Only the income earned from an active business by a Small Business Corporation qualifies for the lower small business tax rate [thanks to the small business deduction (SBD)], up to the corporation’s annual business limit.
What is Active Business Income?
Under the Income Tax Act, “active business income” generally refers to income from a business carried on by a Canadian resident corporation, with two main exceptions:
Specified Investment Business
This is a business whose main purpose is to earn income from property, such as rent, interest, dividends, or royalties. Income from these activities usually does not qualify for the small business deduction unless the business employs more than five full-time employees throughout the year.
Personal Services Business
This is a business where an individual provides services through a corporation, but would otherwise be considered an employee if not for the corporation. Income from a personal services business also does not qualify for the small business deduction.
While the full legal definitions are more detailed, these simplified explanations cover most situations.
Anti-Avoidance Measures and Assignment of Business Limits
Canada’s Income Tax Act contains specific anti-avoidance rules designed to preserve the integrity of the small business deduction and restrict inappropriate access to the business limit for active business income. These rules are especially relevant when dealing with corporate groups, associated corporations, or structures where ownership and control are not fully independent.
The business limit, which sets the threshold for income eligible for the small business deduction, is generally $500,000 per associated group of corporations. When two or more corporations are associated within the meaning of section 256, they are not each entitled to their own separate $500,000 limit. Instead, they must allocate that amount among themselves using a prescribed form, typically Schedule 23 of the T2 return.
Anti-Avoidance Provisions for Artificial Structures
To prevent the multiplication of the small business limit through artificial separation of ownership or income-splitting strategies, the Act includes targeted anti-avoidance provisions. One such measure is in subsection 125(5.1), which addresses situations where corporations that are not legally associated may nonetheless be considered “associated” for the purpose of limiting access to the small business deduction. This rule applies when two corporations are effectively under common control or when the arrangement appears designed to sidestep the association rules.
Furthermore, subsection 256(2.1) allows the Canada Revenue Agency to deem corporations to be associated if their separate existence primarily serves to reduce tax. This discretionary power can apply even in the absence of a formal association, where the operations, finances, or management of two corporations are significantly integrated.
Specified Corporate Income and Restrictions on Internal Billing
Assignment of the business limit among related corporations must be done deliberately and documented properly. Corporations are required to agree on how the $500,000 limit is divided, and failure to file the appropriate election can result in the entire deduction being denied. Inaccurate or inconsistent allocations between corporations may also prompt a review by the CRA.
Finally, rules under section 125(7) and the associated definition of “specified corporate income” are intended to prevent planning strategies where one corporation earns active business income from another related corporation, recycling income through multiple entities to extend access to the small business deduction. Income that falls within this definition is generally excluded from the small business deduction unless the payer and recipient jointly elect to treat it as eligible, and the recipient corporation can demonstrate it has a substantial economic contribution to the arrangement.
Together, these anti-avoidance measures ensure that the small business deduction supports genuinely independent small businesses operating within an applicable income threshold.
Specified Partnership and Farming or Fishing Income
The Income Tax Act also contains detailed rules that determine whether income earned through partnerships or from farming and fishing operations qualifies as active business income. These rules are especially relevant for private corporations seeking to benefit from the small business deduction (SBD), which applies only to qualifying active business income (ABI).
Income from Partnerships
When a corporation is a member of a partnership, its share of income from that partnership may qualify as active business income depending on the nature of the partnership’s business and the corporation’s role. If the partnership is carrying on an active business and the corporation is meaningfully engaged in that business, the corporate partner’s share of income is generally considered active business income.
However, the Act introduces the concept of a “specified partnership income” (SPI) to address potential abuses. SPI applies when a corporation earns income from a partnership in which it is not an actual partner but provides services or property to the partnership and is considered to be related to a partner in the partnership. In these cases, the income is deemed to be SPI and is subject to the business limit rules that restrict the availability of the Small Business Deduction (SBD).
Corporations earning SPI are only allowed to allocate a portion of the partnership’s business limit in order to qualify for the SBD on that income. This prevents multiple corporations from claiming the full business limit on essentially the same partnership income.
Farming and Fishing Income
Income from farming or fishing activities can also qualify as active business income, provided the activities are commercial in nature and conducted with a reasonable expectation of profit. Small family-owned farming and fishing corporations are eligible to claim the SBD on qualifying ABI from these sources, subject to the usual business limit.
Corporations involved in partnerships or cooperative structures must accurately assess whether their income qualifies as active business income and whether the business limit must be shared, allocated, or reduced under the specified partnership or specified cooperative income rules. Proper documentation, tax planning, and professional tax advice are critical to ensure compliance and optimize the tax benefits of this income.
As experienced and licensed CPA tax consultants, we help our clients handle all tax and accounting issues. Give us a call today at 1 844 340 5771 to schedule an assessment.
Case Study
A new client faced a challenging CRA audit, which resulted in the disallowance of an HST refund valued at nearly $1 million. The audit revealed that his previous accountant had made significant errors, which led to the denial.
Our team conducted an in-depth review of the proposal letter from the CRA, in conjunction with the Income Tax Act. We were convinced that the case would be won if the records were corrected and a new argument was submitted as a response to the CRA’s proposal letter.
The CRA auditor denied the response. Our firm filed a Notice of Objection with the CRA.
The Objection was successful, and our client was able to recover not only the original refund but also additional amounts that the previous accountant had missed, which were also awarded to our client.
