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The small business tax rate is available because of what is properly called the “Small Business Deduction”.   A corporation that was a Canadian-controlled private corporation throughout the full taxation year is eligible for the small business deduction on the first $550,000 ($500,000 for 2009 to 2013 and $400,000 for 2007 and 2008) of active business income, subject to the association rules, and to a phase-out for corporations with more than $10 million of taxable capital. The income limit was just raised to $550,000 for 2014 and subsequent years. Corporations whose taxation years straddle the calendar year prorate their small business limits.

The small business deduction is a rate reduction/credit of 17% on “active business income”, as determined on Schedule 7 of the corporate tax return, subject to the two primary limitations discussed below.

Certain businesses do not qualify for the low rate at all; these include specified investment businesses  — essentially small holding companies for real estate or other investment activities — and personal service businesses. A “personal service business” of a corporation is a corporate activity that results from interposing the corporation in what would normally constitute an employer–employee relationship. There is also a restriction on the expenses that are deductible by the corporation in computing its income from such a business.

Specified Investment Business [“SIB’s”]

Special rules are provided for determining income or loss from a source in Canada that is property. The income or loss from a “specified investment business” carried on in Canada, other than income or loss from a source outside Canada, is specifically included as income or loss from a source that is property rather than business. It follows that, for Canadian controlled private corporations, this income is treated as investment income for purposes of the refundable tax and the refundable calculations. It is not active business income and is therefore not eligible for the small business deduction. In general, income or loss from any other business carried on by a corporation will not be income or loss from property.

A specified investment business carried on by a corporation is defined as:

a business (other than a business carried on by a credit union or a business of leasing property other than real property) the principal purpose of which is to derive income from property (including interest, dividends, rents or royalties), but, except where the corporation was a prescribed labour-sponsored venture capital corporation, does not include a business carried on in the year where:

(a)  the corporation employs in the business throughout the year more than five full-time employees; or

(b)  in the course of carrying on an active business, any other corporation associated with it provides managerial, administrative, financial, maintenance or other similar services to the corporation in the year and the corporation could reasonably be expected to require more than five full-time employees if those services had not been provided.

In short, the income from a business which exists primarily to earn income from property is treated as property income unless the business has achieved a certain minimum size (i.e., more than five full-time employees). This prevents small Canadian-controlled private corporations from obtaining the preferable active small business rates, but entitles them to refundable tax treatment on the payment of dividends.

 

Personal Service Business (The Incorporated Employee) [“PSB’s”]

A personal service business is defined as a business of providing services carried on by a corporation where a specified shareholder (ownership of 10% or more of the shares of the corporation by the taxpayer and non-arm’s length parties) of the corporation or related parties provides services to an entity (other than an associated corporation) and in the absence of the corporation, the incorporated employee would reasonably be regarded as an officer or employee of the entity. The intent of the personal service business rules is to attack those situations where a corporation has been interposed in what would normally constitute an employee–employer relationship. Deductions in computing income from a personal service business are restricted to the salary, wages or other remuneration of the individual providing the service, the cost of other benefits or allowances provided to him, amounts expended in connection with the selling of property or negotiating of contracts if these amounts would otherwise be deductible by the incorporated employee if he were an employee, and legal expenses incurred in collecting amounts owing on account of services rendered.

The disadvantages of having a business covered by these rules fall almost entirely on the corporation.  However, the “incorporated employee” may suffer double taxation where funds earned by his or her corporation are not withdrawn as salary or bonus for the year earned. Tax changes in 2006 and subsequent years, including the progressive reduction of general corporate tax rates and the enhancement of dividend tax credits for “designated” dividends  by both the federal government and (again, progressively in some cases) by the provinces, reduced, at least temporarily, the discrepancy between salary and dividends from a personal services business corporation to the extent that it was perhaps worth considering as a tax planning device. However, effective for taxation years that begin after October 31, 2011, technical amendments released on that date provide that a corporation’s income from a personal services business is not eligible for the general corporate rate reduction nor the small business dedcution, meaning that such income will be taxed at significantly higher levels than regular corporate income. As such, the foregoing tax-planning device is no longer advantageous.

Corporations whose business is to provide services which would be employment services if provided by a shareholder or related person directly to the consumer of the services are severely taxed unless they flow all income out to employees. The deduction of expenses of a personal services business of a corporation is restricted to the remuneration and cost of other benefits or allowances provided to an incorporated employee, certain expenses of the corporation associated with selling property or negotiating contracts that are ordinarily deductible from employment income, and amounts paid for legal expenses incurred by the corporation in collecting amounts owing for services rendered.

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