Canadian corporate taxation can be complicated. Many business owners of incorporated businesses are unaware that their tax rate is 38%. That’s because there are multiple deductions that come into play before corporate business income is taxed.
The first is a 10% reduction given because income earned in a province or territory is subject to provincial/territorial tax. The result is an effective corporate tax rate of 28%.
The second reduction was introduced to make Canada’s corporate rates more competitive in a global market. This reduction is equal to 13%, which brings the effective tax rate down to 15% for corporations.
If that wasn’t complicated enough, certain businesses can forgo the 13% reduction and instead claim the small business deduction (SBD), which reduces the federal corporate tax rate by 19% for an effective rate of 9%.
To claim the SBD, businesses must meet specific conditions.
1. You must be a CCPC
To claim the SBD, you must be a Canadian-controlled private corporation (CCPC). This means your business must be incorporated in Canada and be a private corporation not listed on a designated exchange. In addition, the business can’t be directly or indirectly controlled by one or more public corporations or individuals who are not residents of Canada.
2. Your business must have active income
To claim the SBD, your business must have active business income. This means that the SMD can only be applied to income earned from active business in Canada.
Certain businesses do not qualify as an active business. This includes:A personal services business (PSB): A business that provides the personal services of an individual to a person who could be viewed as the individual’s employer if the individual’s business wasn’t incorporated. The individual or a related person must also own at least 10% of the shares in the corporation to be a PSB. The only time a business is not deemed a PSB when it meets these criteria is if:
- The corporation has more than five full-time employees
- An associated corporation pays the corporation that would otherwise be deemed a PSB. PSBs is a concept that was introduced to stop employees from taking unfair advantage of the tax system by incorporating to provide services to their employers and deferring a substantial amount of personal tax.
A specified investment business: A corporation whose principal purpose is earning income from property including interest, rent, royalties and dividends. It does not include businesses that:
- Employs more than five full time employees throughout the year
- Receives managerial, administrative, financial, maintenance, or other similar services from an associated corporation and can be reasonably expected to need more than five full time employees if those services weren’t provided
3. You must determine your SBD amount
The SBD can only be claimed on the first $500,000 of active business income. This means that if your business earns $600,000 of active business income, you can only claim the SBD on $500,000.
The SBD limit can also be reduced and limited if the businesses passive investment income exceeds $50,000 in the given tax year. This reduction is done on a straight line basis. For every $1 of adjusted aggregate investment income that exceeds the $50,000 threshold, your SBD is reduced by $5. That means once a business has adjusted aggregate investment income of $150,000, the SBD is completely eliminated.
Similarly, if your taxable capital exceeds $10 million, the SBD limit will be reduced. In this case, the SBD is reduced by $0.10 for every $1 of taxable capital in excess of $10 million. Once your taxable capital reaches $15 million, the SBD is completely eliminated.
NOTE: The federal government is proposing an increase to the upper limit of taxable capital so that the SBD would be eliminated when a business has $50 million in taxable capital. This change would apply to tax years that begin on or after April 7, 2022.
Finally, where the business has a short taxation year, the $500,000 limit is prorated based on the number of days.
In addition to all of this, if your business is associated with any other corporations, the $500,000 must be shared between the associated group. The percentage that each associated CCPC claims is determined by the businesses and reported by filing an annual agreement.
This is just a basic explanation of the rules governing the SBD. For information on the SBD as it relates to your specific business situation, please contact us today.