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.

Steady As She Goes For Small Businesses

The 2016 federal budget did not make the small business rate unavailable for professional businesses, despite the rumours that suggested it would.  However, the budget did include changes that will affect small business corporations.

Small business corporations are Canadian-controlled private corporations that earn income from an active business carried on in Canada and that have taxable capital of less than $10 million.  The first $500,000 of active business income qualifies for a low rate of tax.  In British Columbia, this low rate is 13%.  This consists of a 10.5% federal rate and a 2.5% provincial rate.

The former government had proposed to reduce the federal component of this tax rate in stages between 2017 and 2019.  The 2016 budget cancels those planned rate reductions.  As a result, the low rate of tax will remain at 13% for British Columbia small business corporations.  In order to integrate the tax paid by a small business corporation and the tax paid by shareholders on dividends received from those corporations, the dividend gross-up and tax credit rates will also remain at 2016 levels.

The low rate of tax applies only to active business income – for example, income from a retail store or a service business.  Except in the case of real estate rentals, it does not matter how many people are employed by the business corporation.  If a corporation is in the business of renting real estate, however, rental income qualifies for the low rate of tax only if the rental business employs more than five full-time employees.  This restriction applies to corporate landlords as well as corporations that rent storage units.

In 2015, the federal government announced a review of the active business classification rules.  It has now completed that review and will not make any changes to the active business income concept at this time.  This means that incorporated real estate rental businesses will still have to employ more than five full-time employees in order to gain access to the low rate of tax on that income.

The low rate of tax is an advantage because it leaves a small business corporation with more after-tax cash.  The rate applies only to the first $500,000 of profit in any one year.  This creates an incentive for taxpayers to try to multiply access to that $500,000 threshold.  Various anti-avoidance rules seek to prevent this.  For example, associated corporations must share the $500,000 limit.  Associated corporations are corporations that have an element of common ownership or that are separate purely for tax purposes. 

The 2016 federal budget adds to these anti-avoidance rules.  These new rules will be addressed in the next blog.

Visit the Dwyer Tax Law web site
for information about our services and lawyers' profiles.

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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.

What Was Not In The Budget

Prior to the 2016 federal budget, rumors swirled surrounding the following possible changes.

·        An increase in the capital gains tax rate.

·        Restrictions on the availability of the small business tax rate for professional corporations and certain other small businesses.

Neither of the above rumors turned into reality on Budget Day.

Capital gains will continue to be taxed at half the normal tax rate.  This compensates somewhat for the effect of inflation over time, as part of any capital gain is usually attributable to inflation.

The small business rate will continue to apply much as it has in the past.  The government announced that it has completed its review on how the small business rate applies in the context of businesses that earn income principally from the rental of property (such as a storage business).  The government has decided to make no changes to the rules at this time.

The small business rate is a low rate of tax that applies to a qualifying corporation on its first $500,000 of active business income.  While the basic rules applicable to this rate continue to apply, the federal government will introduce legislation targeting business structures that attempt to get around the annual $500,000 income limit.  I will describe these rules in a future blog.

Among other announcements, the government has decided to proceed with changes to the amortization of the cost of goodwill and other forms of intangible property.  Such amortization will move to the capital cost allowance system that applies to most equipment and other forms of business property.  This will eliminate the separate amortization system that had applied to goodwill in the past.

Charities will be disappointed that the government has chosen not to implement the 2015 proposal that would have provided an exemption from capital gains tax for certain sales of real estate or private corporation shares to the extent that the proceeds were donated to a charity within 30 days of the sale.  The government did not give any reason for this decision.

As in the past, this firm will comment on specific budget proposal over the next few weeks.  Stay tuned for more on our Tax Talk Blog!

Visit the Dwyer Tax Law web site
for information about our services and lawyers' profiles.

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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.