AK/ADMS 4561 Lecture 10 – Part 3

– Tax Consequences and Planning for Shareholders of Private Corporations for 2018
and future years – last updated November 23, 2022

As discussed in Part I of these notes, most entrepreneurs who have founded businesses are
shareholder-managers of a private corporation. Because the business is a source of family
income and the shares of the corporation are often the family’s most valuable asset,
knowledge of the tax rules and related planning at a very basic level is important.

Lecture 10 - Part I lecture discussed the tax rules applicable for

- starting and incorporating a business
- buying an existing business
- selling an incorporated business
- compensation options for shareholder-managers and their families

Lecture 10 – Part I also reviewed the 4 reasons why individuals transfer their business assets
to a corporation. The first is an important legal reason (limited liability) and the next 3 are
tax reasons:

1. Income sprinkling using dividends

2. Tax deferral
3. Using the LCGE on the sale of shares.1

Lecture 10 – Part 2 examined how the new TOSI rules effect strategy #1: Income sprinkling
starting in 2018. The new TOSI rules are complicated and make income sprinkling more
difficult.

This final Part 3 examines the four restrictions on the low small business (“SB”) rate of tax
addressing strategy #2 to Defer taxes.

But before looking at the four rules which restrict access to the low SB rate, it is important to
remember that the use of a corporation to earn business income in 2022 will still defer
tax when you compare the general corporate rate to a 50% top combined personal rate.

 Although the largest tax deferral results when the corporation retains income that is
taxed at the SB combined corporate rate (9% fed. + 4% provincial)2:
o 50% personal - 13% corporate = tax of 37% deferred

 There is still a significant deferral when corporate income is taxed at the general
combined corporate rate (15% federal + 12% provincial):3
o 50% personal - 27% corporate = tax of 23% deferred
1
Over $800,000 (indexed annually) for QSBC shares, $1million for farming and fishing properties.
2
9% federal and 4% provincial = 13% rate assumed for the 15% gross up for non-eligible dividends since 15/115
= 13%.
3
15% federal + 12% provincial = 27% rate assumed for the 38% gross-up for eligible dividends since 38/138 =
27.5%

Joanne Magee [jmagee@yorku.ca]

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The four rules restricting access to the low SB rate are summarized in this chart.
Rule Reason for rule
1. Associated Individuals should not be able to
corporations incorporate multiple corporations and
must share the access the $500,000 annual limit
$500,000 again and again. That is why
annual limit. corporations owned by the same
person or group or persons or
related persons with 25% cross-
ownership are associated
corporations. (S. 256 discussed in
Lecture 3)
2. Large
corporation rule The low SB rate should not be used
(over $10 by large corporations. Large
million in corporations should be defined by
Canadian Canadian business assets adjusted
taxable capital) for intercompany investment =
Canadian taxable capital.
3. “Specified Taxpayers should not be able to use
corporate a non-associated management
income” rules service corporation (MC) owned by
effective 2017 family members (related persons,
see Lecture 3) to access another
$500,000 SBD limit. Why, for
example, should an MC owned by a
dentist’s children earning income
from providing services (e.g., payroll)
or property (rental of premises) to
PC carrying on the business of his
dental practice get another $500,000
annual limit?
4. “Passive Because SB corporate tax rates are
income rules” so low compared to personal rates,
effective 2019 higher amounts of after-tax income
can be invested inside a corporation
(vs. outside) to earn passive
investment income. This deferral
advantage is used by many people
to defer taxes and save for
retirement. e.g., If you assume a 5%
rate of return, then $1M of
accumulated funds in a corporation
would yield $50K of investment
income annually and $3M of
accumulated funds would yield
$150K of investment income
annually
If both 2 and 4 are applicable, the SBD limit reduction is the greater of the two.
4
Net capital losses are excluded (presumably to make the rules simpler).
Joanne Magee [jmagee@yorku.ca]
Mechanics
Associated corporations have to be identified in each
T2 (Schedule 9).
An allocation of the $500,000 annual limit must be
filed each year in each T2 (Schedule 23).
Allocation can be different every year
$500,000 overall annual limit is reduced to zero on a
straight-line basis as associated group’s Canadian
taxable capital increases from $10 to $15 million. The
upper limit has been increased to $50 million for
years beginning on or after April 7, 2022. (Assets are
often given as a proxy for taxable capital in past CPA
Exam questions)
This type of income is now called “specified
corporate income” (See next page for the full
definition). Specified corporation income does not
qualify for the SBD unless:
(a) all or substantially all (90% or more) of the MC’s
active business income is earned from providing
services/property to arm’s length persons
or
(b) Mom or Dad’s PC (which is paying for the
services) assigns part of its $500,000 annual SBD to
it under subsection 125(3.2)
When prior year’s “adjusted AII” of associated group
is between $50,000 and $150,000, the annual SBD
business limit for the active business income for the
year is reduced from $500,000 to zero on a straight-
line basis.
Adjusted AII/passive investment income = AII
 plus non-connected (passive) dividends
 minus any TCG from the - sale of
o assets used in an active business
(by the CPPC or a related corp.) or
o shares of an QSBC.4
Prior year’s income is probably being used (a) so the
CRA can verify the number in advance and (b) so
CCPCs can estimate their current year’s taxes,
instalments and GRIP with certainty.
(Discussed further on the next page & in Appendix 2)
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Specified Corporate Income Rules Affecting Corporations Effective 2017

Problem:
Some taxpayers used non-associated management service corporations owned by family
members to access another $500,000 SBD limit to save more tax by income splitting.
Accessing another $500K SBD limit was stopped in 2017 when the “specified corporate
income rules” were introduced. (Income splitting was then limited with the 2018 changes to
TOSI.)

Government Response in 2016:

In order to stop schemes aimed at multiplying the SBD annual business limit, for taxation years
beginning after March 21, 2016 (e.g., effective January 1, 2017 for a corporation with a
December 31 year-end), income eligible for the SBD under s. 125(1)(a) excludes:

Income from providing services or property directly or indirectly to another private

corporation where at any time in a taxation year,
 the CCPC service/property provider
 one of its shareholders or
 a person that does not deal at arm’s length with any one of its shareholders
has a direct or indirect interest in this other private corporation. (Note that this rule
applies where any direct or indirect interest exists, even small amounts.)

ABI that meets the above definition is not eligible for the SBD 5 unless:

(a) all or substantially all (90% or more) of the CCPC’s active business income is
earned from providing services/property to other persons who are arm’s length.6
or
(b) the private corporation (which is paying for the services) assigns part of its business
limit for the small business deduction (SBD limit) to it under subsection 125(3.2) 7.

5
S. 125(1)(a)(i)(B) excludes income described in subparagraph (a)(i) of the definition “specified corporate income”
in s. 125(7).
6
This income is eligible for the SBD because s. 125(1)(a)(i)(B) does not exclude it (because subparagraph (a)(i)
of the definition “specified corporate income” in s. 125(7) excludes it).
7
This income is eligible for the SBD because it is “specified corporate income”: see inclusion in s. 125(1)(a)(ii.1)
for “specified corporate income” in s. 125(7).

Joanne Magee [jmagee@yorku.ca]

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Example: A dentist has a PC that earns $800,000 of profit annually from practicing dentistry
(and therefore uses the full $500K annual business limit). A long time ago, he arranged for his
spouse and two adult children to incorporate a management services company (MC) that pays
for all the expenses of the dentistry practice (e.g., $2M of rent, utilities, payroll) and bills the PC
a 15% fee for its services. The annual fee earned by MC from PC is $300,000 ($2M x 15%)
and this is MC’s sole source of active business income. As the management fee is deducted in
arriving at the PC’s income, $300,000 of the PC’s income has effectively been transferred to
the unassociated MC. Both corporations have December 31 year ends.

Starting in 2017, MC with pay the general rate of tax on its $300,000 of active business income
because it:

fails test (a) because none is from providing property/services to AL persons

and

fails test (b) because PC cannot assign any business limit (since it all used).

Examples

Income from services (e.g., management Only Eligible for SBD if SBD limit
services8) or property (interest or rental assigned under
income9) to

Associated CCPC s. 125(3) (the regular SBD limit allocation

section)

Related CCPC
s. 125(3.2) unless income is < 10% of ABI
*CCPC which related person owns 1% of and other ABI is from arm’s length persons

*CCPC which one of its shareholders owns 1%

of

* common sense would tell you that the smaller the ownership interest, the more unlikely that
the SBD limit would be assigned.

8
Examples of management services include payment of salaries, rent etc. for a CCPC carrying on an AB
(including a professional corporation that is carrying on a CPA, legal, medical or dental practice).
9
Note that providing property would only result in ABI if there are > 5 full-time employees throughout the year.

Joanne Magee [jmagee@yorku.ca]

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Passive Income Rule Affecting Corporations Effective 2019

References
1. Department of Finance https://www.fin.gc.ca/n17/data/17-099_1-eng.asp
2. “Passive Investment Income Earned by Private Corporations”, CPA Canada Federal Budget
Commentary 2018, posted with permission in the Online Lecture 10 Folder (pages 2 to 4 only).

Problem: The problem is illustrated in the Department of Finance power-points in the Lecture
3 folder. Briefly, because corporate tax rates on business income are so low compared to
personal rates, higher amounts of after-tax income can be invested inside a corporation (vs.
outside) to earn passive investment income. This deferral advantage is used by most
professionals to defer taxes and save for retirement. The March 2018 federal budget
announced two changes effective for taxation years commencing after 2018, e.g., effective
December 31, 2019 year ends. They don’t eliminate the problem; they just reduce the deferral
by increasing corporate taxes.

Government Response in 2018 effective 2019 = When prior year’s “passive income”
(adjusted AII) of an associated group is between $50,000 and $150,000, the annual SBD
business limit for the active business income for the year is reduced from $500,000 to
zero on a straight-line basis.

For example, the 2022 passive income grind will be based on 2021 passive income.

When the large corporation grind (#2 in the chart) also applies, the greater of the two grinds
will apply.

Prior year’s passive income is probably being used (a) so the CRA can verify the number in
advance and (b) so CCPCs can estimate their current year’s taxes and instalments with
certainty.

If the CCPC is part of an associated group, then the associated group’s prior year’s passive
income needs to be figured out.

In other words, for every $1 of prior year’s passive income above $50,000, the SBD annual
business limit is reduced by $5.

You can remember the “passive income rule” using one of these 2 methods:

Method 1. When prior year’s “adjusted AII” is between $50,000 and $150,000, the annual SBD
business limit for the year is reduced from $500,000 to zero on a straight-line basis.

Method 2. For every $1 of prior year adjusted AII above $50,000, the SBD annual business
limit is reduced by $5.

Passive Income (Adjusted AII) Formula

Joanne Magee [jmagee@yorku.ca]

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Adjusted AII is the technical name for “passive income” and is designed to be
passive income not related to an active business carried on by the CCPC or a related
CCPC and is:

AII under the regular rules

Plus 1. Dividends from non-connected corporations (“portfolio dividends”)

2. Net capital losses deducted (from other years)

Minus Taxable capital gains (TCGs) from the disposition of

1. assets used in an active business carried on by the CCPC or a related

CCPC

2. shares of a connected CCPC that is a qualified small business corporation

(QSBC)

Simple Example:

Facts: To defer personal tax, a lawyer’s PC (not associated with other corporations) has
retained $2M cash over the years rather than paying it out as salary or dividends to the lawyer.
In its December 31, 2021 taxation year, the PC earns passive income (adjusted AII) of
$100,000 (the mid-point of the $50K to $150K SB limit reduction range).

Result: The PC’s December 31, 2022 SBD limit will be $250,000 rather than $500,000 and it
will get the general corporate rate on the excess.

Proof:

Method 1. $250K is the midpoint.

Method 2. $5 x $50K = $250K & $500K minus $250K = $250K.

Joanne Magee [jmagee@yorku.ca]