Defining Active Business Income
Canadian-controlled private corporations (CCPCs) enjoy a substantial tax rate preference on their active business income. Federally, the first $400,000 of such income is taxed at 13.12 per cent, whereas a rate of 22.12 per cent is applied to non-CCPCs. The CCPC rate is scheduled to drop even further — to 11 per cent — in 2009, and the general corporate rate is scheduled to fall to 19 per cent in 2010. When you consider a similar rate preference at the provincial/ territorial level (tax rates range from 1.5 per cent to 8 per cent), the added potential for savings makes it important to understand what active business income encompasses.
The Definition
Changes to the Income Tax Act in 1985 sought to clarify that question once and for all, and, to a great extent, were successful. The Act defines an active business by what it is not: any business that is neither a personal services business nor a specified investment business. Despite this approach, confusion and uncertainty still exist.
Active business excludes income from property and capital gains, so items like interest and rent are not active business income. However, there are three exceptions. If what would otherwise be income from property is “incidental or pertains to” an active business, then the income is considered active business income. An example is interest collected on trade accounts receivable. Another exception is made for the income flowing from “property which is used or held principally for the purpose of gaining or producing income from an active business.” The most common example is rent received from a tenant who occupies part of the business premises.
But when does the income become more than incidental and when is the underlying property not used or held principally? The conclusive test was laid down in Ensite Limited v. The Queen, 1986, which became the determining factor in the question “are the funds employed and risked in the business such that the withdrawal of the property would have a decidedly destabilizing effect on the corporation’s operations?”
Assume XYZ Ltd. is a seasonal operation and, as any prudent business would do, it invests its cash in term deposits during the off-season. At the outset of the season this cash is used to acquire inventory and for other things central to business preparedness. The term deposit interest would be active business income, however, as the business grows, the cash becomes larger and eventually not all of it is used for seasonal preparations. Once the cash becomes permanent, its related income becomes non-active business income.
The third exception to what is otherwise income from property is income received from an associated corporation which is claiming the item as an expense against its own active business income. That covers a situation in which the shareholders of OPCO hold the business’ real estate in REALCO. Any rent from OPCO is considered active business income in REALCO.
There are two interesting sidebars here. One is that if the rental is the receiving corporation’s principal business, then any capital cost allowance (CCA) on the building is not limited to the net rental income. Thus, CCA can be used as a tax shelter against other income the corporation earns, such as interest. The second is that where OPCO and REALCO are related (note: all associated corporations are related), any gains realized on the shares of REALCO may be eligible for the capital gains deduction or, on the flip side, a loss on those shares is eligible for treatment as a business investment loss.
The Exclusions
The two principal exclusions from active business income are income arising from either a specified investment business or from a personal services business.
A specified investment business is one in which the main purpose is to derive income from property, including interest, rents, dividends, and royalties, but excluding the leasing of non-real property. There is an exception though, and that’s where the business employs more than five full-time employees throughout the year. |
