Passive income limit

How the reduction works

The small business deduction applies to active business income up to the business limit, which is $500,000 for most corporations. The CRA reduces that limit when the adjusted aggregate investment income of the corporation, and of any corporations associated with it, is between $50,000 and $150,000. The reduction is $5 for each $1 of income above $50,000, so the limit disappears completely at $150,000.

The income that is measured comes from tax years that ended in the preceding calendar year. A corporation with a December year-end looks at the prior year’s investment income to set this year’s limit. The business limit is also prorated if the tax year has fewer than 51 weeks.

An illustrative example

Take a corporation not associated with any other. Its adjusted aggregate investment income for last year was $90,000. That is $40,000 above the threshold, and five times $40,000 is $200,000. The business limit for the current year falls from $500,000 to $300,000. Active business income above $300,000 is taxed at the higher general rates instead of the reduced small business rate.

Now suppose the same corporation is associated with a second company that earned $55,000 of such income. The group total is $145,000, which is $95,000 above the threshold, and the reduction is $475,000. Only $25,000 of limit remains. This illustration uses round numbers and ignores the other rules that can also cut the limit.

Where people get caught

The test applies to the group, not to each corporation on its own, so a holding company or a family company with large investments can reduce the limit of an operating company. The limit is also reduced by the larger of this reduction and the taxable capital reduction, which applies when combined taxable capital is between $10 million and $15 million. The two reductions are not added together.

Because the measure looks back a year, investment income earned now can affect a later year’s rate on business profit. That timing is easy to overlook when a large gain is realized or a rental property is sold.

What to discuss with your accountant

Ask for a projection of the corporation’s investment income for the current year and an estimate of the effect on next year’s business limit. Bring a list of every corporation you or your family control, last year’s Schedule 7 and records of realized gains. Also ask whether the way surplus cash is held, and the income it earns, still suits the plan for the business.