Defining Active Business Income
Understanding the rules and the exceptions.
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.
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 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.
Hughes & Co. Holdings Limited employed five full-time employees and several part-time. It successfully argued at the Tax Court of Canada that it met the requirement of more than five full-time employees. However, the Federal Court disagreed and ruled that the expression means “at least six
full-time employees.” Interestingly though, in a subsequent case —
Lerric Investment Corp v. The Queen, 2001 — the Federal Court of Appeal questioned that finding in obiter, stating that five full-time employees plus one part-time could meet the requirement.
The Lerric case also saw another long-standing CRA policy, favourable to taxpayers, bite the dust. The taxpayer was involved in a joint venture and had allocated the full-time employees of the joint venture to itself in proportion to its interest in the joint venture, resulting in it having 5.05
full-time employees. The Court rejected this approach, and Lerric was left with specified investment business income rather than active business income.
The second principal exclusion is for a personal services business, which is known as the “incorporated employee” business. This situation arises when the person who performs services on behalf of the corporation is a specified shareholder (owns
10 per cent or more) and would reasonably be regarded as an employee of the person to whom the services are provided. Again, there is an exception if there are more than five full-time employees in the corporation, but here there’s the added test of who can “reasonably be regarded as an employee.” That was the question in
S & C Ross Enterprises Limited v. The Queen, 2002, in which the taxpayer was an employee (both an officer and a director) of a corporation, and his corporation also had a contract to provide services to that same employer. The services Ross provided through his corporation were distinct from the duties he performed in his capacity as an employee, which were detailed in an employment contract. The Tax Court of Canada held that Ross was not an incorporated employee and that the income of his corporation was not that of a personal services business.
Income Tax Act is an ever-evolving complex instrument of economic and social policy, and like any law, it’s open to interpretation. While the definition of active business income is decidedly more certain today than it was before 1985, it is still evolving and likely will never be decided with
100 per cent certainty.
The information appearing in “Tax Strategy” is provided for the interest of the readers. Neither
CGA Magazine nor the column authors and
co-ordinator assumes any responsibility or liability to any persons relying on the information in the article to perform tax planning and/or compliance of any kind.