The small business deduction provides substantial federal and provincial tax savings. So there's a big incentive for companies to try to claim it and just as big an incentive for Canada Revenue Agency (CRA) to try to deny it.

The deduction provides for an 10.5% federal tax rate on the first $500,000 of taxable income, but not income from property. However, there are two major exceptions — a specified investment business and a personal services business. Taxpayers can no longer shelter investments in corporations where they are taxed at a lower rate, nor can they shelter employment income by categorizing it as active business income.

Specified Investment Businesses

These enterprises derive income principally from property in the form of interest, dividends, rents and royalties, except those with "more than five full-time employees throughout the year."

The CRA is very strict in its enforcement of the small business deduction. Many court cases involving specified investment businesses have sprung up from audits performed by the CRA. If you are filing to claim the deduction, keep these points in mind to protect your deduction and avoid trouble:

• Principally means 50% or more. A specified investment business must derive 50% or more of its annual income from sources other than active income. You might hear of "purifying" a corporation by shedding sources of property income and leaving only income from active business. This is usually done for other tax reasons involving eligibility for the capital gains exemption for qualifying CCPC shares.
• Temporary income surge. If your company ordinarily has active business income, but derives a large amount of property income in one period, you do not become a specified investment business on that account alone.
• Full-time employees. To claim the small business deduction, specified investment businesses must employ "more than five full-time employees." This has usually been interpreted by the courts (and the tax department) to mean six or more full-time employees. (R. v. Hughes & Co. Holdings Ltd., 94 D.T.C. 6511, FCTD)
• Associated active income. If you derive property income from an associated corporation and that corporation deducted the amounts from active income, then the income is active business income to you. A common example is a holding corporation that rents out a building, or equipment, to an operating subsidiary. The rental income qualifies as active business income.

Interestingly, in a higher-level court case, the judge stated that he was "not convinced" the requirement "could not be met by a single corporation employing five full-time employees and one part-time employee. All that is necessary is that the employer employs more than five full-time employees." (Lerric Investments Corp. v. The Queen, D.T.C. 5169, FCA 2001)

In the Lerric case, the corporation did not have more than five employees for the years in question. It had interests in joint ventures that had additional employees, but the court ruled a corporation can't allocate "fractions" of employees from joint ventures to meet the more-than-five employee test.

Full time employees must be just that — occupied full-time with supervising or managing the corporation's property business.

Personal Services Businesses

At one time, it was an attractive plan for executives to resign from a company and form a corporation that then contracted to supply the executive's services to the old company. The corporation would claim the small business deduction and the executive would end up paying much less tax than when employed directly. The tax department's answer was to implement legislation denying the small business deduction to "personal services businesses".

A personal services business is a corporation in which a "specified shareholder" provides services to another business and is regarded as an employee of that business. A specified shareholder owns not less than 10% of any class of the shares of the corporation. The corporation is denied the small business deduction and all but a few expenses.

Generally, the only expenses that may be deducted by a personal services business are those paid as salary or wages to the specified shareholder and other expenses that would normally be deductible against employment income, such as travel expenses.

As well, personal services businesses are taxed at the 33% corporate rate.

The laws involving the small business deduction are complicated. Consult with your tax advisor.

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