The small business deduction

Canadian-controlled private corporations (CCPCs) are entitled to claim a small business deduction on active business income (ABI) earned in Canada.

Active business includes any business, as well as an adventure or concern in the nature of trade, but excludes: (i) a business that derives its income from property (including interest, dividends, royalties and rent) and has less than six full-time employees (i.e., a “specified investment business”); and (ii) a business that provides personal services through a corporation, has fewer than six full-time employees and where, were it not for the presence of the corporation, the individuals providing the services would be considered employees or officers of the entity using those services (a “personal services business”).

The small business deduction currently provides for an 11% federal tax rate2 on a CCPC’s ABI. However, only a limited amount of income qualifies for this deduction. The current federal limit is $500,000.

Although all provinces also have a small business rate, the rate and the amount of income that qualifies for this lower rate varies from province to province (see Table 1 of the Corporate Taxation tables). Both the federal and provincial small business limit must be shared by an associated group of companies (see topic 26).

In addition, larger corporations will find that their ability to claim the small business deduction is restricted. The restriction applies to CCPCs whose taxable capital (generally equal to a company’s retained earnings, share capital and long-term debt) exceeds $10 million for the preceding year. If the taxable capital is between $10 million and $15 million, the amount eligible for the low rate is proportionately reduced. Any eligibility ceases if taxable capital surpasses $15 million. These limits are also determined on an associated group basis.

2 This tax rate will decrease to 10.5% in 2016, 10% in 2017, 9.5% in 2018, and 9% in 2019.

Other corporate tax rates

The general federal corporate tax rate is 28%. This rate applies to investment corporations, mortgage investment corporations, mutual fund corporations and non– resident-owned investment corporations. It also applies to income earned in a “personal services business.”

For other corporations, income that is not subject to the small business deduction is subject to a federal corporate income tax rate of 15%.

Example: A CCPC earns income from an active business carried on in Canada and has taxable income of $650,000 for its fiscal period ended December 31, 2015. The income eligible for the small business deduction ($500,000) will be taxed at the lowest federal tax rate of 11%. The $150,000 balance will be taxed at a rate of 15%.

Personal services business

As noted above, active business income does not include income from a personal services business. This is essentially a business carried on by a corporation where the services performed by the corporation are provided by an individual who would otherwise be considered an employee of the recipient of the services. The individual in this situation is often referred to as an “incorporated employee.”

If a corporation is carried on by a personal services business, there are two main tax consequences:

(1) The corporation is not able to claim the small business deduction, either federally or provincially. Also, such corporations do not qualify for the general corporate rate reduction, as such they are taxed at the highest federal rate of 28%.

(2) When calculating the income from the personal services business, eligible deductions are generally restricted to remuneration and benefits for the incorporated employee (plus a few limited other expenses that would otherwise be allowable as a deduction had the incorporated shareholder incurred the expense as an employee).3

The 28% federal tax rate on such income creates a significant lack of integration (see topic 148) and acts as a disincentive to operating a personal services business corporation. In the event there are any risks that you may be considered an incorporated employee, you should consult your tax adviser to help you assess and manage those risks.

3 i.e., expenses that would otherwise be allowed to a commissioned salesperson and legal expenses incurred to collect amounts owing for services rendered