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September 2015

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Let’s Abolish the Small Business Deduction (September 20, 2015)

Allan Lanthier, Tax consultant, Montreal[1]

Liberal leader Justin Trudeau recently suggested that, while small business should indeed be paying a lower corporate tax rate, the rules should be “tweaked” to ensure that wealthy Canadians do not use the lower rate simply to reduce their tax bills. The suggestion resulted in predictable howls of outrage from other political parties and business advocacy groups. But Mr. Trudeau’s comments invite debate on a broader issue: is it time to abolish the preferential rate altogether?

The small business deduction (“SBD”) reduces the federal corporate tax rate on the first $500,000 of active business income earned by a Canadian-controlled private corporation (“CCPC”), or by an associated group of CCPCs, each year. The SBD is phased-out and recovered for a CCPC (or for an associated group) having taxable capital between $10 million and $15 million.

This article summarizes the historical development of the SBD, and discusses the integration of corporate and personal income taxes. Then, after briefly commenting on the objective of the SBD and approaches in other countries, the article sets out the author’s conclusions and recommendation: a repeal of the SBD.

Historical Development of the SBD

A dual rate of corporate tax was first introduced in Canada in 1949, with a reduced rate applying to the first $10,000 of annual corporate profits. By 1971, the limit had increased to $35,000. While the reduced rate was introduced to provide small businesses with more after-tax funds for expansion, the rate in fact applied to all corporations, regardless of size, and to all types of income, whether active or passive.

In 1966, the Royal Commission on Taxation (the Carter Commission) recommended abolishing the reduced rate, stating that “We believe that equity, neutrality and respect for the tax laws would be improved by ending this feature of the corporation income tax”. The Carter Commission also proposed that a Canadian-controlled, small business be allowed an immediate write-off for capital expenditures up to a cumulative limit of $250,000. The government’s response to the Carter Report was tabled as a White Paper in 1969, and also proposed a repeal of the reduced rate. However, in the face of heavy criticism from proponents of small business, 1972 tax reform introduced the SBD.

The SBD became effective in 1972, and reduced the general corporate tax rate of 50 percent to 25 percent[2] for a CCPC (or for an associated group of CCPCs) on the first $50,000 of annual active business income (a limit that has since increased to $500,000). Other restrictions applied.

For example, the SBD was only available up to a cumulative lifetime limit of $400,000 (shared between members of an associated group), a limit that was subsequently increased to $1 million, before being repealed in 1984 as part of a simplification package. Also, a refundable tax applied if income that had benefited from the SBD was invested by a CCPC in portfolio investments, rather than being used to expand the business or to pay dividends to shareholders: this tax on “ineligible investments” was repealed retroactively in 1973 due to its perceived complexity.[3]

In 1994, rules were added to phase-out and recover the SBD for CCPCs having taxable capital employed in Canada between $10 million and $15 million.

In 2015, the SBD therefore applies on the first $500,000 of annual business income earned by CCPCs, provided taxable capital does not exceed $10 million. The general federal corporate tax rate is 15 percent,[4] compared with a federal rate of 11 percent[5] if the SBD applies – a four percentage point differential.

Investment income of a CCPC is taxed at the higher federal rate of 28 percent, and is also subject to a refundable tax of 6.67 percent. Investment income of a CCPC therefore bears federal tax at a rate of 34.67 percent (of which 26.67 percent is potentially refundable). Whether a particular source of income is business or investment income is therefore critical to a CCPC: however, the distinction between the two can often be uncertain and tenuous, an issue that is beyond the scope of this article.

The 2015 federal budget proposed a further two percentage point decrease in the small business rate. The decrease would be phased-in over four years from 2016 to 2019 and, effective January 1, 2019, the SBD rate would be 9 percent. The general federal corporate tax rate would remain at 15 percent. We are of course in the midst of a federal election campaign, and other parties – the Liberal Party, the NDP, and the Green Party – have all deemed it appropriate to endorse the 9 percent rate.

Integration of Corporate and Personal Income Taxes

Integration of corporate and personal income taxes means that income is taxed at approximately the same rate, whether the income is earned directly by individuals, or by one or more corporations and then paid as dividends to the individuals (the shareholders).

Integration is achieved by “grossing-up” the taxable amount of a dividend to account for the corporate tax that is assumed to have applied when the income was earned, taxing the grossed-up amount at the individual’s applicable personal tax rate, and then granting the individual a credit (the dividend tax credit, or “DTC”) equal to the assumed amount of underlying corporate tax.

In 1972, business income of a CCPC that qualified for the SBD was fully integrated, as was investment income of a private corporation. Other income was not, and might therefore have borne significantly more overall tax when distributed as a dividend, than would have been the case had the income been earned directly by individuals.[6]

Of course, many Canadian tax rules have changed since 1972, the most significant (as it relates to integration) being the introduction of the “eligible dividend” rules in 2006, in partial response to the proliferation of publicly-traded trusts and partnerships (and to the significant erosion of the corporate tax base that resulted). A second (and enhanced) gross-up and DTC was introduced for eligible dividends, to integrate tax on income earned by public corporations. The enhanced gross-up and DTC for eligible dividends also applies to dividends paid by CCPCs out of business income that exceeds the SBD limits (taxed at the general rate of 15 percent). The separate gross-up and DTC remains in place for dividends (now termed “ineligible dividends”) paid by CCPCs out of business income that has benefitted from the SBD.

Today, integration therefore applies with respect to most corporate income. This comes at a cost. First, taxpayers must now comply with the complex rules related to eligible versus ineligible dividends, and concepts such as GRIP and LRIP. Second, corporations – both large and small – enjoy a significant deferral until such time as dividends are paid, and the legislation does not exact any compensation for these deferrals.[7]

Objective of the SBD, and Approaches in Other Countries

When the SBD was introduced, its stated objective was to encourage the growth of small businesses by helping them accumulate capital for business expansion.[8] This objective has often been repeated. The 2015 federal budget stated that the SBD encourages small business growth, and allows small businesses to retain more earnings that can be used to reinvest and create jobs. However, there is no requirement that tax savings from the SBD be used to expand a business. There is also an absence of studies or economic evidence supporting the efficacy of the SBD, or a conclusion that its cost is warranted.

From time to time, commentators suggest that the SBD addresses other objectives as well, such as reducing entry barriers for small business in capital intensive industries, or compensating for the relative inefficiency of small firms. There is no evidence of any such Parliamentary intent (nor is it clear why tax legislation would be used to support inefficient firms).

Benefits equivalent to the SBD are generally not available in other countries.
For example, the United Kingdom repealed its “small profits rate” effective April 2015, and all UK corporations are now taxable at the general rate of 20 percent.[9] In 2006, the rate differential had been 11 percentage points - a general rate of 30 percent versus a small profits rate of 19 percent. The 2007 UK budget announced a reduction in the general rate and an increase in the small profits rate, to reduce the differential between incorporated and unincorporated businesses, and to discourage individuals from “incorporating as small companies to avoid paying their due share of tax”.

Is It Time To Abolish the SBD?

It is true that many small businesses have only one or two employees (including for example professionals who may incorporate primarily to avoid personal taxes and access the lower corporate rates of 11 and 15 percent), and that an incorporated small business may benefit from income splitting and other tax planning arrangements. However, Industry Canada estimates that 70 percent of Canada’s private labour force is employed by small business, and so surely a few percentage points of tax (and a bit of tax planning) is a small price to pay to encourage job creation and economic growth. Or is it?

Based on Department of Finance estimates, the existing four percentage point differential reduces annual federal tax revenue by more than $3 billion. If the small business rate is further reduced to 9 percent, the annual cost will be more than $5 billion. This is a significant cost that other taxpayers must bear.

The stated objective of the SBD is to encourage business expansion and job creation by small business. However, even though the SBD has been in place, basically in its present form, for more than forty years, and has effectively been endorsed by successive Liberal and Conservative governments during that period, there is little evidence supporting the proposition that the SBD contributes to economic growth or job creation in any significant way.

There is no doubt that great effort is expended by small business. However, the objective of the SBD is not to reward hard work and effort: if it were, there would be no anti-avoidance rules curtailing the incorporation of employment income. The objective of the SBD is to encourage the growth of small business. But close to 700,000 firms claim the SBD every year: those that are seeking to grow a business; those that are not; and professionals who carry on their practices in corporate form.

Small businesses are critical to job creation and economic growth in Canada. But it is precisely because they are so critical that tax incentives in their favour should be as targeted and effective as possible. The SBD is neither, and it is time to stop spending billions of dollars of our federal taxes on a program of such dubious merit. The Canadian economy – and small business itself – would be better served by a repeal of the SBD, replaced by targeted measures such as tax credits or accelerated deductions for business expenditures by small business, by reductions in payroll taxes, and by targeted non-tax measures such as improved access to financing and a more efficient regulatory environment.

Abolishing the SBD would also simplify our tax legislation, by allowing (for example) a repeal of concepts such as eligible and non-eligible dividends, and of GRIP and LRIP. Finally, a repeal of the SBD would promote fairness by reducing, to some extent, the tax differential between incorporated and unincorporated business and professional income.

Concluding Comments

Canada has one of the most favoured tax regimes for small business in the world relative to the general tax system, including (in addition to the SBD) tax preferences such as the lifetime capital gains exemption and the enhanced SR&ED credit. These tax preferences for the benefit of small and medium-sized enterprises, to the exclusion of larger firms, result in distortions and a lack of neutrality in our tax regime. In other words, small and large businesses are not on a level playing field.

The author recognizes that a proposal to repeal the SBD in favour of targeted measures for the sole benefit of small business means that these distortions would remain.[10] And to that extent the proposal in this article is a modest one. However, the proposal does seek to ensure that the billions of dollars now being spent on the SBD are directed instead towards measures that will actually encourage a significant increase in economic activity and job creation in this country.

[1] An earlier (and shorter) version of this article was published in the Globe and Mail on September 15, 2015.

[2] Both the 50 percent and 25 percent rates that applied in 1972 are before the 10 percent provincial abatement (and before a special 7 percent reduction). This article otherwise generally comments on federal corporate tax rates after deducting the 10 percent provincial abatement, and does not account for the manufacturing and processing tax credit, or for the additional provincial or territorial tax and tax rate differentials that will apply.

[3] In his budget speech of February, 1973, the Hon. John N. Turner stated that “I believe that the policy which gave rise to the ineligible investment test was correct, but I have come to the conclusion that it is too complicated. I believe that these small corporations which enjoy the benefit of the lower rate of tax will, in fact, use these tax savings to expand their businesses, to improve their technology and to create more jobs for Canadians.”

[4] Base federal corporate tax rate of 28 percent (after the 10 percent provincial abatement), less general rate reduction of 13 percent for active business income that is not eligible for other incentives (including the SBD and the manufacturing and processing tax credit). The general rate reduction also applies to investment income of non-CCPCs, including public corporations and private corporations that are controlled by non-residents, and to a CCPC’s business income that exceeds the SBD limits.

[5] Base federal corporate tax rate of 28 percent (after the 10 percent provincial abatement), less SBD of 17 percent.

[6] On the other hand, if a CCPC was owned in part by non-residents of Canada, dividends paid to such shareholders would only be subject to withholding tax in Canada (and often at treaty-reduced rates) resulting in reduced amounts of overall Canadian tax: in addition, dividends received by tax-exempt entities do not bear any shareholder-level tax.

[7] However, changes in tax rates are generally accompanied by immediate changes in the gross-up and credit factors as well. Accordingly, if corporate tax rates decrease, and a corporation pays dividends out of after-tax income that bore higher rates of tax in earlier years, there may be a significant integration cost.

[8] The Hon. E.J. Benson; budget speech of June 18, 1971.

[9] Different rates continue to apply to “ring-fence profits” from oil extraction and oil rights in the UK and the UK continental shelf.

[10] For an alternative approach that would repeal the SBD and also achieve neutrality, see Jack Mintz; An Agenda for Corporate Tax Reform in Canada; Canadian Council of Chief Executives; September 2015.

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  • Phil Jolie 10/10/2015 9:13:51 PM

    A brave government would take a deep breath and eliminate the SBD, the capital gains deduction and a few dozen of the new boutique tax credits. While defenders of the two deductions are active in lobby groups and riding associations, the general public would not feel the change nearly as much as they felt GST, particularly if the resulting savings were partly deployed as general tax reductions.
    And if we can find a few billion dollars for the dairy farmers harmed by TPP, there should be some relief available for some suddenly underemployed tax practitioners.

  • Jason Stephan 10/12/2015 7:10:16 PM

    Most Canadians would prefer our government to first confront its waste and inefficiencies and public "service" unions before increasing taxes on the very taxpayers which produce most of the real goods and services and taxes for the Canadian economy. In any event, I like a modest tax deferral to small business - they are better at growing the economy then Government.

  • David Raddatz 10/13/2015 9:31:06 AM +4

    If this is ever to come to fruition, then there must be serious discussion surrounding the pressure on governments to expand CPP or, as in Ontario, create the new Ontario pension plan. The Ontario plan will be a difficult burden for small business that will likely have an impact on employment in Ontario. How much of a tax burden do we expect small business to bear and survive as the engine of growth in the economy?

  • John Heinrichs 11/13/2015 3:01:49 PM

    The SBD should go and the refundable tax should be expanded to all types of corporate income with refunds provided for payment of dividends, purchase of capital assets, R & D and resource expenditures and inventory increases over historic levels.
    Then it should be TOTALLY integrated on the federal side and ALL provinces should be STRONGLY discouraged from taxing corporations at all.