In other words, if CRA determines an incorporated individual working as a contractor is really just an employee of the company they are working for, they would be deemed a personal services business. This designation comes at a great cost to the individual.
It is important to note the PSB designation is a year-by-year label. Hypothetically, you can be labeled a PSB for the 2015 taxation year, a proper corporation for 2016, and a PSB again in 2017. Each year is judged on the merits of the corporation’s activities in that taxation year. Are you confused? You should be, because it can be confusing, which is why you should always consult your tax advisor before incorporating your business.
One of the major disadvantages of a PSB is that a regular employee cannot claim the same expenses as a small business. The second disadvantage is you would lose your eligibility for the Small Business Deduction (SBD). In Ontario, losing the SBD means your tax rate increases from 15.5 per cent to 25.5 per cent. You would also lose your 13 per cent general rate reduction, causing you to be taxed at 38.5 per cent.
Following is a chart that shows the tax implications of being deemed a personal services business versus a regular corporation.
The bottom line is, the penalties are severe, so speaking to your accountant about ways to ensure you avoid the PSB label is very important. You can plan ahead, as well, if you and your accountant believe being deemed a PSB is plausible in a specific taxation year. You can pay all income out as a salary in order to prevent the punitive additional taxes from being assessed. However, any other expenses would be denied and be subject to the 38.5% tax rate.
The law states you will be declared a PSB if without the existence of the corporation, an individual, or a relative performing service on the corporation’s behalf, could reasonably be considered an employee of the would-be-employer. The exceptions are if the corporation employs more than five full-time employees over the course of the year, or if the services are provided to an associated corporation.
This four pronged test is used to determine if someone is a contractor or an employee. In order to be regarded a contractor, the following must be considered:
This has become a major problem in Ottawa over the last several years because, as a government town, IT professionals and consultants are encouraged by some staffing agencies to incorporate in order to be hired by the government. It’s a “Catch-22” in that if they do not incorporate, they are told they would not be hired; however, when they do incorporate, the scope of the work may appear, in the eyes of CRA, to be no different than that of a regular employee and they can face hefty tax consequences.
You incorporate because you trust that the staffing agency and the government would not put you in such a precarious position. The importance of discussing the situation with your accountant prior to incorporating cannot be overstated.
Recent Cases:
A case recently heard in the Tax Court of Canada was particularly troubling. The taxpayer’s tax liabilities for the taxation years 2007-2009 were reassessed after the company was declared a personal services business for those years. The operating expenses for those years, totaling just under $30,000, were disallowed as a result of the PSB label. The company was also denied the Small Business Deduction.
The conclusion was that were it not for the existence of the incorporated company, the taxpayer could be reasonably regarded as an employee of CRA and a crown corporation for which he was contracted during this time. At no point was the taxpayer working for both organizations simultaneously.
This is why the case is so troubling. Because the government, be it directly or indirectly, encourages certain professionals to incorporate before being hired, the taxpayer may have felt he had no choice but to incorporate. Basically, he did what seemed necessary in order to secure a position with CRA. In return CRA, his employer, turned around and labeled him a PSB, costing him heavily.
In other past tax cases, the corporation being deemed a PSB could argue their case relying heavily on the intent, which is what the taxpayer above argued. He cited the intent precedent set from Royal Winnipeg Ballet v. M.N.R. in his appeal. However, the judge cited the test introduced in Wiebe Door Services Ltd v. M.N.R from 2001, believing it to be more relevant.
Note also that being designated as a PSB would affect the contractor retaining your “corporate” services. They would be responsible for related payroll deductions, WSIB, EHT, statutory holiday and vacation payments.
Rulings in cases 609309 Alberta Ltd. v. Canada (2010 TCC) and 1166787 Ontario Ltd. v. Canada (2008 TCC) show that courts did not view intent as a relevant consideration in personal services business cases, and that the four pronged test is more applicable. The intent still matters, but cannot be solely relied upon. The intent is just another consideration along with the four pronged test.
Lessons Learned
The positive that comes from this new emphasis on PSBs is now we have a better understanding of what measures need to be in place for one not to be labeled as such. The clarity created by the aforementioned cases gives you all the more reason to speak with us about ensuring you maintain your small business classification and avoid being deemed a PSB by CRA.