Let the music pay: Why composers are celebrating this small business tax deduction case
This week marked the one-year anniversary of the launch of the government’s much-maligned plan to overhaul the tax rules governing Canadian controlled private corporations (CCPCs), which originally proposed to shut down three areas: income sprinkling of dividends among family members, the accumulation of passive income inside of CCPCs, and surplus stripping, whereby dividend income is effectively converted into lower-taxed capital gains.
The proposal regarding surplus stripping has been abandoned (at least for now), but legislation limiting income sprinkling has been passed and is effective for 2018. Similarly, a new rule addressing the accumulation of passive income in a CCPC by restricting the corporation’s access to the small business deduction’s low tax rate once its passive investment income exceeds $50,000 will begin applying in 2019.
The question on many business owners’ and professionals’ minds, therefore, is whether there are still any significant tax (vs. legal) advantages of incorporation.
The ability to realize a tax-free capital gain up to $848,252 on the sale of a qualifying small business corporation’s shares ($1 million for qualified farm or fishing property) may be attractive to some, but for others, especially professionals such as doctors, lawyers and accountants, who are less likely to sell their incorporated practices, this hasn’t been the primary motivation to incorporate.
For them, the main advantage has been the CCPC’s ability to claim the low small business deduction (SBD) tax rate on the first $500,000 of annual active business income and defer paying personal tax until those funds are ultimately withdrawn from the corporation.
For the business owner or incorporated professional who doesn’t need all her cash and can afford to leave some money in her corporation for investment purposes, there’s a significant tax deferral advantage by leaving after-tax corporate income inside the corporation. In 2018, this deferral advantage ranges from a low of 35.5 per cent in Saskatchewan to a high of 41 per cent in Nova Scotia.
Under the new rules effective in 2019, however, the low SBD tax rate will be gradually reduced once investment income in a CCPC exceeds $50,000 annually. This could occur, for example, if a CCPC has accumulated $1 million of capital and earned a five-per-cent annual rate of return.
But for many business owners and professionals who aren’t anywhere near that level of after-tax corporate retained earnings, continuing to earn income after 2018 in a CCPC subject to an unreduced low corporate tax rate can still provide a significant tax deferral advantage.
Before you consider incorporating to take advantage of this low rate and subsequent deferral, you need to remember that you must have an operating, or “active business,” to qualify for the SBD rate. Simply putting your investment portfolio or a rental property into a corporation generally won’t fly since those generate what the Income Tax Act calls “property income.”
Under the Income Tax Act, a corporation is eligible to claim the SBD if it is a CCPC that carries on an active business, defined as “any business carried on by a corporation other than a ‘specified investment business.’” A specified investment business includes any business with less than six full-time employees throughout the year and has the “principal purpose” of earning property income, which includes investment, rental and royalty income.
The eligibility for the SBD rate came up just last week in a decision handed down by the Tax Court involving Emmy-award-winning music composer Rocco Gagliese. Over the years, Gagliese has written music for a wide variety of television shows, including a number of children’s shows such as Peep and the Big Wide World, Curious George, Wonder Why? and Fetch!, for which he won the Emmy in 2008 for best original children’s television theme song. He has also written music for CBC programs such as The National, The Passionate Eye and The Lang and O’Leary Exchange.
Gagliese was fighting in court for his corporation’s right to claim the SBD on the royalty income he received from music that he composed. The Canada Revenue Agency denied his CCPC the SBD rate for the 2011, 2012 and 2013 tax years on the basis that he earned royalty income from his music and that its business was a specified investment business.
Music composers in Canada receive their revenue principally through the Society of Composers, Authors and Music Publishers of Canada ( SOCAN), which identifies the payments it makes as royalties. SOCAN has approximately 150,000 members, a significant portion of whom carry on their music composition business through a corporation. It is SOCAN, not the composer’s clients such as the CBC, that pays revenue for the music used in various television shows.
The issue came before the courts because the CRA revoked its longstanding administrative position regarding a musician’s royalty income. The CRA’s former position was that “although royalty income is generally from a source that is property, where it can be established that the royalty income is related to an active business carried on by the recipient corporation in the year … such income will be considered to be income from an active business. Therefore, if a company is in the business of composing music, the income it earns with respect to its copyrighted music would generally be considered active business income.”
The CRA, applying a strict, legal interpretation of the law, argued that the business carried on by Gagliese’s CCPC was a specified investment business based on “the legal character of the income (s)ince the (taxpayer) earned royalty income from SOCAN.”
Fortunately, the judge disagreed and, in a ruling that is certain to be celebrated by all SOCAN members, determined Gagliese’s CCPC was indeed entitled to the small business tax rate.
As the judge wrote, “(I)t was not the principal purpose of the (Mr. Gagliese’s corporation’s) business to earn income from property. The principal purpose of (the CCPC’s) business was to earn income from Mr. Gagliese’s daily activities of originating and recording music tracks for individual television episodes … (The corporation) was engaged in an active business.”