Small Business Deduction

Definition

The Small Business Deduction (SBD) under ITA s.125 is a federal tax reduction available to corporations that are CCPCs throughout the tax year. It applies to the least of eligible Canadian active business income, adjusted taxable income and the available business limit, initially $500,000 before allocation, reductions and short-year proration. It effectively lowers the federal corporate tax rate from the general 15% to 9%, The combined rate depends on the province and the applicable provincial eligibility rules.

Key rules

• Business limit: $500,000 of active business income per year (ITA s.125(2)).
• Federal rate impact: the 38% basic rate (ITA s.123), less the 10% provincial abatement (s.124) and the 19% small business deduction (s.125(1.1)), leaves a 9% federal SBD rate. Income that gets the SBD does not also get the 13% general rate reduction (s.123.4), so the saving against the 15% general rate is 6 percentage points.
• Qualifying income: only active business income carried on in Canada by the CCPC. Investment income, specified investment business income, and personal services business income are excluded.
• Associated-corp sharing (ITA s.125(3)): associated corporations must share one $500,000 business limit. See Associated Corporations Rule.
• Taxable capital grind (ITA s.125(5.1)): the business limit is reduced when the associated group's taxable capital employed in Canada in the prior year is between $10 million and $50 million, and eliminated at $50 million.
• Passive income grind (ITA s.125(5.1)(b)): for a full $500,000 limit, the passive-income reduction is $5 for every $1 of associated-group AAII from taxation years ending in the preceding calendar year over $50,000, fully eliminating the SBD once AAII reaches $150,000.
• Both grinds apply: the reduction is the greater of the two.

Example

Northshore Consulting Inc. was a CCPC throughout its full 2026 calendar tax year and earned $620,000 of eligible active business income and taxable income. Assume the group allocates its entire available business limit to Northshore. The associated group has $12 million taxable capital in 2025 and $40,000 AAII in 2025.

Step 1: Full SBD-eligible amount

Active business income: $620,000, capped at the $500,000 business limit.

Step 2: Taxable capital grind

Reduction = $500,000 × (($12,000,000 − $10,000,000) / $40,000,000) = $25,000.

Step 3: Passive income grind

AAII of $40,000 is below the $50,000 floor, so no passive grind.

Step 4: Adjusted business limit

$500,000 − $25,000 = $475,000.

Step 5: Federal tax

The $145,000 that did not qualify for the SBD (the $120,000 above the business limit plus the $25,000 lost to the grind) is taxed at the general rate and feeds General Rate Income Pool (GRIP), which supports future eligible dividends.

Common mistakes

• Treating the $500,000 as per corporation rather than per associated group.
• Ignoring personal services business (PSB) income. PSB income is excluded from the SBD and taxed at a federal rate of 33%.
• Missing the passive income grind. A single year of AAII above $50,000 shrinks next year's business limit.
• Forgetting that the taxable capital grind uses the prior year's taxable capital of the associated group, not the current year's.
• Applying the SBD to specified investment business income. Check the specified-investment-business definition rather than using an automatic employee-count shortcut. Exceptions include more than five full-time employees throughout the year and certain services supplied by an associated corporation.

Official sources

ITA section 125 sets the federal conditions. Ontario’s corporate income-tax page confirms its rate change effective July 1, 2026; a straddling tax year uses the applicable day-based rates.

Related concepts

• CCPC Status
• Associated Corporations Rule
• General Rate Income Pool (GRIP)
• Schedule 7. Aggregate Investment Income