Jun 20, 2022
Meta tiLearn how incorporating a trading business as a CCPC can provide tax benefits through the Small Business Deduction, tax deferral and section 85 rollovers.tle (54 characters): CCPC Small Business Deduction & Section 85 Rollovers
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Overview
Many Canadian business owners who operate as a sole proprietor eventually ask the same question: does incorporating actually save tax, and if so, how much. The answer usually turns on two mechanisms available only to a Canadian-controlled private corporation, commonly called a CCPC: the small business deduction, and the ability to defer personal tax by leaving profit inside the corporation rather than paying it out as a dividend. A third question follows close behind for anyone with an established sole proprietorship: how do you move the business’s existing assets into the new corporation without triggering an immediate tax bill on their accrued gain. Section 85 of the Income Tax Act answers that question.
This article explains how the small business deduction works, what qualifies a corporation as a CCPC, and how a section 85 rollover lets you transfer business assets into a corporation on a tax-deferred basis. The mechanics described here apply to any active business income, whether the business trades securities, cryptocurrency, inventory, or professional services.
A corporation actively trading cryptocurrency as its business faces some additional, asset-specific issues, which we address directly in our companion article, Tax Benefits of Trading Cryptocurrency as a Business for Canadian-Controlled Private Corporations (CCPCs).
Background
A corporation is a separate legal person from its shareholder, and Canada’s corporate income tax regime taxes it accordingly. When a business incorporates, two layers of taxation come into play: the tax the corporation itself pays on the income it earns, and the personal tax the shareholder eventually pays when that income reaches them as a corporate dividend. Parliament has structured the two layers so that, in principle, the combined tax roughly matches what an individual would have paid earning the same income directly, a concept usually called integration. In practice, timing gives incorporation its main advantage: a shareholder controls when a dividend is paid, and therefore controls when the second layer of tax is triggered.
Layered onto that basic structure is the small business deduction. The regular federal corporate tax rate is set out in subsection 123(1) of the Income Tax Act, with a 10 percent abatement under subsection 124(1) for income earned in a Canadian province and a further general tax reduction of 13 percent, leaving a net federal rate of 15 percent on ordinary active business income. Subsection 125(1) provides a lower rate on a CCPC’s first $500,000 of active business income each year, commonly called the business limit. The combined federal and Ontario small business deduction rate is currently 12.2 percent, compared with a combined general corporate rate of 26.5 percent on income above the business limit.
The label “small business deduction” is misleading in two ways. It is not, strictly, a deduction; a deduction reduces income, while a credit reduces tax payable, and the SBD operates as the latter. And a corporation does not need to be small in any ordinary sense to claim it. A corporation retains the full SBD until its taxable capital employed in Canada reaches $10 million, after which the deduction is reduced on a straight-line basis until it disappears entirely at $15 million of taxable capital.
Key Issues and Findings: What Qualifies as a Canadian-Controlled Private Corporation
To access the small business deduction, a corporation must be a Canadian-controlled private corporation earning active business income. Subsection 125(7) sets out the definition, which comes down to three requirements: the corporation must be a private corporation, meaning its shares are not listed on a designated stock exchange; it must be a Canadian corporation, both incorporated and resident in Canada; and it cannot be controlled by a non-resident person, a public corporation, or some combination of the two.
The name is a common source of confusion, because a Canadian-controlled private corporation does not actually need to be controlled by Canadian residents; it only needs to avoid being controlled by non-residents or public corporations. A corporation half-owned by a Canadian resident individual and half-owned by a public corporation, for example, can still qualify, since neither non-residents nor a combination of non-residents and public corporations controls it.
The Income Tax Act also contains detailed associated-corporation rules, since two or more associated CCPCs must share a single $500,000 business limit rather than each claiming it in full. These rules can apply even where the corporations have no obvious common ownership on paper, and Canadian courts have decided a substantial number of cases interpreting how the associated-corporation tests apply to particular ownership structures. A business owner who operates more than one corporation, or who is considering incorporating a second one, should have a Canadian tax lawyer confirm the associated-corporation analysis before assuming the full business limit is available.
The Tax-Deferral Advantage in Numbers
Consider a Canadian business owner who earns $600,000 in active business income in a year, first as a sole proprietor and then through a CCPC, to see how the deferral works in practice.
As a sole proprietor, at a combined federal and Ontario top marginal personal tax rate of approximately 53.5 percent: net income of $600,000 less personal tax of approximately $321,000 leaves $279,000 in after-tax cash.
Through a CCPC: net income of $600,000, with SBD tax at 12.2 percent on the full $500,000 business limit ($61,000), plus general corporate tax at 26.5 percent on the remaining $100,000 ($26,500), for total corporate tax of $87,500, leaving $512,500 in retained earnings.
The corporation retains $512,500 after tax, compared with $279,000 retained by the sole proprietor on the same income, a difference of $233,500. That difference is not a permanent saving; it is a deferral. The shareholder still faces personal tax, offset by the dividend tax credit, whenever the corporation eventually pays the retained earnings out as a dividend. What incorporation buys is control over timing: capital stays inside the corporation, available for reinvestment, until the shareholder chooses to trigger the second layer of tax.
Practical Implications: Transferring Existing Assets Into the Corporation Under Section 85
Incorporating an established sole proprietorship raises a separate problem. Canada’s Income Tax Act generally deems a non-arm’s-length transfer of property to occur at fair market value, so transferring appreciated business assets into a new corporation would ordinarily trigger an immediate taxable capital gain or business profit on the accrued increase in value. Section 85 of the Income Tax Act overrides that general rule for a transfer to a taxable Canadian corporation.
Under a section 85 rollover, the transferor and the corporation jointly elect an amount other than fair market value for each transferred asset. Within statutory limits, that elected amount becomes both the transferor’s deemed proceeds of disposition and the corporation’s tax cost for the asset. Electing an amount equal to the transferor’s existing tax cost allows the transfer to proceed with no immediate tax payable, deferring the gain until the corporation, or a later owner, ultimately disposes of the asset. See our companion guide on section 85 rollovers for a fuller treatment of the election mechanics.
The rules carry real traps for an unrepresented taxpayer. The value of the shares and other consideration the corporation issues must match the fair market value of the property received. Under subsection 15(1), if the corporation gives consideration worth more than the property transferred, the shareholder must include the excess as a taxable benefit. Under the indirect-benefit rule in paragraph 85(1)(e.2), if the property transferred is worth more than the consideration received, and that excess confers a benefit on a related person who also holds shares in the corporation, the transferor realizes a taxable gain on the shortfall, without a corresponding increase to the adjusted cost base of the shares received, making it a genuinely one-sided penalty.
Section 85 is also unavailable for a transfer to an offshore corporation. The rollover applies only to a transfer to a taxable Canadian corporation, meaning one incorporated under the Canada Business Corporations Act or the corporate statute of a Canadian province or territory. Moving business assets to a non-resident corporation is deemed a disposition at fair market value, with ordinary Canadian tax consequences on any resulting gain.
Where the asset being transferred has features that complicate valuation or characterization, such as cryptocurrency, the general section 85 principles above still apply, but additional issues arise around exactly how and when the asset is valued and how ownership is documented.
Our companion article, Tax Benefits of Trading Cryptocurrency as a Business for Canadian-Controlled Private Corporations (CCPCs), covers the crypto-specific mechanics, including valuation timing, wallet custody documentation, and adjusted cost base tracking, in detail.
Takeaway: Strategic Lessons for Business Owners Considering Incorporation
Whether incorporation makes sense turns on more than the small business deduction rate alone. A business owner should weigh how long profit is likely to stay inside the corporation before being distributed, since the tax-deferral advantage grows with time and shrinks quickly if the funds are needed personally in the near term. A business owner transferring an existing sole proprietorship into a new corporation should also plan the section 85 election carefully, since a mismatched valuation or a late T2057 filing can turn a straightforward incorporation into a costly dispute with the CRA.
“Incorporating an existing business is not simply a paperwork exercise. A shareholder who transfers assets into a corporation without a properly documented section 85 election, and without matching the fair market value of what goes in against what comes out, can turn a tax-deferred rollover into an unplanned tax bill.”
— David J. Rotfleisch, Certified Specialist in Taxation Law (Law Society of Ontario)
Pro Tax Tips: Form T2057, Price-Adjustment Clauses, TOSI, and Updating Your Will
Section 85 requires the transferor and the corporation to jointly file Form T2057 with whichever of their tax returns is due first. The election can still be filed up to three years after that due date, but a late-filing penalty applies, equal to the lesser of $100 for each month or part month the election is late, to a maximum of $8,000, and 25 percent of the amount by which the transferred property’s value exceeded the elected amount, multiplied by the number of months or part months late. In practice, the $8,000 cap is reached once the election is more than six months late. Beyond three years late, CRA additionally requires a written explanation for the delay and will only accept the filing if it considers doing so just and equitable.
A properly drafted price-adjustment clause in the section 85 asset-transfer agreement can protect against an inadvertent valuation mismatch, though CRA will only respect such a clause where the parties genuinely intended to transfer the property at fair market value and meet several other conditions. An experienced tax lawyer should draft the transfer agreement with this in mind from the outset, rather than trying to fix a valuation problem after CRA has already reassessed.
Incorporating also raises income-splitting questions. Section 120.4’s tax on split income, or TOSI, applies top-rate tax to a broad category of dividends and other amounts paid to adult family members from a private corporation, subject to a set of exceptions that turn on the recipient’s age and their involvement in the business. The exceptions are notoriously technical, and a business owner considering paying dividends to a spouse or adult children should have a Canadian tax lawyer confirm the arrangement falls within one of them before the dividend is paid, not after.
Finally, incorporating changes what you own personally. Once your business’s assets sit inside a corporation, your personal estate holds shares rather than the underlying business assets, and an outdated will may not properly address who inherits those shares. Update your will, and consider other estate-planning tools such as an estate freeze, at the same time you incorporate, rather than treating it as a separate task for later. Our individual and family income tax planning team can coordinate the corporate and personal sides of this planning together.
FAQ
How does the small business deduction work in Canada?
The small business deduction gives a Canadian-controlled private corporation a lower combined federal and provincial tax rate, currently 12.2 percent in Ontario, on its first $500,000 of active business income each year. Income above that business limit is taxed at the general corporate rate, currently 26.5 percent in Ontario.
What is a Canadian-controlled private corporation?
A Canadian-controlled private corporation, or CCPC, is a private corporation, meaning its shares are not listed on a designated stock exchange, that is both incorporated and resident in Canada, and that is not controlled by a non-resident person, a public corporation, or some combination of the two. It does not need to be controlled by Canadian residents specifically; it only needs to avoid being controlled by non-residents or public corporations.
How much tax can I defer by incorporating my business?
It depends on your income and how long you leave profit inside the corporation, but the deferral can be substantial. On $600,000 of active business income, a CCPC retains roughly $233,500 more after corporate tax alone than a sole proprietor retains after personal tax on the same income. That amount is a deferral, not a permanent saving, since personal tax still applies when the corporation eventually pays a dividend.
What is a section 85 rollover?
A section 85 rollover lets a taxpayer transfer property, such as the assets of an existing sole proprietorship, to a taxable Canadian corporation in exchange for shares, while electing an amount other than fair market value for tax purposes. Electing an amount equal to the transferor’s existing tax cost allows the transfer to proceed without immediate tax, deferring any gain until a later disposition.
What happens if I miss the T2057 filing deadline?
The T2057 election form can still be filed up to three years after the deadline, subject to a late-filing penalty equal to the lesser of $100 per month or part month late, to a maximum of $8,000, and 25 percent of the amount by which the transferred property’s value exceeded the elected amount. Beyond three years late, CRA also requires a written explanation and will only accept the filing if it considers doing so just and equitable.
Can I use a corporation for income splitting?
A corporation may allow you to divert income to family members in a lower tax bracket, but the tax on split income, or TOSI, under section 120.4 applies top-rate tax to a broad range of dividends and other amounts paid to adult family members from a private corporation, subject to exceptions based on the recipient’s age and involvement in the business. These exceptions are technical, and an experienced Canadian tax lawyer should confirm your arrangement qualifies before dividends are paid.
Can I transfer my business’s assets to an offshore corporation on a tax-deferred basis?
No. Section 85 applies only to a transfer to a taxable Canadian corporation, meaning a corporation incorporated under the Canada Business Corporations Act or the corporate statute of a Canadian province or territory. Transferring assets to an offshore corporation is deemed a disposition at fair market value, triggering ordinary Canadian tax consequences on any resulting gain.
Do I need to update my will after incorporating my business?
Yes. Once your business’s assets sit inside a corporation, your personal estate holds shares in the corporation rather than the underlying assets directly, and an outdated will may not properly address who inherits those shares. Update your will, and consider other estate-planning tools, at the same time you incorporate.
What is a price-adjustment clause and do I need one?
A price-adjustment clause in a section 85 asset-transfer agreement is intended to protect the parties if the agreed value later turns out not to reflect fair market value. CRA will only respect such a clause where the parties genuinely intended to transfer the property at fair market value and meet several other conditions, so it should be drafted by an experienced Canadian tax lawyer rather than adapted from a generic template.
Does incorporating always save me money?
Not automatically. Incorporating defers tax rather than eliminating it, and the benefit depends on leaving profit inside the corporation for a meaningful period. If you need to withdraw most of the business income personally soon after earning it, the deferral advantage shrinks substantially, and the compliance costs of running a corporation may outweigh the tax benefit.
What happens if my corporation is associated with another corporation I control?
Associated corporations must share a single $500,000 business limit rather than each claiming the small business deduction in full. The associated-corporation rules in the Income Tax Act can apply even where the corporations have no obvious common ownership on paper, so a business owner operating more than one corporation should have a Canadian tax lawyer confirm the analysis.
Is the small business deduction only available to small corporations?
No, despite the name. A corporation receives the full small business deduction until its taxable capital employed in Canada reaches $10 million, after which the deduction is reduced on a straight-line basis until it is eliminated entirely once taxable capital reaches $15 million. A corporation with substantial assets can still be quite large by ordinary standards and continue to qualify.
DISCLAIMER: This article provides broad information. It is only accurate as of the posting date. It has not been updated and may be out-of-date. It does not give legal advice and should not be relied on as tax advice. Every tax scenario is unique to its circumstances and will differ from the instances described in the article. If you have specific legal questions, you should seek the advice of a Canadian tax lawyer.
