By July 06 2017
Tax Law

Specified Corporate Income and its Effects

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Brief Introduction to the Small Business Deduction

The small business deduction (the "SBD") is available to certain Canadian-owned corporations[1] that earn active business income in Canada. For most small or mid-sized businesses, the deduction is available for the first $500,000 of income earned within an associated corporate group.[2] The SBD reduces the federal business tax rate by 4.5%. At a provincial level, rates are reduced by as much as 12% in some regions.

The value of the SBD has grown to a significant amount in recent years. For example, in Alberta each $500,000 SBD can save up to $72,500 of corporate-level tax in a year. This can lead to a large long-term deferral benefit, since the tax gap is not recaptured until dividends are paid out to an individual.

The $500,000 SBD limit must be shared among all corporations within an “associated” group. This is intended to prevent taxpayers from multiplying the SBD among two or more corporations that are controlled by the same group of persons or controlled by related persons with sufficient cross-ownership. A number of deeming rules can apply to greatly broaden and complicate this test.

For years, taxpayers have sought the advice of accountants and lawyers to improve access to the SBD. An impressive array of plans have been recommended and implemented for taxpayers in this realm over these years, structuring around the associated corporations rules. In March 2016, however, everything changed.

Specified Corporate Income

Planning around the small business deduction became bread-and-butter structuring for most business owners. Parliament cracked down on these plans last year in the Federal Budget, however. With these changes, Parliament closed the door to many traditional planning opportunities, effective March 21, 2016. Many provinces followed suit, affecting the more valuable provincial SBD with retroactive effect. Alberta, for example, enacted corresponding rules in June 2017.[3] These changes had some possibly unexpected or surprising side effects, discussed later.

Among other changes, the Federal Budget introduced the idea of “specified corporate income”. Where a corporation earns this type of income, that corporation’s SBD may be limited. This is a new concept, designed to prevent the multiplication or expansion of the SBD in situations where the associated corporations rules are ineffective.

The specified corporate income rules apply very broadly. The rules apply where the following conditions are met (subject to a safe harbour, discussed below):

  • a corporation (A Co) provides services or property to a “private corporation”[4] (B Co); and
  • A Co or any shareholder of A Co – or any person not dealing at arm’s length with A Co or any shareholder of A Co – has a direct or indirect interest in B Co.

If income meets these two criteria and does not fall within the safe harbour, the default rule is that the income is ineligible for the SBD. If B Co is a “Canadian-controlled private corporation”[5], B Co may be able to elect for the income to be SBD-eligible, but only by sharing a portion of its $500,000 SBD limit. This outcome is substantially similar to if A Co and B Co were associated, although there are many intricacies to the election that should be discussed with a tax advisor.

Safe Harbour for Specified Corporate Income

It is possible to escape the specified corporate income rules by falling into a safe harbour. If a corporation earns “all or substantially all” of its income by providing property or services to arm’s length persons (other than B Co), the income earned from B Co is excused from the specified corporate income rules. The CRA’s administrative policy is to treat “all or substantially all” as meaning 90% or more.

There are two stages to this safe harbour. First, ask whether A Co is earning more than 10% of its income from B Co. If so, the income from B Co cannot meet the safe harbour exception. Second, ask whether A Co earns 90% or more of its income from arm’s-length sources other than B Co. This test must be run for each source of income.

This safe harbour is fairly limited, but it does allow an operating company to distribute some limited amount of SBD-eligible income to its shareholders. The value of this benefit is quite limited, capped (in Alberta) at around $14,500 per $1 million of profit earned by the operating company.

Examples – Common Plans

The specified corporate income rules affect some of the most common tax planning structures currently in use. If you have done business structuring with a tax advisor in the past, there are reasonable odds that you already have one of these now-tainted structures. It is a good idea to review your structure with a tax advisor to ensure the structure still meets your goals.

Two example plans will be considered below: multiplying the SBD between spouses, and multiplying the SBD in a multi-shareholder situation.

Example #1: Spousal Structure

Imagine that Mrs. X owns all the shares of X Co, which carries on an active business of providing oil and gas services. Mrs. X’s husband, Mr. X, owns all the shares of Sidecar Co, which earns management fees from X Co.

Prior to the 2016 and 2017 amendments, the management fees earned by Sidecar Co would be SBD eligible. Each of X Co and Sidecar Co would have a separate $500,000 SBD limit. Under the new rules, however, the fees would be considered “specified corporate income” and denied SBD treatment. The new rules apply because Sidecar Co provides services to a private corporation (i.e., X Co), and a shareholder of X Co does not deal at arm’s length with Sidecar Co.

The amendments defang this common structure. X Co and Sidecar Co are now required to share a single $500,000 SBD limit in respect of income originating in X Co. If each entity was earning the full $500,000 before, this results in a total corporate tax increase of around $72,500 (depending on province).

Example #2: Multiplying among Multiple Shareholders

Imagine now an operating company, Opco, with three shareholders: A Co, B Co, and C Co. Each of A Co, B Co, and C Co own 33% of Opco. Rather than compensating the shareholders with dividends, Opco has a policy to pay management fees to its shareholders.

Under the old rules, each of A Co, B Co, and C Co would have access to their own small business deduction limits of $500,000, in addition to Opco’s $500,000 limit. They would effectively have a SBD limit of $2,000,000 between them, rather than relying solely on Opco’s $500,000.

Under the new specified corporate income rules, the income earned by A Co, B Co, and C Co from Opco would be tainted and ineligible for the SBD. This is the case even though the companies do not control Opco and are not associated with Opco. They are not related to Opco, and may even be arm’s length from Opco. Irrespective of this, because A Co, B Co, and C Co own shares of Opco, income earned from providing services or property to Opco is tainted under the new specified corporate income rules.

Examples – Surprising Side-Effects

The breadth of the specified corporate income rules may result in absurd situations. The risk is especially high for services companies who have a single widely-held privately-owned client. This can be quite common in certain Canadian markets.

Income can be offside the specified corporate income rules if A Co or its shareholders own even a single share in B Co. There is no minimum threshold amount. For example, imagine that B Co is a widely-held privately-owned construction company. A Co is a general contractor who does 90% of its business with B Co. A Co’s shareholders are Mr. X and Mr. Y, both of whom are unrelated to one another.

If Mr. X owns any shares in B Co, the income received from B Co will be specified corporate income and denied the small business deduction. Similarly, if Mr. Y’s spouse owns even a single B Co share, the income would be denied the small business deduction. With a widely-held corporation, A Co would need to consider whether Mr. X, Mr. Y, or any person related to either of them holds shares in B Co. This can be quite a lengthy exercise, and, in many cases, impossible to determine.

This result is more likely than might be expected. An example may be where a person is employed by an employee-owned corporation and receives a small equity incentive. If that person later converts to an independent contractor role with that same company, his or her minority interest will be enough to put any income earned from that company offside the specified corporate income rules.

In some cases, it may not even be possible for a taxpayer to know if they are running afoul of specified corporate income rules. In a widely-held privately-owned corporation, it is entirely possible to be unaware that a family member owns shares. It is currently unclear how the CRA will enforce this type of situation.

Invitation for Discussion:

The new “specified corporate income” rules have had a significant impact on a number of common planning strategies. If you have structured your business to take advantage of these plans, please contact one of the lawyers in our Tax law group to ensure your planning still meets your goals.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

[1] Specifically, to Canadian-controlled private corporations. The $500,000 limit may be lower in some provinces.

[2] This amount is reduced in large corporations, where the corporation’s “taxable capital” exceeds $10,000,000.

[3] Retroactive to March 21, 2016.

[4] Generally, a Canadian-resident corporation that is not listed on a stock exchange, and that is not controlled by a corporation listed on a stock exchange.

[5] Generally, a corporation controlled by Canadian residents where less than 50% of the shareholdings are owned by non-residents and public corporations.

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