The sixty-second answer
The small business deduction reduces a CCPC's federal tax by 19% of the least of three amounts: active business income earned in Canada, adjusted taxable income, and the business limit. The business limit is $500,000, but subsection 125(2) sets it to nil for a corporation associated with another CCPC unless the group files an allocation agreement. Passive investment income above $50,000 and taxable capital above $10 million grind the limit down under subsection 125(5.1).
A deduction from tax, not from income
The name misleads. This is not a deduction in computing income. Subsection 125(1) permits a subtraction from Part I tax payable, by a corporation that held Canadian-controlled private corporation status throughout the year [1].
The amount is the small business deduction rate multiplied by the least of three figures [1]. That "least of" construction is the whole mechanism, and each of the three is a separate ceiling.
The rate
Subsection 125(1.1) sets the rate and prorates it by days across periods: 17.5% for days before 2018, 18% for days in 2018, and for later days, that proportion of 19% that the days in the taxation year after 2018 bear to the days in the year [1].
For any ordinary year now, the answer is 19%.
The three ceilings
Active business income. Paragraph (a) takes active business income carried on in Canada, plus specified partnership income and specified corporate income, less active business losses in Canada and specified partnership loss [1].
The word doing the work is "active". Investment income is not active business income and does not qualify. This is why a corporation that has wound down its operations but still holds investments loses the deduction even though it remains a CCPC.
Adjusted taxable income. Paragraph (b) takes taxable income, reduced by grossed-up foreign tax credit amounts and by income exempt from Part I tax under another federal statute [1].
The practical effect is that a corporation cannot claim the deduction against income it does not have. A loss year produces no deduction regardless of the other two figures.
The business limit. Paragraph (c) is the corporation's business limit for the year [1], which is the figure everyone actually talks about and the subject of the rest of this article.
$500,000, and the associated-corporation default
Subsection 125(2) states that the business limit is $500,000 unless the corporation is associated in the taxation year with one or more other Canadian-controlled private corporations. Where such association exists, the default outcome is a limit of nil [1].
Nil, not a share. That is a strong default and it is deliberate, because it forces a group to make an allocation rather than each member quietly claiming the full amount.
The escape is subsection 125(3): associated CCPCs may jointly file a prescribed-form agreement allocating percentages among themselves. Each corporation's limit is then $500,000 multiplied by its assigned percentage. If the percentages total more than 100%, every corporation in the group gets nil [1].
The penalty for over-allocating is therefore total, not proportionate. A group that collectively claims 110% does not lose 10%; it loses everything.
And under subsection 125(4), if the group ignores a ministerial demand for an agreement for 30 days, the Minister performs the allocation [1].
When are corporations associated?
This is where owners misjudge their position most often, because association is broader than common ownership.
Subsection 256(1) sets out five tests. One corporation controls the other. Both are controlled by the same person or group. Each is controlled by a person, those persons are related, and one of them holds at least 25% of the issued shares of any class other than a specified class in each. A person controlling one is related to every member of a group controlling the other and holds at least 25% of the other. Or each is controlled by a related group, every member of one group is related to all members of the other, and overlapping members hold at least 25% in each [2].
Two features of that scheme matter in practice. Relatedness on its own is not enough in the (c), (d) and (e) tests; there must also be a 25% equity connection. But "controlled" is not limited to holding a majority of votes. Subsection 256(5.1) extends it to any direct or indirect influence that, if exercised, would result in control in fact [2].
De facto control is a facts-and-circumstances test, and it can associate corporations whose share registers look entirely separate.
The passive income grind
Subsection 125(5.1) reduces the otherwise-determined business limit, notwithstanding subsections (2) through (5), by the greater of two computed amounts [1].
The first is a large-capital reduction driven by taxable capital employed in Canada above $10 million, aggregated across associated corporations where associations exist [1].
The second is the investment-income reduction, computed on the aggregate adjusted aggregate investment income of the corporation and every corporation associated with it, for taxation years ending in the prior calendar year, with the formula anchored at $50,000 [1].
This second one reaches many more small businesses than the first. A corporation that accumulates retained earnings and invests them can grind away its own business limit through investment returns, without any change in its operating business.
There is also an anti-avoidance rule at subsection 125(5.2), treating certain related-but-unassociated corporations as associated for that computation where property is lent or transferred and it is reasonable to consider that one purpose was reducing the investment income figure [1].
Short years
A smaller point that is easy to miss. Paragraph 125(5)(b) prorates the business limit by days over 365 where the taxation year is shorter than 51 weeks [1].
A corporation incorporated partway through a year, or one changing its year end, gets a proportionate limit rather than the full $500,000.
A second reason the deduction matters
The deduction is worth claiming for its own sake, but it also unlocks something else. Subparagraph (d)(i) of the balance-due day definition gives a corporation three months rather than two to pay its balance, and one of its three conditions is that an amount was deducted under section 125 in the current or preceding year [3].
So losing the small business deduction can also cost a month of payment time, on top of the tax.
Characterisation is a bookkeeping question
The determinant that a business actually controls, year to year, is the first ceiling: how much of its income is active business income earned in Canada.
That is a characterisation question, and characterisation is decided by how transactions were recorded. A corporation that reaches year end with a general ledger of loosely-coded entries has to reconstruct the active-versus-passive split from memory, under time pressure, in the two months before its balance is due.
MapleTax avoids that shape of problem by working from records that were coded when they were created. Expenses captured in MapleExpense carry GIFI codes through the year and revenue comes from what MapleInvoice actually issued, so the figures feeding the section 125 calculation are the ones the books already support rather than a year-end reallocation.
For a group of associated corporations the case is stronger still, because the allocation agreement under subsection 125(3) requires knowing each company's position before deciding how to divide the limit - and getting that division wrong by a single percentage point costs the entire group its deduction.