On March 22, 2016, the Federal Government tabled a budget that proposes significant changes to the Small Business Deduction (SBD)1 by introducing concepts called Specified Corporate Income (SCI) and “designated members” of partnerships. It is also expected that provincial government legislation will mirror the federal government legislation. These changes came into effect for corporate years beginning March 22, 2016, and impact virtually any small business or partnership group where fees or rents are paid to a related corporation. The intent of the proposals is to curtail multiplication of the SBD, which is a perceived loophole and abuse of the tax system. However, with the proposed changes, the government may have thrown the proverbial “baby out with the bathwater” and may restrain legitimate business and investment practices, as well as increase the costs of tax compliance to the small business owner.
The small business deduction reduces the income tax rate, in Ontario for example, to combined 2016 rates of 15.5%2 for qualified small businesses earning $500,000 or less of net active business income, which provides savings of 11%2 over the general tax rate, or up to $55,000 in tax savings (deferral).
Corporate groups that are associated with each other share the SBD, and large corporate groups lose their entire small business tax savings once they reach a certain size. This mechanism is meant to ensure that only small businesses benefit from tax savings, and only one business that is controlled by an individual or related group of individuals benefit from the reduced tax rate.
Complex or even relatively simple corporate structures and income allocation methods were set up to get around the above mentioned “association” rules, where any number of business partners and their families can flow income into their personal corporations, each benefiting from the low rate of tax.
These types of structures are standard tax planning for large private business and professional partnership groups (lawyers, doctors, accountants, etc.) earning more than $500,000 of combined net active business income.
The New Rules
Changes to the Small Business Deduction rules and introduction of Specified Corporate Income are very complicated, but the proposed legislation effectively reduces the small business deduction on income related to the provision of intercorporate services or property, where the companies or shareholder(s) of companies are directly or indirectly related or do not deal with each other at arms length or in any matter whatever. The exception is where 90 percent3 or more of the payee’s (recipient) corporation’s net active business income comes from non-related sources.
A Compliance Headache
Net income that relates SCI income and SBD is not calculated automatically. You must identify them individually and elect jointly, so any small business of any size which derives service or property income from non-arm’s length parties will have to identify these fees and their related expenses separately to benefit from the lower tax rates.
Following are several fictional scenarios that demonstrate the potential effects of the changes to small business taxes.
Scenario #1: Not So Complicated and Not Very Large
John Smith has a business (JohnCo) earning $1,000,000 of net active business income in Ontario. Jane Smith, his spouse, who is neither a shareholder nor a director of John’s company, is a highly skilled business person or professional who runs her own independent business. JohnCo pays $500,000 to JaneCo for legitimate business services4. Net income from fees charged to JohnCo comprises more than 10% of JaneCo’s total net income.
Under the old rules JohnCo and JaneCo are not associated and because John and Jane do not control nor do they have cross-ownership of 25% or more in each other’s companies5, can benefit from combined tax savings (deferral) of up to $110,000. Under the new proposed rules6 JohnCo may assign up to $500,000 of its net income to JaneCo. JohnCo’s small business deduction in now reduced to nil.
The result: JohnCo loses his access to low tax rates, even though the fees he pays JaneCo for services are a relatively small percentage of JaneCo’s net income.
Scenario #2: Get Out of Our Family!
Son (Jack) and daughter (Jill) are shareholders of a family construction business (FamCo.)7 but are not involved in day-to-day operations. Jack is a one of a group of unrelated shareholders in a construction consulting business (ConsultCo.) with 11% shareholdings8 which provides construction management services to FamCo. Jill owns, together with a group of unrelated shareholders, a property management company with more than five full-time employees (PropertyCo) which rents space to FamCo. Jill also has 11% shareholdings in PropertyCo.
If ConsultCo and PropertyCo derive more than 10% of its active business income from FamCo., they fall under the new SCI rules, and all three companies would share one small business deduction, or whatever part of it may be left.
But it gets worse! As described above, SCI rules dictate that related corporations must jointly elect to designate the deduction. What if Jack and Jill do not want to share their personal financial affairs with Mom and Dad, have different accountants, or the other 89% or more shareholders object to Jack and Jill sharing corporate information with Mom and Dad? Will Mom and Dad want to do business with their children or siblings?
The result: Independently owned and operated business owned by family members may lose some or all of their small business deduction.
Scenario #3: It’s Just a Coincidence
Mr. Smith owns a business (SmithCo) and rents a warehouse from his unrelated friend Mr. McDonald’s Company9 (McDonaldCo). Coincidentally, Mr. Smith helped Mr. McDonald finance McDonaldCo. and became an 11% shareholder8. Since Mr. Smith has direct shareholdings in McDonaldCo, Mr. Smith falls into SCI rules if more than 10% McDonaldCo’s net income comes from renting property to SmithCo.
The Result: Two virtually unconnected businesses with minimal direct shareholdings now share the small business deduction.
So what can you do the minimize the effects of the new tax rules?
- Speak to your accountant as soon as possible. Tax planning is most effective when done in advance, and it’s very difficult and costly fix poor planning after the fact.
- Keep detailed accounting records. Expenses related directly to fees/rentals reduce specified corporate income, allowing you take advantage of higher tax savings. Keep separate General Ledger accounts for all income and expenses (including a portion of indirect expenses) related to these type of fees.
- Share information. If you do not use the same accountant for your family’s groups of companies or a company in which you have a direct shareholding interest, discuss and agree on what information you have to share to take advantage of the small business deduction. The election must be filed jointly.
- Use the same year-end for groups of companies. Having the same year-end simplifies the application of SCI and ensures the maximum tax savings (deferral) every year.
- Consider alternative corporate structures. Possible alternatives include spinning off lines of business, joint ventures, and other arrangements. While conceptually these may be possible, they may not be practical or cost-effective for a number of business reasons.
- Exercise caution. The proposed legislation is brand new. It is neither “court-tested” nor has CRA indicated how they will apply and interpret these rules. Tread carefully when aggressively interpreting proposed legislation.
The changes that pertain to the Small Business Deduction affect virtually all corporate groups. Sloan Partners can help you maximize your tax savings and minimize compliance costs in the face of the ever-evolving tax rules.
Disclaimer: This article is intended for educational and informational purposes only. It is not intended in any way whatever to provide tax advice. The reader should be aware that legislative changes have been proposed and are subject to change. None of the persons involved in the preparation of this article accepts any responsibility for its contents or the consequences that arise from its use.
- It is expected the provincial government legislation will mirror the federal government. References to the Small Business Deduction and tax rates refer to combined federal and provincial rates.
- Rates for 2016.
- “All or substantially all” which under current Court interpretations refers to 90% or more
- Assuming that JaneCo is not a “Personal Service Business”
- ss256 and ss.129(6) ITA
- ss125 (7)(a)(i)(A) ITA
- With $15,000,000 or less of “taxable capital”
- Theoretically, even 1% shareholdings may apply. There is some doubt as to whether legislation includes deminimus shareholdings Property Co.’s rental income qualifies as active business income
- In a case that this rental income meets the definition of active business income
Robert McGaghran is a Tax Manager and Roman Belenky is a Supervisor at Sloan Partners.