4562-3 1
1 4562 Lecture 3 - Corporate Tax for CCPCs
Last updated May 1, 2015
This lecture discusses
- Taxation of Business Income and Integration
- Associated Corporations
- Scientific Research and Experimental Development (SR&ED) and
- CPA Canada’s Mock Simulation Mamma Jill’s Pizza (problem set)
Readings
ADMS 3520 Lecture 9 Notes
Read sections ITA 89, 125(1) to (7), 125.1(1), 129(6), 256
FIT Ch. 12 (exclude 12300 to 12390)
Recommend
Ch. 12, Review Questions 1 to 4, 6&7, 10; Multiple Choice 1 to 3, 5, 6; Exercises 3 to 5
Lecture 3 Problem Set
Remember to print the lecture notes, read the lecture notes and do the Problem Set and Exercises. You should also review the recommended Review Questions and Multiple Choice Questions and you may wish to bring your textbook and the Act to class.
In ADMS 3520 lecture 9 you learned about the three main types of corporations and about the tax preferences given to Canadian controlled private corporations (CCPCs).
Recall that a public company is a company resident in Canada with a class of shares listed on a designated stock exchange in Canada; and a private company is a company resident in Canada that is not a public company and that is not controlled by one or more public companies [s. 89(1)]. A CCPC is a private corporation that is a Canadian corporation and that is: (a) not controlled by non-residents and/or public companies; and (b) that does not have any class of shares listed on a designated stock exchange [s. 125(7)].
The most significant of these tax preferences is the small business deduction [s. 125(1)] which results in a low rate of tax for the first $500,000 of Canadian active business income.
You also learned about
- associated corporations and how they must share this $500,000 annual business limit
- some of the basic rules that make corporations associated
- the three basic rules in s. 256(1)(a) to (c)
- the rules that determine whether
- individuals are related [s.251(2)(a)] by blood [s. 251(6)(a)], marriage [s. 251(6)(b)] and adoption [You also learned that a person is deemed to be related to himself: s. 256(1.5) ]
- corporations and individuals are related: s. 251(2)(b) and
- two corporations are related 251(2)(c)
- the deemed ownership rule for shares owned by minors: s. a.256(1.3)
- the anti-avoidance rule: s. 256(2.1)
Now we will learn the more complex rules.
2 Types of Income Earned by Canadian controlled private corporations (CCPCs)*
* Note: if a corporation becomes a CCPC or ceases to be a CCPC then:
(a) its taxation year will be deemed to end immediately prior to becoming/ceasing to be a CCPC; and
(b) a new taxation year will begin [subsection 249(3.1) of the Act]
Deemed year-ends and their tax consequences will be discussed in lecture 8
There are three basic types of income earned by CCPCs:
2.1 Canadian Active Business Income (Can ABI): s. 125(7)
See definition of “active business…”
= Division B Net income - foreign ABI - specified investment business income (SIB) - personal services business income (PSB)
- ABI includes an adventure in the nature of trade
See definition of “income…from an active business”
- active business income includes income incidental to the business (s. 125(7)) such as
- interest on accounts receivable
- interest on the short-term investment of working capital
- recapture of CCA previously deducted in computing ABI
- short-term rental of premises usually used in an active business
2.2 Specified investment business (SIB): s. 125(7)
Investment income will be active business income only if
1. The investment business has > 5 full-time employees throughout the year (see definition of SIB: s. 125(7) or
2. The investment income earned relates to: (a) an amount paid or payable by an associated company; and (b) the expense is deductible by the associated company, in any taxation year, from an active business carried on in Canada: see s. 129(6).
SIB income
= investment income which is not active (most investment income is not active)
= Canadian and foreign rents, royalties, interest, dividends and taxable capital gains
There are two types of SIB income
1. tax-free Canadian dividends (s. 112) are subject to a 33 and 1/3% Part IV tax which is potentially refundable as a dividend refund
2. other investment income which is taxed in Ontario at 46.17% (28% plus 6 and 2/3% additional refundable tax (ART) plus 11.5% Ontario tax rate
- 26 2/3% is potentially refundable as a dividend refund- net tax is about 19.5% [i.e., 46.17% - 26.67%]
We will talk more about SIB income next week.
2.3 Personal services business (PSB): s. 125(7)
If it is not deemed to be active (due to one of the three exceptions listed below), the incorporated employment income is a personal services business (PSB)
A PSB exists when:
1) a corporation provides services;
2) the person who provides the services on behalf of the corporation is a specified shareholder; and
3) the person, described in (2), would reasonably be considered to be providing the services of an employee (as opposed to the services of a self-employed independent contractor)
A specified shareholder is someone who, at any time in the year, owns 10% or more of any class of shares of the corporation [s. 248(1)]. For purposes of this definition, shares owned by persons related to the taxpayer are deemed to be owned by the taxpayer.
PSB income is not eligible for:
· the small business deduction;
· dividend refund treatment (i.e., PSB income is not AII, discussed next lecture); and
· for year-ends ending after October 31, 2011, PSB income is not eligible for the general rate reduction. Hence for PSB income tax is paid at the top corporate rate
· Also when computing PSB income the corporation cannot deduct any expense other than:
1. salary paid to the incorporated employee; and
2. section 8 expenses that the incorporated employee could deduct if
he/she was not incorporated
2.4 SIB and PSB Income Deemed to be Active (Exceptions)
- SIB and PSB income is deemed to be active if there are > 5 full-time employees employed in the business throughout the year: s. 125(7) definitions of SIB and PSB
- SIB income (e.g. rent, interest etc.) is deemed to be active if the investment income earned relates to: (a) an amount paid or payable by an associated company; and (b) the expense is deductible by the associated company, in any taxation year, from an active business carried on in Canada. S. 129(6) and Exhibit 12-12 of FIT
- PSB income is deemed to be active if it’s earned from services provided to an associated corporation: s. 125(7) definition of PSB
2.5 Test Yourself on ABI vs. SIB vs. PSB:
1. Peter owns 100% of P Ltd. and P Ltd. owns 100% of the common shares of S Ltd. P Ltd. has one full-time employee (Peter). Prior to the incorporation of P Ltd., Peter was an employee of S Ltd. S Ltd. earned $200,000 active business income in Canada in 2014 (after deducting all expenses) and is using $200,000 of its business limit to claim the small business deduction on this entire amount. P Ltd. earned $130,000 in 2014: $50,000 by renting a building to S Ltd. for use in its active business and $80,000 in respect of management fees charged for services that Peter performs for S Ltd.
Which of the following statements is true?
(a) P Ltd. earned $50,000 of specified investment business income and $80,000 of personal services business income.
(b) P Ltd. earned $50,000 of active business income and $80,000 of personal services business income.
(c) P Ltd. earned $130,000 of specified investment business income.
(d) P Ltd. earned $130,000 of active business income.
The correct answer is (d).
[Note: rental income is usually property income (but it meets the exception). Can you explain why it meets the exception? Management fee income initially appears to be personal services business (PSB) income (but it meets the exception). Can you determine why it appears to be PSB income? Can you explain why it meets the exception?]
2. A Ltd. manufactures machine parts in Canada and also owns 60% of B Ltd. Mr. A owns all of the A Ltd. shares and is a resident of Canada. B Ltd. earns interest and rental income and has no employees. A Ltd. pays rent to B Ltd. for the warehouse it uses in its manufacturing business. How should B Ltd. report the rental income it received from A Ltd.?
(a) income from property
(b) active business income
(c) specified investment business income
(d) personal services business income
The correct answer is (b)
3 Associated Corporations
3.1 Why is it important to determine whether corporations are associated? - it is relevant only for CCPCs
1. Associated CCPCs must share the $500,000 annual business limit for the SBD
- the associated corporation rules prevent you from incorporating several corporations and multiplying your access to the small business deduction (SBD)
2. the 35% Scientific Research and Experimental Development (SRED) Investment Tax Credit (ITC) is available only for the first $3 million of expenditures of an associated group of CCPCs
3. The $500,000 SBD limit is reduced if the corporation is “large”. The formula takes into consideration the size of an entire associated group of CCPCs.
4. SIB income is deemed to be active if the income relates to: (a) an amount paid or payable by an associated company; and (b) the expense is deductible by the associated company, in any taxation year, from an active business carried on in Canada (as discussed above)
5. PSB income is deemed to be active if it is earned from services provided to an associated corporation (as discussed above)
3.2 Why is it important to determine whether individuals and/or corporations are related?
1. It is relevant for several of the association rules
2. It is relevant for rules you have taken in ADMS 3520 and ADMS 4561 for non-arm’s length transfers (because related persons are deemed not to deal at arm’s length)
3. It is relevant for rules we will take later in this course (e.g., affiliated person rules in the lectures on s. 85(1) and s. 84.1)
3.3 Basic Association Rules
Besides the association rules you learned in ADMS 3520, that is two corporations are associated if any one of (1), (2), or (3) applies:
1. One corporation controls the other s. 256(1)(a);
2. Two companies are each controlled by the same person or group of persons s. 256(1)(b);
3. One person controls one corporation and another person controls a second corporation; the two persons are related; and one person owns 25% or more of each corporation (i.e., cross ownership) s. 256(1)(c)
4. Shares owned by a minor child are deemed to be owned by the parents: s. 256(1.3). Note: that each parent is deemed to own all of the shares of the minor child for purposes of the association rules (hence there can be double-counting)
5. Anti-avoidance rule: Two companies are deemed to be associated if one of the main reasons for their separate existence was to reduce tax (e.g., by accessing another small business deduction): s. 256(2.1)
There are several more complex rules. Corporations are also associated if any one of the following applies:
256(1)(d) One corporation is controlled by a person and the other corporation is controlled by a group of persons; the one person is related to each person in the group that controls the other corporation; and that one person owns 25% or more of the other corporation
256(1)(e) Both corporations are controlled by related groups of people; each person in one group is related to each person in other group; and one or more persons who are members of both groups (i.e., people who own shares in both corporations) either alone or together own 25% or more of both corporations
3.4 Other association rules
Note: these other association rules only apply for purposes of determining if two (or more) corporations are associated. As you will see there are lots of rules that make it easier for corporations to be associated. If associated, corporations must share various things like the $500,000 annual business limit.
256(1.1) Shares of a specified class. These shares don't count for purposes of the “25% cross-ownership” tests/conditions found in 256(1)(c) to (e). Defined as non-convertible, non-voting, fixed dividend ($ or %) with a dividend rate not greater than the prescribed rate at the time of issue, and redemption amount not > issue price (plus any unpaid dividends)
256(1.2)(b) A corporation can be considered to be controlled at the same time by several persons or groups of persons (a group = 2 or more persons, each of whom owns shares of the same corp.)
256(1.2)(c) You are deemed to have control if you own > 50% of the FMV of all shares (or all common shares) of the corporation
256(1.2)(d)-(f) Look-through rules for shares owned through holding corporations, partnerships or trusts:
- For corporate owned shares you multiply through the ownership percentages…e.g., If Mr. X owns 50% of P Ltd. which owns 50% of S Ltd., he is deemed to own 25% (i.e., 50% x 50%) of the shares of S. Ltd. for purposes of the association rules (e.g., the cross ownership test).
For shares owned by trusts, the beneficiary is deemed to own shares owned by the trust. If the trust is discretionary (i.e., the trustee determines the amount, if any, of the trust’s income or capital that a beneficiary is entitled to) then each beneficiary is deemed to own all of the shares owned by the trust (for purposes of the association rules). If the trust is not discretionary (i.e., the beneficiaries are entitled to a certain amount of the trust’s income and/or capital based on the trust deed) then each beneficiary is deemed to own the shares owned by the trust based on the FMV of their respective beneficial interest of the trust (for purposes of the association rules).