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Avoid having corporations share the 15.5% tax rate on their first $500k of net income…

By November 16, 2013December 14th, 2021Corporate

Here’s the situation.  You’re a dentist. You have a spouse. You also have a dentistry professional corporation.  You want to have multiple practices, each one carried on by a different dentistry professional corporation.  And you want each corporation to take advantage of the 15.5% tax rate on the first $500,000 of active business income.  What’s simply stopping you from setting up two professional corporations (one for each practice) and getting that tax advantage, you say?

Well, the Income Tax Act says that if two corporations are ASSOCIATED with one another, then they must SHARE the 15.5% tax rate on the first $500,000 of active business income.  So this effectively eliminates multiplying this tax benefit across professional corporations.  Ouch!  The policy rationale behind this is that the government only intends to provide the full amount of this tax break to each individual, no matter how many businesses they operate.

So what does it mean for one corporation to be associated?  Well, there are a number of rules in this regard, so let’s take a look at some of them, shall we?

Scenario #1: Control of Two (2) Corporations by Same Person

Where both corporations are controlled, directly or indirectly in any manner whatever, by the same person, they will be associated.  This would look something like this:

So in this very easy example, Professional Corporation #1 and Professional Corporation #2 WOULD BE Associated and have to share the 15.5% tax rate on the first $500k of active business income.   Worth mentioning is that, section 125(3) of the Income Tax Act allows the two associated corporations to file an agreement as to the business limits for each corporation.

So what does “control” mean?

In the example above, Dr. Carabash owned 100% of the shares of both corporations.  But what if he owned less than 100%.  Does that mean he still “controls” both corporations?

There are three (3) concepts of control you need to understand:

1. Legal or De Jure Control

If a person such as a dentist owns 50% + 1 of the issued and outstanding Common Voting Shares of the corporation, then they will be considered to be in control of that corporation.  Why?  Because those shares allow them to vote in the board of directors, who then appoint the officers of the corporation (i.e. President, VP, Secretary, Treasurer, etc.), who then hire managers and employees.  So these types of shareholders effectively CONTROL the corporation LEGALLY because they can outvote other shareholders in determining who should sit on the board of directors.

Note: in the case of Buckerfield’s Ltd. v. Minister of National Revenue, (1964) 1964 CarswellNat 351, the Court defined de jure control as “the right of control that rests in ownershipo of such a number of shares as carries with it the right toa  majority of the votes in the election of the Board of Directors”.

Note: the courts will look past the share registry in the minute book to determine legal or de jure control.  They have looked, for example, at the rights, restrictions and privileges of the shareholders over the long term to determine who has de jure control.

2. Fair Market Value Control

Under section 256(1.2)(c), a corporation will be deemed to be controlled by a person who owns shares, the fair market value of which is greater than 50% of all the shares issued and outstanding.  Alternatively, a corporation will be deemed to be controlled by a person who owns COMMON shares, the fair market valueo f which is greater than 50% of the fair market value of the common shares issued and outstanding.  So unlike with Legal or De Jure Control, we’re not looking at voting rights.  We’re looking at fair market value of the shares vis-a-vis all of the shares outstanding.

3. In Fact or De Facto Control

Under section 256(5.1), a final way in which a corporation will be deemed to be controlled by a person is where there is direct or indirect influence by that person which, if exercised, would result in control IN FACT of that corporation.  So the idea is that there is a potential influence that exists (actual influence is not required) which makes the corporation controlled by a person IN REALITY, though not legally (e.g. they may not be a shareholder).  You can see this type of control, for example, when you look at a Franchisor exerting influence and control over a Franchisee (though it doesn’t own the shares of the Franchisee).  Close relationships will also be examined in this regard.

SO PLEASE KEEP THESE IN MIND WHEN LOOKING AT ALL OF THE EXAMPLES!!!

Scenario #2: Control of Two (2) Corporations by Same Group of Persons

Where both corporations are controlled, directly or indirectly in any manner whatever, by the same group of persons, they will be associated: section 256(1.2)(a).  A “group of persons” means any two or more persons.  Typically, this will mean a dentist and their spouse.  Here’s what this would look like:

So in this example, Dr. Carabash and his Spouse both control Professional Corporation #1 and Professional Corporation #2. This makes those two (2) Corporations Associated and, as such, they would have to share the 15.5% tax rate on the first $500k of active business income.  In this example, the two (2) corporations are controlled by the same group because combined, Dr. Carabash and his Spouse have Legal or De Jure Control (i.e. 60% of the shares).  We don’t need to get into Fair Market Value Control or De Facto Control.

Scenario #3: Control of Two (2) Corporations by “Related” Persons and Cross-Ownership of Shares

Ok, this situation is a little different.  Here, each of the Professional Corporations are controlled by one (1) Person.  So Professional Corporation #1 is controlled (Legally or De Jure) by Dr. Carabash.  And Professional Corporation #2 is controlled (again, Legally or De Jure) by the Spouse, who is also a dentist and who can own the Common Voting Shares of this professional corporation.  Now here’s the kicker: Dr. Carabash also owns 25% of Professional Corporation #2.  So there is CROSS OWNERSHIP of Professional Corporation #2 by Dr. Carabash.  This would look like this:

In this situation, since Dr. Carabash is RELATED (by marriage) to the Spouse and owns 25% of Professional Corporation #2.  So although we have two Professional Corporations which are controlled Legally or De Jure by one person, there is some cross ownership of a RELATED Person.  A RELATED person includes persons related to each other by blood, marriage, adoption, etc.  Section 256(1)(c) of the Income Tax Act says that, in these situations, if Dr. Carabash owns not less than 25% of the issued shares of any class of share (other than a specified class of share), then the two professional corporations will be associated and have to share the 15.5% tax rate on the first $500k of active business income they make.

Important concept: less than 25% of the issued shares of any class

As you can see above, if Dr. Carabash own 25% of the issued shares of any class in Professional Corporation #2, then the two (2) corporations WOULD be Associated.

Important concept: specified class of share

As you can see above, if Dr. Carabash owned ANY AMOUNT of a specified class of share in Professional Corporation #2, then the two (2) corporations would NOT be Associated.  So what is a “specified share” you ask?  Well, the criteria are in section 256(1.1) of the Income Tax Act and are as follows:

  • The shares are not convertible or exchangeable
  • The shares are non-voting
  • The dividend payable is a fixed amount by reference to a fixed percentage of an amount equal to the fair market value of the consideration for which the shares were issued
  • the annual rate of the dividend cannot exceed the prescribed rate of interest at the time the share were issued; AND
  • the amount that the shareholder is entitled to receive on the redemption, cancellation or acquisition of the shares by the corporation cannot exceed the total of an amount equal to the fair market value of the consideration for which the shares were issued and the amount of any unpaid dividends thereon.

So, let’s take a look at one more example, shall we?

So in this example, the “Special Shares” are non-voting, redeemable by the shareholder (i.e. the shareholder can require the corporation to buy them back for a set price), retractable by the corporation (i.e. the corporation can require the shareholder sell the shares for a set price), and offer an 8% dividend (at a time when interest rates were was 10%) and were issued for $80,000 to Dr. Carabash.

As we saw in the first example of Scenario #3, the two professional corporations in this example WOULD GENERALLY BE CONSIDERED ASSOCIATED because each is legally or de jure controlled by persons who are related to each other (i.e. Dr. Carabash and the Spouse) and because Dr. Carabash owns more than 25% of the issued shares of any class of Professional Corporation #2.

BUT these two corporations are NOT ASSOCIATED because the “Special Shares” would be considered a “Specified Class of Shares”.  They are non-voting, non-convertible or exchangeable, they pay out a fixed dividend of 8% which did not exceed the 10% interest rate at the time they were issued, and the amount that Dr. Carabash is entitled to receive on redemption, cancellation or acquisition of the shares doesn’t exceed the total of the fair market value of the consideration for which the shares were issued and the amount of any unpaid dividends thereon.  As such, section 256(1)(c) would not make Professional Corporation #1 and Professional Corporation #2 associated.

That said, don’t forget, those two corporations might still be associated if Dr. Carabash controls Professional Corporation #2 in fact or through de facto control pursuant to section 256(5.1) (for example, by holding the company hostage by threatening to redeem the shares at any time when the corporation doesn’t have the funds to buy them!) or through the fair market value control (section 256(1.2)(c)) or if it can be reasonably be considered that one of the main reasons for the separate existence of those corporations is to reduce the amount of taxes that otherwise would be payable under the Income Tax Act (section 256(2.1)).

DMC