Profit and Policy: Unpacking the Small Business Deduction
Photo Credit: Canadian Chamber of Commerce
By: Ken Lee | KLee Tax and Financial Services Co.
Published: 3 November 2025 4:00AM EST
All references to a spouse include common-law partners. All references to the ‘Act’ or the 'ITA' mean the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended. All references to the ‘Regulations’ or the 'ITR' mean the Income Tax Regulations. The following should not be construed as legal nor tax advice. Consultation with your usual tax/legal professional is advised. Please contact us to discuss the contents of the article herein.
Good morning Toronto! The Small Business Deduction (SBD) is one of the most powerful tools that small Canadian corporations can use to reduce their tax burden. In today's article, we will discuss how the owner-manager can apply the SBD, as well as some limitations they should be aware of.
The Canadian corporate tax system, similar to personal taxes, is made up of both federal and provincial components. However, corporate taxes diverge from personal taxes by applying one uniform tax rate, in comparison to the graduated rate scheme seen for individuals. For an Ontario-based CCPC, the combined general corporate tax rate, after all applicable reductions, is currently 26.5% - 15% federal and 11.5% Ontario. Most corporations pay income tax at this rate.
A corporation must be a CCPC to claim the SBD, which provides for preferential tax treatment on up to the first $500k of active business income (passive income does not qualify) earned in Canada. This $500k is referred to as the Business Limit (BL) and is the maximum income eligible for the SBD. The BL itself can be lowered by several situations, which are discussed below. As the name implies, the SBD takes the form of deduction. In the event that the CCPC’s tax year was under 51 weeks, then the SBD is prorated by dividing the BL by 365 days and multiplying by days in the tax year. A Personal Services Business (PSB) is NOT eligible for the SBD on any portion of its income, with a few exceptions. These exceptions, along with a discussion of the tax implications of PSBs, will follow in the next article.
All provinces/territories have concepts similar to the federal SBD, offering a lower tax rate on income that qualifies for the SBD. Ontario, as with most jurisdictions, aligns its phase-out rules (discussed below) with the federal system. Most provinces allow the small-business rates on income up to $500k, mirroring the federal government. However, some provinces choose to enact different thresholds, such as Saskatchewan, where the small-business rate is 1% of taxable income, up to $600k.
Example 1
Sabrina owns HatCo. The corporation’s taxable income for the 2024 Fiscal Year was $600k. The corporation was a CCPC throughout the year, with a sole PE in Saskatchewan.
It can be assumed that HatCo qualifies to claim the full SBD.
| Saskatchewan | Federal | |
|---|---|---|
| A. SBD tax rate | 1% | 9% |
| B. General tax rate | 12% | 15% |
| C. SBD Limit | $600,000 | $500,000 |
| D. Income taxed at SBD rate | $600,000 | $500,000 |
| E. Income taxed at General rate | $0 | $100,000 |
| F. Total Tax Liability [(D * A)+(E * B)] | $6,000 | $60,000 |
From time to time, a CCPC may carry on business in more than one province/territory, rendering it liable for tax in each jurisdiction. For tax purposes, §400(2) of the Regulations determines what qualifies as a Permanent Establishment (PE). A PE is deemed to exist if a corporation has a fixed place of business (i.e. office, branch, factory, etc.) or has an agent with the authority to contract on behalf of the corporation. PEs determine income tax liability in a province or territory.
If a corporation only has one PE, it follows that 100% of its taxable income will be taxed in that province. However, if a corporation has multiple PEs, the corporation's taxable income and SBD must be allocated between the provinces. ITR §402(3)(a) provides that both of these allocations are made by averaging the percentages of wages paid and gross revenue earned in each PE.
Example 2
Sabine owns PhotoCo, which has offices in both BC and Ontario. In 2025, PhotoCo's projected wages paid and gross revenue are $500k and $1m, respectively. In Ontario, PhotoCo will pay $300k in wages and earn $800k in gross revenue.
It can be assumed that PhotoCo qualifies for the full BL.
| Ontario | British Columbia | |
|---|---|---|
| A. Combined SBD-sheltered income tax rate | 12.2% | 11% |
| B. Combined general corporate income tax rate | 26.5% | 27% |
| C. % of wages paid in PE | 60% | 40% |
| D. % of gross revenue earned in PE | 80% | 20% |
| E. ITR §402(3) deemed % allocation [(C+D)/2] | 70% | 30% |
| F. Deemed gross income of PE ($1m * E) | $700,000 | $300,000 |
| G. BL of PE ($500k * E) | $350,000 | $150,000 |
| H. Income taxed at SBD rates (F-G) | $350,000 | $150,000 |
| I. Income taxed at general corporate rate (F-H) | $350,000 | $150,000 |
| J. Tax Liability [(H * A)+(I * B)] | $135,450 | $57,000 |
As its name suggests, the SBD is intended for small businesses. To prevent abuse, the government provides that the SBD may be shared between corporations or reduced under certain circumstances.
First, the BL is shared by related (a.k.a associated) corporations. This is to be mutually decided between the related corporations. Paragraph 256 of the Act defines that corporations are related if one controls the other (such as with holding corporations), or if both are controlled by the same person or group of persons. In this case, ‘control’ means to own more than 50% of the voting shares in the corporation.
Example 3
Zhoutong owns 100% of HolCo, which owns 100% of ACo and 100% of BCo.
- HolCo and ACo are related, as HolCo controls ACo.
- HolCo and BCo are related, as HolCo controls BCo.
- ACo and BCo are related, as they are both controlled by HolCo, which is, in turn, controlled by Zhoutong.
The same paragraph contains further situations where a corporation may be related to each other. ITA §256(1)(c) provides that two corporations can be associated if:
- Each corporation is controlled, in any manner, by a person, AND
- The persons controlling the corporations in question are related to each other1, AND
- Either of the persons owns at least 25% of any share class (generally, voting shares) in both corporations. (The cross-ownership test)
1§251(2) ITA defines related persons to be individuals connected by blood, marriage/common-law partnership, or adoption. Blood relationship means ascendants, descendants, siblings, their spouses (brother/sister in-laws), or siblings of your spouse. As a result of this provision, aunts, uncles, nephews, nieces, and/or cousins would NOT be connected by blood relationship under the Act, and hence, are not related persons.
By ITA §256(2), corporations can also be considered related if they are each related to a common corporation.
Example 4
Annika owns 100% of ACo and 25% of BCo. Sophie owns 75% of BCo and 25% of CCo. Sarina owns 75% of CCo. Assume that there is only one share class and that all companies are CCPCs which qualify for the SBD. They are all sisters.
- The sisters are considered related persons under the Act.
- ACo and BCo are controlled by Annika and Sophie, respectively. The cross-ownership test is met by Annika owning 25% of BCo. ACo and BCo are related.
- BCo and CCo are controlled by Sophie and Sarina, respectively. The cross-ownership test is met by Sophie owning 25% of CCo. BCo and CCo are related.
- ACo and CCo are controlled by Annika and Sarina, respectively. The cross-ownership test is not met, as neither Annika nor Sarina owns shares in the other’s corporation.
- ACo and CCo did not meet the definition of ‘related’ under ITA §256(1)(c). However, due to BOTH being related to BCo, ITA §256(2) would subsequently deem them to be related.
As all three corporations are related, the siblings need to come to an agreement to split the 500k business limit evenly between the 3 CCPCs.
If a corporation’s shares are owned through another corporation (i.e holding corporation), the Act deems that the aforementioned shares are considered to be owned by the shareholder of the other corporation as an anti-avoidance measure. While there are many more situations where corporations may be considered to be related, these are beyond the scope of the article - only the more common situations were covered.
Example 5
With respect to Example 4, Annika decides to move all of her shares to a HolCo she 100% owns.
- The HolCo’s 100% stake in ACo and 25% stake in BCo will be deemed to be owned by Annika
- Hence, ACo and BCo are still related.
A corporation may also be subject to a partial or full phase-out of the SBDs if the combined Taxable Capital Employed in Canada (TCEC) of the CCPC and all associated corporations are over $10m. Generally, this is the sum of the shareholders' equity, surpluses, debt, and reserves, less investments/debts held in related corporations. The BL is also reduced, where the combined Adjusted Aggregate Investment Income (AAII) of the CCPC and its associated corporations are over $50k in the tax year concerned. AAII is defined as the sum of all passive income (interest, dividends, capital gains, etc.), reduced by certain allowable deductions under the Act
The calculation for the reduction to the BL is seen below. Neither calculation can exceed the BL. Note that if a CCPC exceeds both provisions (above), the greater of the two calculations applies:
TCEC Reduction = (BL/$500k) x (Portion of CTCEC over $10m/$40m)
AII Reduction = (BL/$500k) x 5(AAII-$50k)
A CCPC will be ineligible for the SBD if it and all its associated corporations’ combined TCEC is over $50m OR if combined AAII is over $150k. This is to ensure that the SBD only goes to small to medium businesses that are principally engaged in active business.
Example 6
Sabine’s PhotoCo and Sabrina’s HatCo are associated corporations. Sabine and Sabrina mutually decided to allocate the full BL of $500k to PhotoCo. Some of PhotoCo’s term investments matured this year, totalling $1m in income. The TCEC and AAII for PhotoCo are $6m and $1m. These numbers are $5m and $0 for HatCo.
- The calculations consider the combined TCEC and combined AAII of PhotoCo and all of its related corporations.
- Hence, for calculation purposes, the combined CTCEC and combined AAII are $11m and $1m.
- The calculation for TCEC reduces the BL by $12.5k, while the AAII calculation reduces the BL by $500k.
- Hence, by taking the greater of the two calculations, the PhotoCo does not qualify to claim the BL.
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