As devastating as the global pandemic has been, it did create a new way of thinking for businesses large and small. Remote work became common, Zoom calls the norm and businesses of all sizes shifted their workflow, both to accommodate lockdown restrictions and the evolving work preferences of their employees. At the same time, a wave of solopreneurs took flight, many of them operating personal services businesses (PSB).
From truck drivers and administrative assistants to independent consultants, the concept of remote work provided these budding business owners with a newfound freedom. Organizations enjoyed a similar benefit as they engaged an increasing number of self-employed individuals, thereby relieving their balance sheet of the costs associated with employing full-time team members. It wasn’t a new trend, per se, but it gained momentum amid the uncertainty of the pandemic.
Many of these individuals and sole proprietors chose to incorporate their personal services businesses as they engaged clients, serving them either part-time or exclusively. It’s that last part that’s raised the ire of the Canada Revenue Agency, resulting in a tax compliance education and information-collection campaign targeting personal services businesses and the organizations that use them.
Employee vs. self-employed or incorporated service providers
At issue in situations where the personal services provider is an individual, is their employment status. Although they—and the organization that engages them—may consider themselves to be self-employed, the CRA may rule otherwise, determining that they meet the criteria to be considered employees. This could result in a denial of expense deductions to the individual (the ‘payee’) and a raft of tax liabilities for the organization (the ‘payer’) including CPP, EI and income tax withholdings and related non-compliance penalties. The payee faces similarly onerous liability exposure.
When the personal services business is a Canadian-controlled private corporation, however, the payee could face significant tax risk if they treat their income as being eligible for the small business tax rate, rather than paying income tax at the appropriate marginal rate. A personal services business is taxed at a much higher rate than a corporation eligible for the small business deduction. In provinces such as Ontario, the combined federal and provincial tax rate on personal services business income is a whopping 44.5 per cent, compared to 12.2 per cent for corporations eligible for the small business rate.
The tax hit on personal services business income could be as high as 66.3 per cent when paid as a dividend to an individual in Ontario’s top tax bracket. In addition, corporations earning personal services business income can only claim a limited slate of deductions including salary paid to an incorporated employee, their employment benefits, expenses that would be allowed if they were a commissioned salesperson and legal expenses related to revenue collections.
The payer faces no tax liability in this scenario (assuming they are not an associated corporation to the incorporated personal services business).
The CRA uses four tests to determine when personal services business tax classification rules should apply, including: Whether the service provider is also a shareholder of the corporation (owning at least 10 per cent of its shares); if the corporation’s income is generated from their services; if the corporation employs fewer than five full-time employees in a given tax year; and if the incorporated individual would be considered an employee of an organization to which they were providing services, if that individual was not incorporated.
Take steps to mitigate risk
If your organization regularly engages an individual or corporation to provide personal services, it’s important to be proactive and determine early on whether the individual you’re engaging could, in fact, be considered an employee. Remember that it is possible to request a determination on the matter from CRA. With that documentation in hand, your organization could carry on its relationship with the personal services provider and rest easy knowing that you won’t face tax compliance issues. The risk, however, is that such a request could invite greater CRA scrutiny in other areas, including your arrangement with other service providers.
Comprehensive documentation can also be used as evidence that you had no intention of engaging in an employment relationship with the personal services provider—although it may not mitigate the risk of a CRA audit in the first place. It’s also important to note that even if a personal services business is incorporated, your organization could still face risk if the corporation is not active. In that case, it’s best to refer to the personal services business test outlined above and, as always, contact your Chartered Professional Accountant or lawyer for advice.
Armando Iannuzzi, Co-Managing Partner
For more information on the CRA’s review of personal services businesses, contact a member of our team today.