In the Summer edition of Insight we introduced the 2016 Budget item that significantly alters access to the low active business tax rate for small businesses.

These broad and complex rules apply to corporate year-ends commencing after March 22, 2016; thus, practically, they will effect year-end tax filings commencing March 31, 2017.

The implications of the changes are broad..

Example: OpCo renting

premises from a related HoldCo

The implications here likely will be more of form than substance. Ordinarily, rents are taxed as passive, not active, income; however, the rental profit enjoyed by HoldCo in this situation would be considered active. But the two associated entities would have to share the $500,000 small business deduction (SBD) using the long-standing Schedule 23. Under the new rules, HoldCo’s rental income now will be termed “specified corporate income” (SCI) and not be eligible for the SBD using Schedule 23. Instead, a new form still will qualify this income as actively taxed by way of Opco transferring (not sharing) its own SBD.

Example: ACo and BCo business transactions

ACo is owned by Mr X, and Mr Y (related to Mr X) has a minimal ownership in BCo. Unless the business that ACo does with BCo is immaterial (10% or less of profit), ACo will be denied the SBD due to the related party relationship with MrY. The messy part is that it is ACo’s profit (not revenue) from serving BCo that is denied the SBD. Now we have accounting issues as to what expenses apply to that BCo revenue…ohhh joy!

BCo could transfer some of its SBD limit to ACo, but that would be highly unlikely. Even if BCo is willing to share, a ludicrous situation arises: what is to be shared is profit not revenue! Therefore, ACo would need to determine and disclose its profit to BCo in order to settle how much BCo transfers to ACo! Mr Y’s minimal ownership in BCo, and his relationship with Mr X, cause Mr X either embarrassment or a conundrum. Likely he would choose to do nothing, “suck it up” and pay tax at the higher corporate rate.   This draconian result would not occur under the old rules because ACo and BCo would not be “associated”, due to Mr Y’s small ownership in BCo.

This new provision also places a ridiculous burden on tax preparers, who now need to flush out these related party relationships. They will need to review with the owner the list of revenue customers. Where ACo is owned by multiple business partners, the questioning ought to be done with every owner! And the 10% test is applied on profit not revenue, so profit calculations ought to be made.

Example: ACo and BCo and management fees

ACo provides active business management services to a related BCo, which owns rental properties. Previously, ACo would pay tax on this income at the low active rate and BCo would enjoy a tax deduction at the high passive rate. Collectively, they come out ahead with CRA. Now, that net income in ACo will be “SCI” and not eligible for the SBD, and thus pay a higher corporate tax rate by approximately double. Of small benefit, this higher-taxed income will qualify for tax-preferred eligible dividend status rather than ineligible.

Tax planning philosophy may need to shift.