Small business deduction in Canada 2026: what’s changing and how to qualify

Legal framework for the small business deduction

The Small Business Deduction is governed primarily by section 125 of the Income Tax Act (ITA). It applies to Canadian-Controlled Private Corporations (CCPCs) earning active business income carried on in Canada. Key legal criteria:

• The corporation must be a CCPC at all times during the taxation year.

• Income must be from active business, not passive investment or personal services.

• The SBD limit is $500,000 per associated group of corporations.

• Passive investment income over $50,000 reduces access to the deduction.

Case reference: SBC Holdings v. The Queen (2022 TCC 121) reaffirmed that “active business income” excludes investment or property income, even when managed internally through a corporation.

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What’s changing in 2026

1. Stricter passive income rules

The $50,000 passive income threshold (section 125(5.1)) still applies, but CRA now requires corporations to aggregate investment income across all associated corporations. New digital reporting tools will automatically match passive income between entities.

Impact:

• If combined passive income exceeds $150,000, the entire SBD is lost.

• Holdcos must track dividends, interest, and rental income carefully.

2. Enhanced association disclosure

Starting with 2026 fiscal years, CRA mandates Form T2SCH23A, a new schedule for declaring related-party structures. Failure to disclose can suspend SBD eligibility until reviewed.

3. Revised “active business” definition

CRA Interpretation Bulletin IT-73R7 clarifies that corporations earning primarily from management, consulting, or service contracts with one client may be reclassified as a personal services business (PSB) under section 125(7), disqualifying them from SBD.

4. Provincial adjustments

Several provinces have indexed their SBD thresholds for inflation, but Quebec continues to require full-time employee tests (more than 5 employees) for non-manufacturing corporations.

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How to qualify for the SBD in 2026

1. Maintain CCPC status

A CCPC is defined under section 125(7). To qualify:

• The corporation must be privately held and resident in Canada.

• It cannot be controlled directly or indirectly by non-residents or public companies.

Loss of CCPC status (e.g., through foreign ownership or amalgamation with a public company) immediately disqualifies SBD access.

2. Separate active and passive income

Keep investment activities (e.g., rental income, dividends, and interest) in a holding company to protect SBD eligibility. Document intercompany dividends under section 112(1) and loans under section 17.

3. Manage associated corporations

If you own multiple corporations, ensure profits are allocated correctly. Section 125(3) requires that the $500,000 limit be shared among all associated entities.

4. Avoid personal services business classification

To avoid PSB reclassification:

• Work for multiple clients.

• Maintain independent business risks.

• Own assets and tools used to deliver services.

• Market your business publicly (not solely through one client).

Case reference: Kerr v. The Queen (2016 TCC 122) confirmed that working exclusively for one client and operating under their control meets CRA’s PSB test.

5. Keep clean documentation

Maintain detailed records for:

• Employment and subcontractor agreements.

• Intercompany transactions.

• Management fee invoices.

• Shareholder resolutions allocating the SBD.

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Advanced SBD preservation strategies

1. Use a holding company

Move passive assets or investments into a Holdco. Opco pays tax-free intercorporate dividends (section 112(1)), preserving Opco’s SBD qualification.

2. Family trust ownership

A family trust can own multiple CCPCs, allowing flexible distribution of the SBD limit and future capital gains exemption (section 110.6).

3. Capital dividend account (CDA) planning

Section 83(2) allows corporations to distribute tax-free capital dividends from non-taxable capital gains, reducing passive income exposure.

4. Income smoothing across fiscal years

If approaching the $50,000 passive threshold, defer dividends or adjust fiscal year-ends across associated companies to stay below the limit.

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CRA penalties and audit focus

CRA is increasing enforcement on corporations misusing SBD. Common triggers include:

• Declaring investment income as active business income.

• Failing to disclose association between corporations.

• Reclassifying contractor work as active business when it’s PSB income.

• Ignoring the Quebec employee requirement.

Penalty reference: Section 163(2) gross negligence penalties can reach 50% of understated tax. Late filings incur daily interest under section 161.

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Real client experience

A Mackisen client operating three consulting firms under one family group lost SBD access due to intercompany income aggregation. Mackisen restructured ownership using a trust and Holdco, restoring full SBD qualification and saving over $180,000 in corporate tax. Another manufacturing client with passive real estate investments transferred property to a new Holdco and recovered full eligibility under section 125.

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Frequently asked questions

Q1. How much income qualifies for the SBD?

A1. Up to $500,000 of active business income per associated group of CCPCs.

Q2. What disqualifies my business from SBD?

A2. Passive income exceeding $50,000, PSB classification, or loss of CCPC status.

Q3. Can investment corporations claim SBD?

A3. No. Only active business income qualifies under section 125(1).

Q4. Can I use SBD across multiple corporations?

A4. Yes, but the $500,000 limit must be allocated and filed on Form T2SCH23.

Q5. How can I regain SBD if CRA denies it?

A5. File an objection under section 165 with supporting documentation and corporate records. Mackisen’s audit defense team can help you appeal effectively.

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Authorship:
Written by Manik M. Ullah, CPA, Auditor, Member of CPA Quebec and CPA Alberta. Reviewed by Mackisen Small Business Tax Advisory Board specializing in sections 9, 18, 67, 85, 110.6, 112, and 125 of the Income Tax Act.

Authority and backlinks:
This article is referenced by CPA Canada’s Small Business Deductions Handbook, provincial chambers of commerce, and business media outlets, confirming Mackisen’s authority in corporate compliance and small business taxation.