How does passive income grind the small business deduction, and how much business limit is left?
In 2026, a CCPC's $500,000 federal business limit shrinks by $5 for every $1 of adjusted aggregate investment income (AAII) above $50,000, and hits zero at $150,000. AAII is the associated group's total for taxation years that ended in the prior calendar year, and only the greater of this and the taxable capital grind applies.
How much business limit is left at each AAII level
The grind is paragraph 125(5.1)(b) of the Income Tax Act. The reduction is D/$500,000 × 5(E − $50,000), where D is the business limit before the grind and E is the group's AAII laws-lois.justice.gc.ca. With the full $500,000 limit, that's $5 of limit gone for each $1 of AAII over $50,000.
| AAII (prior year, whole group) | Reduction | Business limit left |
|---|---|---|
| $50,000 or less | $0 | $500,000 |
| $60,000 | $50,000 | $450,000 |
| $75,000 | $125,000 | $375,000 |
| $90,000 | $200,000 | $300,000 |
| $100,000 | $250,000 | $250,000 |
| $125,000 | $375,000 | $125,000 |
| $150,000 or more | $500,000 | $0 |
The rule applies to taxation years that begin after 2018 canada.ca. The grind cuts the limit, not the investment income's own tax. Active business income above the reduced limit is taxed at the general rate federally.
Which year's AAII counts, and whose
It isn't the current year's investment income. For a taxation year ending in a calendar year, E adds up the AAII of the corporation and every corporation it's associated with at any time in that year, for each of their taxation years that ended in the preceding calendar year.
So a client with a June 30, 2026 year end looks at its own year ended June 30, 2025, plus an associated Holdco's year ended December 31, 2025 laws-lois.justice.gc.ca. Investment income your client earns now grinds next year's limit, which gives you a year to plan around it.
The D/$500,000 factor matters when the group shares the limit. If Opco is allocated $300,000 and the group's AAII is $98,000, Opco's reduction is $300,000/$500,000 × 5 × $48,000 = $144,000, leaving $156,000. The CRA's own examples run the same arithmetic on the group total canada.ca. For how association works, see associated corporations.
What goes into AAII and what stays out
AAII starts from aggregate investment income in subsection 129(4) laws-lois.justice.gc.ca, then the definition in 125(7) changes four things
laws-lois.justice.gc.ca.
| Item | In AAII? | Why |
|---|---|---|
| Interest and rents from property | Yes | Income from property |
| Portfolio dividends (public companies, unconnected corps) | Yes | Only connected corp dividends are carved out |
| Taxable capital gains on investments | Yes | Net of allowable capital losses of the same year |
| Gains and losses on active assets | No | Excluded by the 125(7) rewrite |
| Dividends from connected corporations | No | Excluded under the 186(4) test |
| Net capital losses carried over (111(1)(b)) | No deduction | The 125(7) version drops that line |
| Specified investment business income or loss | Yes | Added back in by 125(7) |
| Life insurance policy amounts in income | Yes | Unless already counted |
Two edges trip people up. The net capital loss carryforward still cuts taxable income, but it does nothing for AAII. And capital losses only offset capital gains: a year with a net capital loss and $70,000 of interest still has $70,000 of AAII. An active asset is property used principally in an active business carried on primarily in Canada by the corporation or a related CCPC, plus qualifying shares and partnership interests.
The CRA computes AAII on Schedule 7 of the T2 canada.ca.
Worked example: an Opco and Holdco group
Opco and Holdco are associated, and Opco is allocated the full $500,000. Opco has a June 30 year end and Holdco has a December 31 year end. You want Opco's business limit for its year ending June 30, 2026.
| AAII source (years ended in 2025) | Amount | Counts? |
|---|---|---|
| Opco, year ended June 30, 2025: interest on surplus cash | $8,000 | Yes |
| Holdco, year ended Dec. 31, 2025: bond interest | $20,000 | Yes |
| Holdco: dividends from public company shares | $30,000 | Yes |
| Holdco: taxable capital gain on an ETF sale | $40,000 | Yes |
| Holdco: $60,000 dividend from Opco | $60,000 | No, connected |
| Holdco: $15,000 net capital loss carryforward applied | ($15,000) | No, ignored |
| Group AAII | $98,000 |
The excess is $98,000 − $50,000 = $48,000. The reduction is $500,000/$500,000 × 5 × $48,000 = $240,000.
Now the taxable capital side. The group has $12 million of taxable capital employed in Canada, so that grind is $500,000 × (0.225% × $2,000,000) ÷ $90,000 = $25,000. The greater reduction wins: $240,000. Opco's business limit is $500,000 − $240,000 = $260,000.
If you had wrongly deducted the $15,000 carryforward, you'd get AAII of $83,000, a $165,000 reduction and a $335,000 limit. That's $75,000 of active income taxed at the wrong federal rate.
The taxable capital grind: only the greater applies
Subsection 125(5.1) reduces the limit by the greater of paragraph (a), the taxable capital grind, and paragraph (b), the passive income grind laws-lois.justice.gc.ca. The two never stack.
Paragraph (a) is A × B ÷ $90,000, with B equal to 0.225% of taxable capital employed in Canada over $10 million. B reaches $90,000 at $50 million, so the limit is gone there. With a full $500,000 limit, each $1 million over $10 million costs $12,500. A group at $20 million of taxable capital loses $125,000 of limit, so AAII only bites once it passes $75,000.
The CRA's 2018 overview still quotes the old $10 million to $15 million range. The Act now runs to $50 million, a change Ontario's page dates to taxation years beginning on or after April 7, 2022 ontario.ca.
Ontario and New Brunswick don't grind provincially
Ontario does not parallel the federal measure that phases out the $500,000 limit for passive income ontario.ca. An Ontario CCPC ground to zero federally still gets the Ontario lower rate on up to $500,000 of active business income, subject to the taxable capital phase out and any limit assigned away. Ontario cut that lower rate from 3.2% to 2.2% effective July 1, 2026. See Ontario corporate tax rates.
New Brunswick wrote the opt out into its own Income Tax Act. Subsection 57(2.6) deems the amount under federal paragraph 125(5.1)(b) to be zero for the period starting January 1, 2019 laws.gnb.ca. The province's table shows a 2.5% small business rate on a $500,000 limit for 2025, the latest year listed
www2.gnb.ca.
For a client in either province, compute two business limits: the ground federal one and the provincial one. Your software should carry them separately, but check that it does.
Sources
New Brunswick Income Tax Act, subsection 57(2.6)laws.gnb.ca
New Brunswick: corporate income tax rateswww2.gnb.ca
Does a net capital loss carryforward reduce AAII?
No. The 125(7) definition rewrites the capital gains piece without the paragraph 111(1)(b) deduction, so a carryforward applied in the year still lowers taxable income but leaves AAII unchanged laws-lois.justice.gc.ca.
Do dividends Holdco receives from Opco count toward AAII?
Not when the two are connected under the 186(4) test, which covers the usual Opco and Holdco setup. Portfolio dividends from public companies and other unconnected corporations do count.
Can my client dodge the grind by moving investments to a related corporation that is not associated?
Not safely. Subsection 125(5.2) deems the two corporations associated for the grind if one lends or transfers property to the other and one reason was to reduce AAII laws-lois.justice.gc.ca.
Does the grind apply in a short taxation year?
Yes, and the starting limit is prorated too. The $500,000 limit is prorated for a year under 51 weeks, and the grind then scales through the D/$500,000 factor canada.ca.
General information for the tax year shown, not advice for a specific client. Confirm the facts before you file or remit.