Making use of small business exemption

Case focuses on ‘principal purpose’

BTax Expert usiness owners who operate their business through a private corporation, known in tax lingo formally as a “Canadiancontrolled private corporation” (CCPC), often do so for a variety of tax reasons. These include the potential to implement various incomesplitting opportunities with a spouse/partner or adult children or perhaps to ultimately take advantage of the $835,716 lifetime capital gains exemption on the sale of the business.

But for some, especially incorporated professionals such as doctors, lawyers and accountants, the No. 1 attraction of incorporation is the ability to claim the small business deduction on the first $500,000 of active business income, thereby paying an extremely low rate of tax when the income is initially earned. For the business owner or incorporated professional who “doesn’t need all her cash” and can afford to leave some money in her corporation for investment purposes, there a significant tax deferral advantage by leaving the aftertax corporate income inside the corporation as opposed to paying it out immediately. This deferral advantage ranges from a low of 35 per cent in Alberta, B.C. and Quebec to a high of just over 40 per cent in Nova Scotia.

A recent tax case dealt with a taxpayer who owned eleven rental properties inside his CCPC and attempted to claim the small business deduction on the corporation’s rental income. The Canada Revenue Agency denied the deductions on the basis that the “principal purpose” of the corporation’s business was to earn rental income and that its business was a “specified investment business.”

Under the Income Tax Act, a corporation is eligible to claim the small business deduction if it was a CCPC which carries on an “active business.” An “active business” is defined as “any business carried on by a corporation other than a ‘specified investment business.’ ” A “specified investment business” includes any business with less than six full-time employees throughout the year and has the “principal purpose” of earning investment or rental income.

While the term “principal purpose” isn’t defined in the Act, prior jurisprudence found that “(i)n determining the ‘principal purpose’ of a business carried on by a corporation the stated object of the person who carries it on is not necessarily the only, or even the most important, criterion. Of critical importance is what the corporation in fact does and what its sources of income are.”

The taxpayer’s representative testified that corporation was incorporated with the intent that it would purchase houses which could be developed and resold for a profit. Throughout the period 2006 to 2016, the taxpayer had owned eleven houses which it rented out.

The taxpayer stated that the properties were only rented out “to help cover their costs.” He testified that he is a property developer but he cannot buy and sell immediately because he didn’t have the funds to develop all of the houses when they were initially purchased. It was his goal to own twelve houses, renovate them and then sell them at a profit.

The judge had to determine what the true “principal purpose” of the corporation’s business was rather than simply relying on the taxpayer’s testimony. While the taxpayer testified that the corporation’s “principal purpose” in the 2010 and 2011 tax years was to earn income from the purchase and sale of real estate, the judge said “(t)he documentary evidence does not support his testimony.”

Indeed, on the corporation’s 2010 and 2011 income tax returns, the taxpayer described its operations as the “rental of residential properties,” declaring that “100 per cent of its revenue was earned from the rental of residential properties.”

As a result, the judge concluded that the “principal purpose” in 2010 and 2011 was to earn income from the rental of residential properties and found that the taxpayer, who did not employ six full-time employees, was indeed operating a “specified investment business.” Since the corporation didn’t earn “active business income” in 2010 and 2011, the corporation was not entitled to the small business deduction.

As for the future of the small business deduction, it remains to be seen whether the government will crack down on its use for corporations with only one or two employees. You may recall that in the 2015 election platform, the Liberals stated that they “will ensure that … CCPC status is not used to reduce personal income tax obligations for high-income earners rather than supporting small businesses.”

This proposal was commonly understood to be specifically targeted at high-income professionals who use the small business deduction to enjoy the significant tax deferral advantage. While the last year’s federal budget introduced new legislation aimed at preventing the inappropriate multiplication of the small business deduction among multiple corporations, no changes were made to the ability for a CCPC, including a professional corporation, to continue to be able to claim the deduction on active business income.