Corporate Partnership May Avoid the Paragraph 125(5.1)(b) Grind

The excerpt below is taken from “Tax for the Owner-Manager” Volume 20, Number 4, October 2020

The 2018 federal budget added paragraph (b) to subsection 125(5.1) to penalize certain CCPCs that earn excessive investment income. Generally, the paragraph modifies the calculation of the small business deduction (SBD) limit available to a group of associated corporations based on the adjusted aggregate investment income (AAII) of the associated group, which is defined in subsections 125(7) and 129(4) and includes passive investment income such as interest, portfolio dividends, and certain capital gains. In particular, the SBD limit is reduced by $5 for every $1 of AAII of the associated group of corporations over $50,000 in the previous taxation year. Therefore, if the AAII exceeds $50,000, the corporations in the group with the active business income will generally be subject to a higher effective corporate income tax rate due to the lower SBD limit available to them.

Consider, for example, the following common structure (illustrated in figure 1) in which two spouses, both residents of Canada, own two CCPCs. One CCPC (Opco) is wholly owned by Mr. X, and the other CCPC (Investco) is owned 49 percent by Ms. Y and 51 percent by Mr. X. Opco is engaged in an active business carried on in Canada that generates more than $500,000 of taxable income on an annual basis. Investco has an investment portfolio worth $2 million and earns $90,000 in investment income annually. Assume that the $90,000 of investment income should be fully included in Investco’s AAII.

In determining whether paragraph 125(5.1)(b) will apply in these circumstances, the associated-corporation rules in section 256 should be examined. Opco and Investco are associated pursuant to paragraph 256(1)(b) because Mr. X controls both corporations. Therefore, since the AAII of Investco exceeds $50,000 (and assuming that there is no further SBD limit reduction because the taxable capital employed in Canada exceeds $10 million), the SBD limit available to the associated group will be reduced by the amount commonly referred to as the SBD grind, calculated as follows (according to the formula in paragraph 125(5.1)(b)):

SBD limit reduction = SBD limit of $500,000/$500,000 × 5 × (AAII of $90,000 − $50,000) = $200,000

Thus, Opco will have an SBD limit of $300,000 (the $500,000 limit less the $200,000 reduction), and any income in excess of the limit will be taxed at a higher corporate tax rate.

The structure could be modified such that Ms. Y and Mr. X will have the same economic interests in the $2 million investment portfolio and Opco while preserving the full SBD limit for Opco. In particular, instead of holding the investment portfolio in Investco, Ms. Y and Mr. X could hold the same portfolio in a partnership (Invest LP). The interests in the partnership would be held by Ms. Y and Mr. X through holding companies (Holdco X and Holdco Y, respectively). Figure 2 illustrates the modified structure (ignoring the general partner of Invest LP, which would hold a nominal interest).

The analysis of the application of paragraph 125(5.1)(b) begins with the analysis of the associated-corporation rules in section 256. As noted earlier, Holdco X and Opco are associated pursuant to paragraph 256(1)(b) because Mr. X controls both corporations. Holdco Y should not be associated with either Holdco X or Opco because there is no cross-ownership or common control (assuming that there is no de facto control of Holdco Y by Mr. X or of Holdco X or Opco by Ms. Y).

Because it has been determined that Opco and Holdco X are associated, we must consider the AAII of each of Holdco Y and Holdco X and how such amounts affect Opco’s SBD limit. The investment income of Invest LP is allocated to Holdco Y and Holdco X pursuant to subsection 96(1); the character of the income allocated from Invest LP to Holdco Y and Holdco X is retained pursuant to paragraph 96(1)(f ). Therefore, for the purposes of calculating the SBD grind in paragraph 125(5.1)(b), the AAII of Holdco X is $45,900 ($90,000 × 51%), and the AAII of Holdco Y is $44,100 ($90,000 × 49%). For the purposes of calculating the SBD grind, Opco should be required to include only the AAII of Holdco X in the formula in paragraph 125(5.1)(b) described above. The AAII of Holdco Y should not affect the SBD limit of Opco, because Opco and Holdco Y are not associated. Thus, Opco’s SBD grind is based on AAII of $45,900. That amount does not exceed $50,000, and thus there is no SBD grind for Opco.

The modified structure may allow the preservation of Opco’s SBD limit while maintaining the spouses’ desired ownership of the investment portfolio. Note, however, that the modified structure will have higher maintenance costs due to the greater number of entities and certain complexities surrounding the partnership rules in the Act. Consideration should be given to the specific anti-avoidance provision in subsection 256(2.1), which may deem Holdco Y to be associated with Opco and Holdco X if one of the main reasons for the separate existence of those corporations was to reduce taxes payable. Finally, one must always keep GAAR in mind, since the CRA may seek to challenge the structure under that provision.

Stan Shadrin CPA Solutions LLP Thornhill, ON sshadrin@cpasolutions.ca

Alex Ghani CPA Solutions LLP Thornhill, ON aghani@cpasolutions.ca

Josh Harnett Wilson Vukelich LLP Markham, ON jharnett@wvllp.ca