As of the time of writing this piece, the basic federal corporate tax rate, established by the Canadian Income Tax Act, is 38 percent of a corporation’s taxable revenue. Under the same act, the federal rate is reduced by ten percent if they earn income in a Canadian province.
However, for reasons of tax policy, certain corporations and types of income are taxed at a lower rate than others. Subsection 125(1) of the Canadian Income Tax Act permits a “small business deduction” in certain limited circumstances. To put it another way, a private corporation controlled by a Canadian receives a 17 percent tax credit on active business income up to a maximum of $500,000 in Canada.
As an added bonus, a private corporation controlled by Canadians pays federal tax at 11 percent on the first $500,000 of active business income. But what is a small business deduction, and who is qualified to claim it? We will find out in this article.
What is a small business deduction?
The small business deduction tends to reduce the corporate income tax that a private company would have to pay in a taxation year in which it was a privately controlled Canadian corporation. This is a provision the Canadian government gives to corporations to encourage them to do more business in the country.
There is a calculation that corporations usually follow to determine its small business deduction for a certain taxation year, which is by multiplying its small business deduction rate by the lesser of its income for the year from an active business carried on in Canada, excluding certain income and surpassing certain losses, taxable income for the year, and business limit for the year.
However, not all businesses and corporations with operations in Canada are eligible for this provision. It depends on how much of the corporation’s taxable capital is employed in Canada. When taxable capital employed in Canada surpasses $10 million, the $500,000 business limit is decreased, and it is eliminated when taxable capital exceeds $15 million.
In 2018, under the new budget, small business deduction rules will be subject to change for all future taxation years. Additionally, rules regarding small business deductions and dividend refund accounting will adapt to a corporation’s taxation year that begins in 2018 and ends in 2019, regardless of the preceding year.
One of the reasons for the transaction, event, or series was to defer the application of the small business deduction and dividend refund rules to the corporation.
How can a business qualify for a small business deduction?
There are three things that we should remember about small business deductions.
First, the term “small business deduction” is not really a deduction. A deduction is claimed against revenue to lower income; a credit is claimed against tax payable to lower tax liability. As a result, the small business deduction is not a deduction; rather, it is a tax credit.
Second, not everyone gets a small business deduction. Not because you have operations in Canada doesn’t mean you are automatically eligible for this perk. Under the definition of a “Canadian-controlled private corporation,” you should be a private corporation and not listed on the stock exchange.
You must be a Canadian corporation, meaning your business should be both based in Canada AND incorporated in Canada. Lastly, the private corporation should not be controlled by either someone who is not a Canadian resident, a public corporation, or both. Meaning you should be a private Canadian corporation owned by a Canadian.
Finally, a corporation should not necessarily be small to benefit from this. Thus, any corporation that fits the criteria can be eligible for the small business deduction initiative, regardless of its size.
Is this applicable to all Canadian provinces?
Because it was legislated and given Royal Assent by the federal government, the small business deduction applies to all of Canada, from the nation’s capital to the westernmost regions of the country.
A similar small business deduction is available in Canadian provinces and territories. For example, the small business deduction in Ontario reduces the corporate income-tax rate on active business income earned by a Canadian-controlled private corporation to 4.5 percent.
However, Canadian provinces and territories can opt to change or revise certain provisions in the small business deduction. Let’s take Ontario as an example.
Although the federal government announced in 2018 that it would phase out the $500,000 small business limit for corporations earning $50,000 to $150,000 in passive investment income in a taxation year, Ontario is not doing the same.
In addition, a corporation that allocates any of its federal business limit to another corporation will also reduce its Ontario business limit by the same amount.
Aside from Ontario, the province of New Brunswick is also following suit in not abiding by the federal government guidelines for small business deductions.
Canadian provinces and territories have the power to tweak the provisions according to the needs of their citizens.
Pro-tip: Always prepare for problems when incorporating.
To qualify as a private corporation eligible for the small business deduction, it is a must that your business should be incorporating. The small business deduction is one of many factors to consider when deciding whether or not to incorporate.
While incorporation may allow your business to benefit from the SBD, it may also cause a slew of issues if you are unprepared, particularly concerning associated corporations or activities that do not qualify for the small business deduction tax credit (SBD). Furthermore, incorporating may bar you from deducting business expenses from other sources of personal income, such as employment income.
The small business deduction is an initiative from the Canadian federal government to help small Canadian businesses grow and contribute little by little to the national economy. It is not really a deduction but more of a tax credit.
Nevertheless, this helps small local businesses earn more for their needs. A Canadian business can be eligible for a small business deduction if it fits the criteria.