Characterizing the different types of income that your business earns will have an impact on the rate of tax applied to the income earned. For instance, Canadian controlled private corporations (CCPCs) are granted a tax reduction on active business income, known as the small business dedution. Federally, in 2017, the first $500,000 of a CCPCs ABI is taxed at 10.5%, whereas a rate of 15% is applied to non-CCPCs. The 2017 combined Federal and Provincial tax rate in Ontario on a CCPCs first $500,000 of ABI is 15%. However, the combined rate in Ontario on any investment income is 50.2%. Investment income is earned on passive investments made by the corporation. Thus, there is a significant tax savings if income is characterized as ABI instead of investment income. Note that the current Liberal government announced on July 18th, 2017 that it is considering changes to the taxation of investment investment earned in a CCPC.
What is ABI?
The definition of ABI is defined by what it is not: any business that is neither a personal services business nor a specified investment business. Generally speaking, a personal services business is a business that a corporation carries on to provide services to another entity (such as a person or partnership) that an officer or employee of that entity would usually perform and a specified investment business is a corporation whose principal purpose is to derive income (interest, rent, dividends, and royalties) from property, unless the business employs more than 5 full time employees.
Consider Anthony who owns a CCPC that operates a grocery store. Any business income derived from the operation of the grocery store is considered ABI. However, if Anthony decided to invest the corporation’s retained earnings in a term deposit, any income generated by this investment would be passive income and subject to a higher level of taxation. Any residual income that a corporation earns outside of its normal course of business is considered passive income.
Tax deferral advantage
A significant advantage of operating a business through a CCPC is that the low ABI tax rate gives business owners such as Anthony the ability to defer personal taxation. In the example provided above, if Anthony does not need to withdraw all the income that the grocery store earns for his personal use, he can defer personal taxation on the income by leaving it in the corporation until a time when it is subsequently required. The period of time in which Anthony leaves the funds in the corporation is the tax deferral. The benefit of the tax deferral to Anthony will depend on the rate of return the corporation realizes on the funds.
Assuming Anthony’s grocery store is located in Toronto:
Small business tax rate on first $500,000 of income (A) = 15%
Maximum tax rate on personal income (B) = 53.53%
Tax deferral available (B-A) = 38.53%
Assume that Anthony’s grocery store generates an ABI of $$500,000. Anthony requires $200,000 of pre-tax income to fund his personal lifestyle. In this example, Anthony can leave the $300,000 (that he does not require personally to live his lifestyle) in the company and take advantage of deferring $115,590 ($300,000 x 38.53%) in taxes. These funds can then be used for investments which could yield further residual income, or invested back into the business to facilitate business growth and development.