Corporations are normally taxed federally at a rate of 38 per cent.
However, one of the tax reductions available is the ability to claim the small business deduction of 17 per cent up to the small business limit of $500,000 provided that the corporation qualifies for the deduction.
The purpose of the deduction is to help smaller businesses retain more after tax income for reinvestment and expansion to fight the higher financing and capital costs that face small incorporated businesses.
The small business deduction is defined in Section 125 of the Income Tax Act.
In order to qualify for this deduction the corporation must be a Canadian controlled private corporation that carries on active business in Canada, including an adventure in the nature of trade.
A Canadian controlled private corporation means that the corporation is a small business corporation that must be incorporated in Canada and have its head office in Canada.
It can have non-resident shareholders, but it must be controlled by Canadian resident shareholders.
It must be a private corporation that does not trade stock on any stock exchange.
An adventure in the nature of trade means that the business attempted to enter into a sideline or other business venture where it would not normally operate in order to determine whether it could expand into that area.
A small business corporation is defined as a corporation that uses 90 per cent of the fair market value of its assets to create active business income in Canada.
The definition of an active business in Canada means that the corporation must be receiving operating income in Canada excluding income from property.
It cannot be a specified investment business and cannot be a personal services business.
The purpose of a business needs to be determined on an annual basis to determine if it still qualifies for the deduction.
A specified investment business is defined as a business that receives most of its income from property.
Such as interest, dividends, rentals from real estate and royalties.
The exceptions are if the company is in the business of leasing property or if the company has five or more employees, or if the company provides administrative, managerial, financial, maintenance or other similar services to an associated corporation qualifying for the deduction.
There are also exceptions to these exceptions.
For example, if the business purchased property for its own use and then moved but was unable to sell the property for a period and decided to rent it in the interim, this would be considered an adventure in the nature of trade, rather than an investment business.
A personal services business is defined as a business that provides services to one corporation or on behalf of the corporation and the person providing the services could be considered an employee except for being an incorporated employee.
It is also considered a personal services corporation if the person providing the service is related to the shareholder of the corporation who owns more than 10 per cent of the issued shares of the corporation or has less than six employees.
If the corporation qualifying for the small business deduction is associated with another or several corporations, they must all share the same annual limit of $500,000.
This limit can be allocated between the corporations to receive the best tax benefit when filing the tax return each year.
The agreement between the corporations is in effect for the calendar year even if the associated corporations have different fiscal periods.
Section 256 of the Income Tax Act contains the complex rules to determine if corporations are associated.
The foremost consideration is control of the corporation as it has been determined by case law or de facto control (control in fact) explained in Section 256.1.
For example, if one corporation is controlled by another corporation by way of share ownership, voting control or control by the same group of persons, the corporations are associated.
When dealing with multiple corporations and possible associations, accountants need to receive a copy of the minute book(s) to determine if there are any relations or associations that may affect taxes payable.
If you are a shareholder of a corporation it must qualify as a Canadian controlled private corporation, for your shares to qualify for the lifetime capital gains exemption of $750,000 .
In order to qualify as a Canadian controlled private corporation, the corporation must, in the two years prior to the year of disposition of those shares, use at least 90 per cent of the fair market value of its assets to create active business in Canada.