The “One of the Main Reasons” Test in Subsection 256(2.1) of the Income Tax Act

Tax planning for a Canadian-controlled private corporation frequently involves ensuring that the corporation is eligible for the small business deduction. As associated corporations must share the business limit (i.e., the amount of active business income eligible for the small business tax rate), an important consideration in such planning is the deemed association rule in subsection 256(2.1) of the Income Tax Act (the “Act”).  This provision provides that for the purposes of the Act, where it may reasonably be considered that one of the main reasons for the separate existence of two or more corporations in a taxation year is to reduce the amount of tax that would otherwise be payable under the Act (or to increase the amount of refundable investment tax credit under section 127.1), the corporations are deemed to be associated with each other in the year. 

The Tax Court of Canada considered the application of subsection 256(2.1) in Prairielane Holdings Ltd. v. The Queen, 2019 TCC 157.  In that case, the Court found that none of the main reasons for the separate existence of second-tier corporations in a “stacked corporation” partnership structure was to reduce tax, notwithstanding that one of the two tax results achieved by the structure was the claiming of the small business deduction by the corporations.  In reaching this conclusion, the Court provided useful guidance on the legal principles that are applicable in making the factual determination of whether a reduction of tax is one of the main reasons for the separate existence of two or more corporations.  These principles are also likely relevant in determining the main reasons for, or the primary purpose of, a transaction in the context of other provisions of the Act or a relevant tax treaty.