2016-0679721E5 The small business deduction

Principal Issues: Whether the receipt of specified corporate income limits the small business deduction available to a corporation.

Position: Yes.

Reasons: See below.

Author: McCarthy, Kathryn
Section: 125(3.2); 125(3.1); 125(1)(a); 125(7) “specified corporate income”

XXXXXXXXXX                                                                                                                                      2016-067972
                                                                                                                                                              Kathryn McCarthy

April 20, 2017

Dear XXXXXXXXXX,

Subject: The Small Business Deduction

We are writing in response to your letter dated December 13, 2016, and our telephone conversation (McCarthy/XXXXXXXXXX) on February 10, 2017. Your letter concerned how the recent changes to the small business deduction (SBD) rules in section 125 of the Income Tax Act (the “Act”) that were contained in Bill C-29 and received Royal Assent on December 15, 2016, may apply in the following hypothetical situations.

Situation 1:

Individual (“T”) owns the following percentages of the issued and outstanding shares of corporations that are involved in the fishing business:

*     30% of BuyCo 1
*     100% of SellCo A
*     Less than 50% of SellCo B

SellCo A and SellCo B sell 100% of their catch to BuyCo 1 such that all of SellCo A’s income and SellCo B’s income for the year is derived from sales to BuyCo 1. BuyCo 1 purchases the majority of its fish from non-related parties.

Situation 2:

The following related individuals own the following percentages of the issued and outstanding shares of corporations that are involved in the fishing business:

*     Individual (“K”) owns 65% of BuyCo 2
*     K’s brother owns 100% of SellCo A
*     K’s son owns 100% of SellCo B

SellCo A and SellCo B sell 100% of their catch to BuyCo 2 such that all of SellCo A’s income and SellCo B’s income for the year is derived from sales to Buyco 2. BuyCo 2 purchases the majority of its fish from non-related parties.

In each of the situations, we have been asked to assume that each corporation is a “Canadian controlled private corporation” (“CCPC”), as that term is defined in subsection 125(7) of the Act, throughout the particular year and that none of the corporations are otherwise associated. Further, for these purposes we will assume that the taxation years of these corporations all begin after March 21, 2016.

Our comments

This technical interpretation provides general comments about the provisions of the Act and related legislation. It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination. The income tax treatment of a particular transaction proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Section 125 of the Act provides the rules for the calculation of the SBD available to a CCPC on its income from carrying on an active business in Canada. Using the SBD, a CCPC may reduce its tax otherwise payable on such income by an amount equal to the SBD rate multiplied by the least of three amounts described in subsection 125(1).

As noted, subsection 125(1) sets out the lesser of three amounts that determines the amount of a CCPC’s SBD claim for a taxation year. For the purposes of this response we will focus on the amount described in paragraph 125(1)(a). In general terms, this amount is equal to the sum of the portion of the CCPC’s income from an active business carried on in Canada for a taxation year excluding certain income and exceeding certain losses. Subparagraph 125(1)(a)(i), clauses (A) to (C) indicate the portions, if any, of a CCPC’s income from an active business that are not eligible for the SBD.

In particular, clause 125(1)(a)(i)(B) refers to the portion of a CCPC’s income that is described in subparagraph (a)(i) of the definition of “specified corporate income” (“SCI”) in subsection 125(7) for the year. Very generally speaking, where a CCPC earns income that would otherwise be considered as income from an active business from the provision of property or services to another private corporation and it (or one of its shareholders) or a person who does not deal at arm’s length with the CCPC (or one of its shareholders) holds a direct or indirect interest in that other private corporation, such income would not be considered as being eligible for the SBD unless one of the following conditions is met:

*     all or substantially all of the CCPC’s income for the year from an active business is from the provision of services or property to persons (other than that private corporation) with which the CCPC deals at arm’s length, or partnerships with which the CCPC deals at arm’s length, other than a partnership in which a person that does not deal at arm’s length with the CCPC holds a direct or indirect interest; or

*     the particular private corporation described above is able to (and does) assign all or a portion of its business limit to the CCPC under subsection 125(3.2).

The above rules, as generally described, are also subject to certain anti-avoidance rules; however, they will not be discussed for the purposes of this response.

In each of the situations described above, the income earned by each SellCo would not be eligible for the SBD unless (and only to the extent) that the particular BuyCo was able (and actually did) make an assignment of all or a portion of its business limit to that SellCo under subsection 125(3.2) of the Act. Each BuyCo’s business limit will be reduced under subsection 125(3.1) of the Act by any portion of its business limit that it assigns to another CCPC under subsection 125(3.2).

In order for a business limit assignment under subsection 125(3.2) to be valid, each CCPC is required to file a prescribed form with the Minister of National Revenue for their respective taxation years. These forms are the T2SCH7, Aggregate Investment Income and Active Business Income, and the T2, Corporation Income Tax Return.

We trust these comments will be of assistance.

Yours truly,

Michael Cooke, C.P.A., C.A.
Manager
Business Income and Capital Transaction Section
Business and Employment Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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