. If this election is made, business income earned in the corporation will not be eligible for the small business deduction. However, the election will only apply to change the CCPC status of the corporation for certain tax rules — not all rules.
The small business deduction — restrictions Certain restrictions apply to limit access to the small business deduction and recent changes to the tax rules have significantly expanded these restrictions.
Association rule - Associated corporations must share the small business limit — that is, corporations that are under common control and ownership. Therefore, if you hold businesses in separate corporations, your corporate group will need to share the small business deduction within the associated group of companies.
Denial rules - Other restrictive rules for accessing the small business deduction were implemented effective for tax years beginning after March 21, 2016. These rules apply to deny the small business deduction in certain circumstances where a CCPC earns income from the provision of property or services to a private corporation (that is generally not associated) or to a partnership where certain non-arm’s length relationships exist Where specific conditions are met, the small business deduction will only be allowed if a business limit assignment can be made to the corporation that would otherwise be subject to the denial. Note as well that the assignor’s business limit will be reduced accordingly. The rules are extremely complex.
Taxable capital reduction - For large CCPCs, the small business deduction may be reduced. The reduction is based on the corporation's taxable capital in Canada. If a corporation's taxable capital in Canada exceeds $10 million, the corporation is subject to at least a partial reduction of their small business limit in the following year. Once taxable capital in Canada exceeds $15 million, access to the SBD is eliminated. The 2022 federal budget proposes to increase the upper limit from $15 million to $50 million for taxation years that begin on or after April 7, 2022. In addition, the $10 million and $15 million/$50 million thresholds must be shared among a group of associated corporations.
Passive income rules - Since 2019, there is another restriction to using the small business deduction for certain corporations. CCPCs earning investment income over a $50,000 threshold in the previous year will be subject to a reduction of the amount of small business deduction that can be claimed in the current year. Under these new rules, the small business limit is reduced by $5 for every $1 of investment income above the $50,000 threshold. Under this formula, the small business deduction is eliminated when investment income reaches $150,000 in a given taxation year. Note that the investment income of all associated corporations in a group must be considered in determining whether these thresholds are met.
For purposes of applying these passive income rules, the definition of adjusted aggregate investment income (AAII) generally includes the following types of investment income: interest, taxable capital gains in excess of allowable capital losses of the current taxation year from the disposition of passive investments, rents, royalties, portfolio dividends, and dividends from foreign corporations that are not foreign affiliates. Also included in the definition of AAII is income from savings in a life insurance policy that is not an exempt policy. Specifically excluded from AAII are gains or losses from the disposition of “active assets” such as from the disposition of shares of a company that is carrying on an active business. Dividends received from connected corporations are excluded from this definition, as is income from AgriInvest and rents or interest received from an associated business if such income is re-classified for income tax purposes to be active business income. In addition, where the activity of earning income from property is sufficient, it is excluded from AAII on the basis that it is income from an active business and not investment income. For example, if more than five full-time employees were engaged in earning rental income, that rental income would be active business income, and would therefore not be AAII.
To date, all of the provinces except Ontario and New Brunswick have adopted this passive income restriction to claiming the small business deduction in computing provincial income taxes.
The passive income rules operate alongside the reduction that applies in respect of taxable capital in excess of $10 million. The reduction in the small business limit is the greater of the reduction under these rules and the reduction based on taxable capital.