Canada

CRA applies the small business deduction recharacterization rule

TAX ALERT  | 

The small business deduction allows Canadian-controlled private corporations (CCPCs) to benefit from favourable tax rates on their active business income. The regime is governed by a set of detailed rules to police perceived abuses. The Canada Revenue Agency (CRA) recently opined on the application of one such rule relating to the recharacterization of income.

The small business deduction

CCPCs are permitted a ‘small business deduction’ from tax otherwise payable in respect of their first $500,000 of income derived from an active business carried on in Canada. After taking into account the small business deduction, the federal corporate tax rate applicable to CCPCs’ eligible small business income is 9 per cent. Each of the provinces and territories also provide for a small business rate of between 0 and 6 per cent, resulting in combined small business rates varying between 9 and 15 per cent. The small business rate is thus significantly lower than the combined general corporate tax rate on CCPCs’ active business income of between 26.5 to 31 per cent.

Virtually every type of business qualifies for the small business deduction other than a ‘specified investment business’ or a ‘personal services business’. However, there are a number of restrictions on the application of the small business deduction. Among other limitations:

  • The small business deduction is generally only available in respect of income up to $500,000
  • The business limit must be shared among ‘associated’ corporations
  • The business limit is phased out on a straight-line basis if the associated CCPC group’s ‘taxable capital employed in Canada’ in the immediately preceding taxation year exceeds $10 million
  • The business limit is phased out on a straight-line basis if the associated CCPC group’s passive investment income (the ‘adjusted aggregate investment income’) exceeds $50,000 in the preceding taxation year

Recharacterized active business income

Another particularity of the small business deduction is that under subsection 129(6) of the ITA, property income of a corporation is deemed to be income from an active business where it was received from an associated corporation and resulted in a deduction in computing the associated corporation’s income from an active business. More specifically, in computing a corporation’s income from property, such income will not include any portion of an amount that was deductible in computing income from an active business carried on in Canada by an associated corporation. Additionally, the deductible portion will be deemed to be income from an active business of the recipient.

The purpose of subsection 129(6) is to prevent associated corporations from converting active business income into income from property in order to generate a dividend refund. This is because, in the private company context, one-half of the taxes paid on certain types of investment income are refunded at the time of payment of dividends.

Assume, for example, that X Co and Y Co are associated corporations. X Co holds a patent, the rights of which are leased for an annual amount of $10,000 to Y Co. In computing its active business income, Y Co deducts the rental fees of $10,000 paid to X Co. But for subsection 129(6), X Co would consider the $10,000 fees to be income from property and consequently, the deduction would reduce the combined business income of the associated group by $10,000. Also, the $10,000 of property income could subsequently give rise to a tax refund if X Co paid out a taxable dividend to its shareholders. However, subsection 129(6) would apply in this situation such that the $10,000 payment would be added to X Co's active business income for purposes of the small business deduction, and be excluded from X Co's investment income.

Recharacterization rule applies to payments made between associated corporations

In a July 2019 CRA view (2019-0795751E5), the following fact pattern was presented. Company A has a taxation year ending Dec. 31, 2018. Company B has one taxation year commencing Jan. 1, 2018, and ending on March 27, 2018. Company B has a second taxation year that commences March 28, 2018, and ends on Dec. 31, 2018. Company A and B were associated for Company B’s first taxation year ending on March 27, 2018, but they ceased to be associated on March 28, 2018.

Throughout 2018, Company A rents a property to Company B. Company B uses the property in its active business carried on in Canada and the rental expense is deductible by Company B in computing income from that business.

The question was whether subsection 129(6) would apply to deem the rental income received by Company A to be active business income for its entire 2018 taxation year, or only the portion received during the Jan. 1, 2018 to March 27, 2018 period.

The CRA’s view is that the taxation year referenced in regards to the deductible portion for purposes of subsection 129(6) is that of the payer (Company B), rather than the recipient (Company A) because under the provision, the payer must be an associated corporation in relation to the recipient in that taxation year.

Accordingly, CRA concluded that subsection 129(6) will apply to deem the rental income received by Company A to be active business income for only that portion of the income received for the period Jan. 1, 2018, to March 27, 2018.

Association drives recharacterization

This latest CRA interpretation appears to align correctly with the purpose and scope of subsection 129(6). The recharacterization rule was applied to payments made between associated corporations, but only for that period of time that they were associated. A broader application of the rule may have unduly circumscribed the taxpayers’ ability to access the small business deduction.

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