The small business deduction (SBD) reduces the corporate tax rate for qualifying businesses and therefore creates a greater deferral of tax than for business income taxed at the general corporate rate. As such, the SBD is one of the most common tax advantages available to Canadian-controlled private corporations.
In 2019, the combined corporate tax rate on income up to the small business limit is just 12.5 per cent in Ontario. This allows the corporate taxpayer a significant tax deferral where active business income is retained in the company.
Recent changes to the tax rules have significantly restricted the SBD. For corporations with Dec. 31, 2019 year-ends, we will see the impact for the first time.
New SBD restriction explained
Under the new rules, the small business limit will be reduced by $5 for every $1 of investment income above the $50,000 threshold. Under this formula, the SBD will be eliminated when investment income reaches $150,000 in a given taxation year. Note that investment income is aggregated for all associated corporations for purposes of this threshold.
As part of these changes, a new definition of investment income — adjusted aggregate investment income (AAII)— was introduced. Generally, AAII includes:
- portfolio dividends,
- dividends from foreign corporations that are not foreign affiliates, and
- taxable capital gains in excess of current year allowable capital losses from the disposition of passive investments.
You will need a tax advisor to help you to understand this definition and how the new rules impact your corporation.
Annual planning for the new SBD restriction
Because the new SBD restriction is based on AAII earned in the previous year, annual planning may make sense in situations where the amount of AAII shows growth or fluctuates year to year so that the following year’s SBD can be managed. For example, you could look at the investment portfolio in your company, and if it makes investment sense, look at a more tax-efficient mix of investments. Options for the owner may include:
- Hold more equity investments within your corporation rather than fixed income investments. This would be helpful because only 50 per cent of the gains realized on the sale of shares;
- Consider investing excess funds in an exempt life insurance policy; and finally
- Consider setting up an individual pension plan (IPP). The new passive investment rules do not apply to these plans, which makes them an attractive retirement savings option for business owners. For eligible individuals, the use of an IPP can allow for greater contributions, which generally grow with age, when compared to a registered retirement savings plan. Additional benefits of an IPP include the ability to make up for poor investment performance and the possibility of higher retirement benefits.
Keep in mind that you should evaluate whether these plans make sense by also taking into account the non-tax considerations before changing your investment strategy.
Scott Conner is a Tax Partner at BDO Canada LLP. With over 15 years of experience as CPA, CA specializing in Canadian income tax, Scott helps a variety of individuals and private companies pay the least amount of tax possible with great tax planning strategies. He also specializes in planning for estates, trusts, and non-resident dispositions of real estate.