Archived - Tax Expenditures and Evaluations 2013
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Taxation of Small Businesses in Canada
Small businesses play an important role in the Canadian economy, contributing to employment, investment and innovation. The tax system provides a number of preferential measures to help small businesses retain more of their earnings for investment, expansion and job creation.
This paper presents information on the taxation of small businesses in Canada. The first section of the paper provides a description of specific tax measures targeted at small businesses in Canada, while the second section presents a statistical profile of small businesses and of their importance in the Canadian economy using corporate income tax data.
Tax Preferences Available to Small Businesses in Canada
What Is a “Small Business”?
A small business can be conducted either directly by one or more individuals, or indirectly through one or more separate legal entities set up by individuals. In Canada, a corporation is the most frequently used legal vehicle in the latter situation, although a business can also be conducted through a trust or a partnership.
There is no agreed-upon threshold at which a business is considered “small” from an economic standpoint. Depending on their focus or interest, analysts, researchers and statisticians have been using different thresholds based on variables such as assets, capital, revenue or number of employees.
Canadian tax laws also do not provide a single definition of “small business” for tax purposes, but a number of tax preferences are targeted at “small” incorporated businesses. Access to these tax preferences is generally conditional on a measure of size. Many of the tax preferences available to “small” businesses are restricted to corporations that are Canadian-controlled private corporations (CCPCs), that is, corporations resident in Canada that are not public or controlled by public corporations or non-residents.
The next two sections present key tax preferences that are available to small incorporated businesses in Canada.
Lower Tax Rate Applicable to Small Businesses
A preferential federal tax rate applies on the first $500,000 of income earned by a small CCPC from an active business carried on in Canada. This preferential tax rate is intended to increase the amount of after-tax income that may be retained for reinvestment in the active business. The mechanism for reducing the federal corporate income tax rate from the 15% general corporate income tax rate (applicable since January 1, 2012) to the 11% small business tax rate (applicable since January 1, 2008) is known as the “small business deduction”. In order to target the small business deduction to small businesses, the $500,000 income limit (known as the “business limit”) begins to be reduced when a CCPC’s taxable capital reaches $10 million, and is eliminated when taxable capital reaches $15 million.1 Income other than active business income, such as income from passive investments or income of certain incorporated individuals that is similar to employment income, is not eligible for the small business tax rate.
All provinces and territories2 provide for lower tax rates for small CCPCs. Generally, provincial small business tax rates apply to the first $500,000 of a CCPC’s income derived from an active business carried on in Canada (except in Nova Scotia and Manitoba, where the business limit is $350,000 and $425,000 respectively as of 2014), and this business limit is gradually reduced to nil for CCPCs with taxable capital between $10 million and $15 million (except in Ontario, where CCPCs—regardless of their size—are provided with a preferential tax rate on their first $500,000 of taxable income).3
Chart 1 shows the federal tax rate applicable to small CCPCs from 2000 to 2014, along with the weighted average provincial rate and changes in the federal business limit over the period.
Tax rates applicable to small CCPCs have declined since 2000. The federal tax rate was effectively reduced to 11% from 13.12% on January 1, 2008 as a result of a 1-percentage-point reduction in the federal small business tax rate (from 12% to 11%) and of the elimination of the 4% federal corporate surtax in that same year (which effectively reduced the corporate income tax rate by 1.12 percentage point). At the provincial level, the weighted average provincial tax rate decreased from 6.9% in 2000 to slightly less than 4.3% in 2014. The federal business limit on the amount of income eligible for the small business tax rate increased over this period, from $200,000 in 2000 to $500,000 by 2009. The business limits applicable in most provinces were typically increased in a comparable manner. As a result of these changes, a small CCPC with $500,000 in taxable income has seen the amount of federal tax it pays cut by more than one-half since 2000, from $113,600 to $55,000, while the amount of provincial income tax it pays has been reduced by about three-fifths, from $53,750 to $21,300.4
Chart 2 shows the spread that exists in 2014 between the general statutory corporate income tax rate and the small business tax rate for each province. Provincial spreads range from a low of 3.9 percentage points in Quebec to a high of 13 percentage points in Nova Scotia.
Other key tax changes have reduced the tax burden of corporations in Canada. Important reductions in general statutory corporate income tax rates—which apply generally to all corporations in Canada, and to a small CCPC’s taxable income in excess of the small business limit—were implemented by both the federal and provincial governments. In addition, the federal capital tax was eliminated for medium-size corporations (i.e., corporations with taxable capital between $10 million and $50 million) as of 2004 and phased out for all other corporations by 2006,5 and all provincial general capital taxes were eliminated by July 1, 2012.
Chart 3 shows the combined federal-provincial tax rate that a small CCPC would be facing in 2000 and 2014 on each additional dollar of income earned as its stock of taxable capital grows (i.e., its “marginal” statutory tax rate). As shown in the chart, a CCPC’s marginal statutory tax rate follows a general pattern consisting of four different phases:
- First, at low levels of taxable capital, all of the active business income of a small CCPC is assumed to be within the small business limit, and therefore eligible for the weighted average combined federal-provincial small business tax rate (20% on up to $200,000 of taxable income in 2000, and 15% on up to $500,000 of taxable income in 2014).
- A CCPC may generate taxable income in excess of its small business limit, while keeping its taxable capital below $10 million (i.e., the threshold at which the small business limit starts to be reduced). At that point, the CCPC will begin paying tax on its marginal income at the combined federal-provincial general corporate income tax rate (43% in 2000 and 26% in 2014), while still being eligible for the small business tax rate on taxable income below the small business limit. In the cases illustrated in Chart 3, this point is reached by the CCPC at $2 million in taxable capital in 2000 and $5 million in taxable capital in 2014 (reflecting an assumed 10% pre-tax rate of return on capital).6
- A CCPC with taxable capital between $10 million and $15 million faces a higher marginal statutory tax rate (51% in 2000 and 35% in 2014) due to the gradual reduction in the amount of income eligible for the small business tax rate as taxable capital rises above $10 million, which increases taxes payable on the first $200,000 of taxable income earned in 2000 and the first $500,000 in 2014.
- Finally, once a CCPC’s taxable capital exceeds $15 million, the marginal statutory tax rate returns to the level of the combined federal-provincial general corporate income tax rate (43% in 2000 and 26% in 2014).
Comparing how this pattern changed between 2000 and 2014, three key observations can be made:
- The combined federal-provincial small business tax rate applicable during the first phase has been significantly reduced between 2000 and 2014 (from 20% to 15%), and is now available to much larger CCPCs as a result of the cumulative increases in the business limit (from $200,000 to $500,000 for the federal business limit).
- The marginal statutory tax rates that a CCPC would face as it grows past this first phase have also been significantly reduced over the 2000 to 2014 period, reflecting the reductions in general statutory corporate income tax rates that were implemented at both the federal and provincial levels.
- CCPCs of all sizes now face marginal tax rates that are much lower than the top federal-provincial statutory personal income tax rate, which is 47% for 2014 (down from 49% in 2000). This provides an incentive for CCPCs to reinvest their earnings and grow their business rather than distribute their earnings as dividends or wages.
Table 1 shows estimated and projected tax expenditures associated with the federal and provincial small business tax rates. The projected tax expenditure for 2013 for the federal small business tax rate is $2.9 billion.
|Newfoundland and Labrador||26||27||32||42||64||63|
|Notes: Tax expenditure estimates for different jurisdictions are not strictly comparable as they may have been derived using different methodologies or different periods (e.g., calendar year versus fiscal year). Tax expenditure estimates are not available for Prince Edward Island, New Brunswick, British Columbia and the territories. Based on information available as of January 1, 2014.
Sources: Department of Finance Canada; various provincial publications.
Other Tax Preferences Available to Small Businesses
Table 2 lists other key tax preferences available to small incorporated businesses in Canada that are of particular significance in terms of policy or fiscal impacts, and provides the associated federal tax expenditures. A brief overview of each of these measures is also provided.7
|Federal Tax Expenditures|
|Lifetime capital gains exemption|
|Small business shares||620||475||540||590||610||620|
|Farm and fishing property||385||320||325||385||460||470|
|Enhanced Scientific Research and Experimental
Development Investment Tax Credit for small CCPCs
|Rollovers of investments in small businesses||10||5||3||4||4||4|
|Deduction of allowable business investment losses|
|Deferral through 10-year capital gain reserve||<2.5||<2.5||<2.5||<2.5||<2.5||<2.5|
|Note: As of 2012, the enhanced Scientific Research and Experimental Development Investment Tax Credit for small CCPCs is classified as a transfer payment under the new accounting standard regarding tax revenues issued by the Public Sector Accounting Board, and is no longer considered a tax expenditure.
Source: Department of Finance Canada.
Lifetime Capital Gains Exemption
Individuals who sell shares of a CCPC can claim an exemption on up to $800,000 of capital gains realized on the disposition of qualified property. The shares of small CCPCs are eligible provided that more than 50% of the fair market value of the assets of the CCPC was used mainly in an active business carried on in Canada (certain other conditions must also be met).8
Budget 2007 increased the lifetime exemption limit from $500,000 to $750,000 effective March 19, 2007. The limit was further increased to $800,000 in Budget 2013 (effective January 1, 2014), and will be indexed for inflation thereafter.
Enhanced Scientific Research and Experimental Development (SR&ED) Investment Tax Credit for Small CCPCs
Eligible CCPCs can claim an investment tax credit in respect of eligible SR&ED expenditures at the enhanced rate of 35% on up to $3 million of eligible expenditures annually. Also, unused investment tax credits in respect of the first $3 million of eligible expenditures each year are fully refundable to eligible CCPCs, while 40% of unused credits in respect of eligible expenditures in excess of $3 million are refundable.
The $3 million expenditure limit is phased out for CCPCs whose taxable income for the previous taxation year is between $500,000 and $800,000 or whose taxable capital employed in Canada for the previous taxation year is between $10 million and $50 million (up from $15 million before February 26, 2008). CCPCs that are above these thresholds as well as non-CCPCs can claim the SR&ED Investment Tax Credit at the rate of 15% (20% before 2014) and are not eligible for a refund of unused credits.
Rollovers of Investments in Small Businesses
Individuals can defer the tax on a capital gain arising from the disposition of shares in a qualified small business if the proceeds are reinvested in shares of another qualified small business within a specified period.9 Shares in a qualified small business consist of newly issued shares in an active CCPC with assets not exceeding $50 million.
Deduction of Allowable Business Investment Losses
Capital losses arising from the disposition of shares and debt instruments are generally deductible only against capital gains. However, a portion of capital losses in respect of shares or debts of a small business corporation, known as “allowable business investment losses”, may be used to offset other income. Unused allowable business investment losses may be carried back 3 years and forward 10 years, and after 10 years revert to ordinary capital losses (which may be carried forward indefinitely).
Deferral Through 10-Year Capital Gain Reserve
If proceeds from the sale of small business shares to children, grandchildren or great-grandchildren are not all receivable in the year of sale, recognition of a portion of the capital gain realized may be deferred until the year in which the proceeds become receivable. However, a minimum of 10% of the gain must be brought into income each year, creating a maximum 10-year reserve period. This contrasts with the treatment of most other property, where the maximum reserve period is 5 years. A similar measure exists for dispositions of farm or fishing property to a child, grandchild or great-grandchild.
Statistical Profile of Small Businesses in Canada
Statistical information on small businesses is available from a number of sources.10 This section adds to this information by providing a high-level statistical profile of small businesses using federal corporate income tax data from 2000 to 2011 (the most recent year for which data is available). The information presented in this section covers small CCPCs that are claiming the small business deduction at the federal level.11
Number of Small CCPCs
Chart 4 shows the number of small CCPCs for 2000 to 2011. Some 622,000 small CCPCs claimed the federal small business deduction in 2011, up from 374,000 in 2000, representing average annual growth of 4.6%. In 2011, more than 97% of CCPCs carrying out an active business (with positive taxable income) claimed the small business deduction at the federal level (or were associated with other corporations that did so).
Distribution of Small CCPCs by Taxable Income and Taxable Capital
Chart 5 plots the number of small CCPCs by level of taxable income for 2000, 2007 and 2011. The vast majority of small CCPCs are concentrated at low levels of taxable income.
An increased concentration of CCPCs is observed in all three years at levels of taxable income at or just below the applicable business limit for these years ($200,000 in 2000, $400,000 in 2007 and $500,000 in 2011).12 This concentration (and its movement over the time series) may reflect that small business owners have some flexibility vis-à-vis the timing and form of distribution of the compensation they receive from their small business. A small business owner has a choice between retaining earnings within the small business, or distributing earnings in the form of salaries or dividends. Salaries are deductible for corporate income tax purposes and subject to personal income tax at the owner’s marginal tax rate. In contrast, dividends are paid out of post-corporate income tax earnings and subject to personal income tax, with a notional dividend tax credit provided at the personal level that is intended to compensate individuals for corporate income taxes that are presumed to have been paid.
Depending on applicable marginal tax rates, a small business owner may realize tax savings in certain circumstances by increasing his or her own salary in order to keep corporate taxable income of the small business under the business limit. As shown in Chart 3, the marginal statutory tax rate in 2000 was 20% on the first $200,000 of taxable income (the business limit applicable in that year) but was 45% on income exceeding that business limit. A small business owner facing a marginal personal income tax rate of less than 45% in 2000 and generating earnings above the business limit could have paid him or herself higher wages: this would have ensured that taxes payable on earnings in excess of the business limit are subject to personal income tax rather than corporate income tax. This strategy was more advantageous in 2000 than it was in 2007 or 2011 as, prior to the changes to the tax treatment of dividends that were announced in Budget 2006, the corporate income taxes that were paid on income not eligible for the small business tax rate were only partly relieved at the personal level once that income was paid out as dividends.13
Chart 6 shows the number of small CCPCs by level of taxable capital for the same years as those shown in Chart 5. Similar to the distribution seen in Chart 5, the vast majority of small CCPCs are concentrated at low levels of taxable capital, with about 97% of small CCPCs claiming the federal small business deduction having less than $3 million in taxable capital (in order to facilitate the presentation, Chart 6 plots only the number of small CCPCs that have between $3 million and $15 million in taxable capital). There is no concentration of CCPCs observed in Chart 6 at the levels of taxable capital at which the small business tax rate is phased out ($10 million) and eliminated ($15 million). This suggests that the concentrations observed in Chart 5 at the levels of taxable income at or just below the business limit are likely the result of tax planning, rather than changes in real economic decisions.14
Table 3 provides a breakdown of the number of small CCPCs by sector for 2000 and 2011. Professional, scientific and technical services and construction are the two sectors that account for the largest proportions of small CCPCs in 2011 (19.3% and 13.3% respectively), while the largest growth over the 2000 to 2011 period was seen in the health care and social assistance and transportation and warehousing sectors. An important shift in the sectoral composition of small CCPCs took place between 2000 and 2011, towards the health care and social assistance, professional, scientific and technical services, construction, and transportation and warehousing sectors, from the manufacturing, wholesale trade, retail trade, and finance and insurance sectors.
|Number of CCPCs||Sectoral Distribution|
|2000||2011||Change||2000||2011||Change in Share|
|Professional, scientific and technical services||60||114||90.0||16.2||19.3||3.1||19.4|
|Health care and social assistance||17||54||214.3||4.6||9.2||4.5||97.5|
|Administrative and support,
waste management and remediation services
|Accommodation and food services||15||21||44.9||4.0||3.6||-0.4||-9.0|
|Other services (except public administration)||17||28||63.9||4.5||4.7||0.1||3.0|
|Agriculture, forestry, fishing and hunting||23||31||34.8||6.2||5.2||-0.9||-15.3|
|Real estate and rental and leasing||21||32||55.5||5.6||5.5||-0.1||-2.3|
|Finance and insurance||22||25||12.2||6.0||4.2||-1.8||-29.5|
|Transportation and warehousing||18||38||113.7||4.8||6.5||1.6||34.2|
|Management of companies and enterprises||10||13||32.3||2.7||2.3||-0.5||-16.9|
|Note: Excluding CCPCs for which the sector of activity is unknown.
Source: Department of Finance Canada.
Economic Importance of Small CCPCs
Chart 7 provides an indication of the importance of the role played by small CCPCs in the Canadian economy. The chart shows total capital investment and wages and salaries reported by small CCPCs and other corporations over the 2000 to 2011 period. Capital investment is measured as the total cost of depreciable capital assets acquired in a given year.
Capital investment by small CCPCs reached $23.8 billion in 2011, up from $16.4 billion in 2000, and represents 13% on average of total capital investment. Growth in capital investment by small CCPCs over this period was fairly steady at an annualized rate of 3.4%, with only one year of decline in 2009. Growth in capital investment by corporations other than small CCPCs was more variable, with negative growth observed in 6 years out of 11 between 2000 and 2011. The growth in capital investment by small CCPCs partly reflects the growth in sectors with high concentrations of small CCPCs, such as construction, and agriculture, forestry, fishing and hunting.
Trends in wages and salaries paid by small CCPCs and other corporations were similar between 2000 and 2011, and the share of the total accounted for by small CCPCs remained relatively stable (at 26% on average). Wages and salaries paid by small CCPCs totalled $148 billion in 2011, up from $90 billion in 2000 (an average annualized growth rate of 4.5%), with growth in the professional, scientific and technical services, construction, and health care and social assistance sectors more than offsetting the small decreases in the manufacturing and finance and insurance sectors.
Chart 8 shows the distribution of capital investment made and wages and salaries paid by small CCPCs, by size of CCPCs (in terms of total assets). The largest among small CCPCs, those with assets of $1 million or greater (representing about 20% of the number of small CCPCs), account for more than two-thirds on average of capital investment made by small CCPCs, and an even larger share (85%) of the growth in capital investment by small CCPCs observed between 2000 and 2011. Small CCPCs with assets of $1 million or greater account on average for about 63% of wages and salaries paid by small CCPCs, and for a similar proportion of the growth in wages and salaries paid observed over the period.
Summary of Key Findings
This paper describes key tax measures that provide support to small businesses in Canada. It also reviews developments since 2000 in this regard, notably the significant decrease in the corporate income tax rates applicable to the eligible income of small CCPCs and developments in the eligibility criteria.
- A small CCPC with $500,000 in taxable income now pays less than one-half the corporate income taxes it paid in 2000 at the federal and provincial levels.
- CCPCs of all sizes now face marginal tax rates that are much lower than the top federal-provincial statutory personal income tax rate. This provides an incentive for CCPCs to reinvest their earnings and grow their business rather than distributing their earnings as dividends or wages.
The paper provides information about the distribution of small CCPCs that claimed the federal small business deduction by taxable income and taxable capital:
- Concentrations of CCPCs are observed in all years at levels of taxable income at or just below the limit of taxable income eligible for the small business tax rate in a given year (e.g., $500,000 in 2011), which may reflect flexibility regarding the timing and form of distributions of the compensation received by small business owners.
- No such concentrations of CCPCs are observed at the levels of taxable capital at which the small business tax rate is phased out ($10 million) and eliminated ($15 million).
Other key statistical findings with respect to small CCPCs in Canada that claimed the federal small business deduction are as follows:
- Some 622,000 small CCPCs claimed the federal small business deduction in 2011, up from 374,000 in 2000, representing average annual growth of 4.6%. In 2011, more than 97% of CCPCs carrying out an active business that had positive taxable income claimed the small business deduction at the federal level (or were associated with other corporations that did so).
- An important shift in the sectoral composition of small CCPCs took place between 2000 and 2011, with more small CCPCs now being found in the health care and social assistance, professional, scientific and technical services, transportation and warehousing, and construction sectors.
The vast majority of small CCPCs are concentrated at the low end of taxable income and taxable capital categories, yet small CCPCs account for 13% on average of total capital investment and 26% of total wages and salaries reported by corporations in Canada. The largest among small CCPCs account for a significant proportion of these investments.
1 For this purpose, a CCPC’s taxable capital is equal to its taxable capital employed in Canada, and generally includes the sum of shareholders’ equity in the CCPC, retained earnings, and most of the CCPC’s debt liabilities, less certain types of investments in other corporations. Where a CCPC is part of a group of associated corporations, the business limit and taxable capital thresholds apply for the group as a whole.
2 From this point forward, references to “provinces” also include the territories.
3 Prior to July 1, 2010, Ontario levied a 4.25% surtax on CCPCs with taxable income in excess of $500,000 (applicable to firms other than those in the manufacturing sector), the effect of which was to gradually phase out the Ontario small business tax rate and eliminate it entirely for CCPCs with taxable income of $1.5 million or greater.
4 Provincial tax savings are estimated based on the weighted average provincial small business tax rate and the federal business limit.
5 The federal capital tax did not apply to corporations with less than $10 million in taxable capital.
6 The slightly higher marginal rate in 2000 for CCPCs with taxable capital between $2 million and $5 million (when compared to CCPCs with taxable capital between $5 million and $10 million in 2000) is due to the Ontario surtax that was in place prior to July 1, 2010 (see footnote 3 for details).
7 Additional information on these measures can be found in the 2010 edition of Tax Expenditures: Notes to the Estimates/Projections, as well as in the “What’s New” sections of the post-2010 editions of this report.
8 The shares of a CCPC that are qualified property are referred to as shares of a “small business corporation” in the Income Tax Act, even though no particular size limitation applies for this purpose. Qualified property also includes qualified farm and qualified fishing property.
9 A qualified small business generally includes an active CCPC.
11 Data on unincorporated small businesses, large CCPCs (i.e., those with taxable capital in excess of $15 million), and incorporated small businesses that are not CCPCs, as well as data on small CCPCs that do not claim the small business deduction at the federal level (e.g., because their taxable income is nil or because they do not earn active business income), are not presented. Except for charts 5 and 6, the data is shown on an unconsolidated basis, and thus does not take into account that small CCPCs may operate via groups of commonly controlled corporations.
12 While not illustrated in Chart 5 to simplify the presentation, similar concentrations are observed at or just below the applicable business limit every year throughout the period.
13 This resulted in the combined federal-provincial marginal personal income tax rate applicable to dividends paid out of income not eligible for the small business tax rate being appreciably higher than the rate applicable to wages. For instance, a taxpayer residing in Ontario would have paid tax on such dividends at a rate of 62.3% in 2000 versus 47.9% on wages (excluding the Ontario Employer Health Tax). Budget 2006 enhanced the dividend tax credit for dividends paid after 2005 out of corporate income subject to the general corporate income tax rate, from 13⅓% to 18.9655% (since then reduced to 15.0198%), and correspondingly increased the dividend gross-up rate applicable to these dividends. This and other tax rate changes resulted in the combined tax rate on dividends paid out of income not eligible for the small business tax rate being less than 1 percentage point higher than the combined tax rate on salaries in 2013.
14 Such tax planning appears to have become less frequent in recent years. This may be due to a number of factors: the increase in the business limit, which resulted in more small business owners being eligible for the small business tax rate for all of their business income; the increased incentive to retain earnings that is caused by the increased differential between the general corporate income tax rate and the top personal income tax rate (see year 2014 in Chart 3); and changes to the tax treatment of dividends announced in Budget 2006 (see footnote 13).