Two Reasons CRA Could Deny Small Business Deduction 

The Canada Revenue Agency (CRA) offers Small Business Deduction (SBD) to Canadian Controlled Private Corporation (CCPC) on the first $500,000 in active business income. Under the deduction, CCPC’s pay a preferential tax rate of 9% instead of 38%. This deduction can save small businesses a significant amount in the tax bill, encouraging them to incorporate their business and get the CCPC status. The objective behind this deduction is to give more income to small business owners so they can reinvest and grow their businesses.

However, many business owners misuse the deduction by opening more than one CCPC to multiply the SBD. Many business owners also use the extra income from tax savings to earn passive income from investments rather than reinvest in the business. The CRA has laid out rules that could deny SBD to CCPCs under such scenarios.

In this article, we will discuss two scenarios where the CRA can deny you SBD and strategies you can implement to maximize the deduction.

Failure to File the Business Limit Agreement 

The Small Business Deduction has the associated corporation rule, under which a small business owner with multiple CCPCs can claim a combined SBD of only $500,000. They cannot claim $500,000 SBD for each corporation.

Suppose John owns four Corporations. Corporations 1 and 2 earn $150,000 each, and Corporations 3 and 4 earn $100,000 each. He can divide the $500,000 SBD limit among the four corporations to make the most of the tax benefit. However, the CRA can deny the deduction if the four CCPCs fail to file a valid agreement under Schedule 23 to share the business limit.

Even if the corporations have filed the agreement, it may not be valid under the following circumstances:  

• If only one corporation is filing Schedule 23 for all four, it will be considered invalid as it may not reflect the true agreement among the corporations.
• Moreover, any inconsistency in the amounts in the Schedule 23 agreements filed by the four CCPCs means there is no agreement, and the deduction will be denied.
• Another scenario could be where John’s Corporations 1 and 2 and Corporations 3 and 4 have a valid agreement to allocate business limits. However, the agreement between Corporations 1 and 3, 1 and 4, 2 and 3, and 2 and 4 are missing. The CRA could deny SBD to all four corporations.

Solution: If the Schedules filed by CCPCs are invalid, each of the four corporations has to re-file Schedule 23.

The CRA may issue a written notice demanding corporations to file or re-file valid agreements. Once the notice is issued, the corporations must file the agreements within 30 days. If you fail to file the Schedule, the CRA will allocate the business limit among the associated corporations. As we saw in the above scenario where John’s four corporations earned different business incomes, John may not be able to make the most of the SBD.

An experienced tax consultant can help you file Schedule 23 and comply with all the requirements to qualify for the Small Business deduction and any other tax benefit.

Passive Income Business Limit Reduction

Another clause in the SBD is that the $500,000 deduction is on active business income. The objective is to encourage business owners to invest in the business for growth and expansion. If your business earns too much passive income, the SBD limit will be reduced. Every $1 passive income earned above $50,000 will reduce the SBD by $5. Your SBD could become nil if your business earns $150,000 in passive income.

If you create a new corporation to transfer passive income investments, it won’t help as the new corporation will be related and fall under the associated corporation rule. 

Solution: Instead of transferring the investments to another corporation you could consider the following options:

• Reduce passive income and use it in the business, converting it to active income.
• Pay the passive income as dividends to shareholders.  
• Realize capital losses in the current year and deduct that from capital gains, reducing the passive income.

Contact KSSP Partners LLP in Markham to Help You Improve Tax Efficiency

Talk to a professional tax consultant to help you make the most of the various tax benefits the CRA offers and reduce your tax bill without avoiding taxes. To learn more about how KSSP Partners LLP can provide you with the best tax planning expertise, contact us online or by telephone at 289-554-5997.