Tuesday, March 29, 2016

Preventing Too Much of a Good Thing

As indicated in the last blog (click here to read it), small business corporations enjoy a low rate of tax on the first $500,000 of profit from an active business carried on in Canada.  In British Columbia, this low rate is 13%.  This consists of a 10.5% federal rate and a 2.5% provincial rate.

The low rate of tax leaves a small business corporation with more after-tax cash.  Because the rate applies only to the first $500,000 of profit in any one year, taxpayers have an incentive to try to multiply access to that $500,000 threshold.  Income tax law already contains various anti-avoidance rules that seek to prevent this.  The 2016 federal budget adds a few more.

Some taxpayers have tried to have more than one $500,000 limit apply to a single business by having other corporations provide services to a corporation that carries on the main business. 
  • For example, assume that Storeco carries on the business and has two shareholders, Manfred and Peter. 
  • In order to increase access to the low rate of tax, Storeco does some creative outsourcing to “friendly” corporations. 
  • Manfred incorporates a corporation (“Manco”) and Storeco hires Manco to provide business management services to Storeco. 
  • Meanwhile, Peter also incorporates another corporation (“Peterco”) and Storeco hires Peterco to handle inventory purchases. 
  • Storeco pays a fee to Manco and Peterco for those services.

Under current rules, each of the three corporations is carrying on a separate business and can claim the low rate of tax on up to $500,000 of income from that active business.  If there had been no outsourcing, Storeco would have had a single $500,000 limit.

Under the new rules, neither Manco nor Peterco will qualify for the low rate of tax because
  • each corporation is owned by a shareholder of Storeco; and
  • neither corporation earns substantially all its active business income from arm’s-length persons other than Storeco.

The same result applies if the shareholders are spouses or children or other persons who do not deal at arm’s length with Manfred and Peter.

In order to claim an independent low rate of tax, each corporation (Manco and Peterco) would have to earn substantially all its respective active business income from arm’s-length entities (and Storeco doesn’t qualify as arm’s length).  In other words, the corporation would have to carry on an independent business that happens to also provide services to Storeco, among many other clients.

Similar new rules will apply to a partnership that outsources various parts of its business to friendly corporations.  If the friendly corporation (or a shareholder of the friendly corporation) is also a member of the partnership, the new rules will require that the $500,000 limit be shared among all such friendly corporations dealing with that partnership.

A corporation will be deemed to be a partner if
  • the corporation provides services to the partnership; and
  • a member of the partnership is related to, or otherwise deals on a non-arm’s-length basis with, that corporation or a shareholder of that corporation; and
  • the corporation does not earn substantially all its active business income from arm’s-length persons other than the partnership.

A corporation (even if friendly) will escape the rules if the corporation carries on an independent business that happens to include the partnership as one of many clients.

These rules could affect family businesses in which various members of a family have their own independent incorporated businesses if the separate corporations also do significant business with each other.  Whether substantially all business income is earned from arm’s-length customers will be a question of fact in any one case.


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The above article provides general commentary of an educational nature. It does not constitute advice for any specific person or any specific set of circumstances. Because circumstances vary, readers should consult professional advisers in order to obtain advice that is applicable to their specific circumstances.