In recent years, we’ve seen a shift in the business world, with many companies opting to hire contractors on a long-term basis instead of offering permanent full- or part-time employment. More recently, some industries have taken this a step further, requiring contractors to incorporate their services through a corporation as a condition of their contracts.
From the hiring corporation’s perspective, this arrangement offers flexibility and can reduce costs like employee benefits, overtime, vacation pay, and payroll source deductions, such as employee income taxes and CPP/EI premiums.
On the other hand, incorporating can offer individual contractors significant tax advantages, including:
- Income tax deferral opportunities
- Lower small business tax rates applicable to Canadian Controlled Private Corporations (CCPCs) earning active business income of $500,000 or less
- Numerous business expense deductions
- Income splitting options, though these are subject to TOSI rules
- Lifetime capital gains tax exemption
- Succession and estate planning
While this setup can be mutually beneficial, it also comes with specific tax obligations, especially for those contractors who offer services to just one organization. The Canada Revenue Agency (CRA) has been increasingly vigilant about scrutinizing incorporated contractors, often classifying them as Personal Services Businesses (PSBs).
What is a Personal Services Business (PSB)?
The CRA’s PSB rules, outlined in the Income Tax Act subsection 125 (7), aim to prevent individuals who would otherwise be considered employees from incorporating solely to take advantage of corporate tax efficiencies. These rules ensure that the relationship between the parties is genuinely that of a contractor/client rather than an employee/employer.
A PSB is characterized by:
- An individual rendering services on behalf of a corporation (an “incorporated employee”)
- The incorporated employee or any related person directly or indirectly owning 10% or more of the issued shares of any class of the corporation or of any related corporation (a “specified shareholder”)
- The incorporated employee being considered an officer or employee of the client if not for the corporation’s existence
- The incorporated employee not employing more than five full-time employees
- Services not being provided to an associated corporation
The corporate tax rate for PSB income is 33% federally and 8% provincially in Alberta (2021 rates), resulting in a combined tax rate of about 41%.
Determining whether a contractor relationship qualifies as a PSB often depends on the specific facts of each case. The CRA’s assessments have evolved through case law, which helps establish whether an individual is an employee or an independent contractor.
Factors Considered in PSB Determination
The CRA uses several factors to determine whether an individual is an employee or an independent contractor:
- Degree of control the client has over the contractor’s activities
- Tools and equipment provided by the client
- Whether the contractor’s services are integral to the client’s business
- The contractor’s ability to hire subcontractors
- Whether the contractor has the opportunity for profit or risk of loss
Recent tax court cases have shown that contractors whose businesses were deemed to be PSBs often lacked certain elements that would typically characterize a contractor-client relationship, such as:
- Marketing efforts, written agreements, and invoicing by the contracting corporation
- Registration and collection of GST on services provided
- Control over their own schedule, with contractors following the client’s schedule instead
- A compensation structure similar to that of full-time employees
- Dedicated office space provided by the client
- The contractor being an integral part of the client’s business
- Inability to provide similar services to other clients
- Use of the client’s tools and equipment
- Lack of financial risk, such as liability for project overruns
- Inability to hire and manage outside contractors
- Limited independence in performing services, requiring full-time presence
Determining whether you’re classified as a Personal Services Business can have significant tax implications. Just having a contractual agreement and a corporation doesn’t guarantee you’re free from being classified as a PSB. The CRA looks at the entire situation, considering various factors.
If you’re operating as an incorporated contractor and your circumstances align more with those of an employee, it might be time to reassess your corporate structure. If incorporating is unavoidable due to contract requirements and you find yourself classified as a PSB, consider paying all corporate earnings as salary to avoid the higher PSB tax rate. Remember, salary is only deductible when actually paid, so accrued salary isn’t deductible.
Navigating these complexities requires expert tax guidance. Understanding the potential tax consequences is crucial to making informed decisions for your business.
Looking for tailored advice on your business structure? Book a free meeting with a Business Link advisor to discuss your options and ensure you’re on the right track.
Sources:
Government of Canada. Personal Services Business (PSB) Pilot [2024].
Government of Canada. Corporation Income Tax [2024].
