Is your company running the risk of being classified as a personal services business by Canada Revenue Agency ?
In the previous article on Employee vs Contractor, we discussed the benefits for the payer to reclassify the employee as an independent contractor, without interposing a corporation; however, it should be noted that the existence of the corporation mitigates risk for the payer.
From the payers point of view, the existence of the corporation eliminates the risk that the payer may be reassessed for uncollected and unremitted CPP contributions and EI premiums, plus penalties and interest, and there is less risk that the individual will be a deemed employee for workers’ compensation, labor relations, or employment standards purposes.
Since the payer does not realize any of the potential costs of incorporation, it is unsurprising that payers often demand that individuals incorporate as a condition precedent to being hired.
Consequently, it is a common practice for individuals to contract out the services of the principal shareholder of the corporation to one or more businesses by setting up their own corporations. The primary advantages to this arrangement from an income tax perspective, are lower corporate income taxes, ability to claim business expenses and the flexibility to pay salaries or dividends to family members, to name a few.
However, it is important to note that incorporation does not automatically make the individual shareholder of the incorporated entity an independent contractor.
The CRA will apply the four tests discussed in the previous article on employee vs contractor, and if the conclusion is that the shareholder is a combined employee, the business carried on by the corporation will be considered a Personal Services Business (PSB), which will result in significant adverse tax consequences.
In the oil and gas industry, it is common practice for oil and gas producers to hire independent contractors, through their corporations, to perform oilfield service work. Recently, the CRA has reassessed many of these corporations as being personal services businesses (PSBs), thus disallowing the small business deduction and the majority of business expenses.
If your corporation falls under the definition of personal service business, you might not even be aware of your status and may have filed your tax returns incorrectly and also might have claimed the small business deduction. If audited by CRA, this could result in significantly increased taxes owing as well as associated penalties and interest. Furthermore, you might have received a portion of your income from dividends from your corporation, and if you claimed the small business deduction, these dividends were likely ineligible dividends. If many years down the line, CRA ascertains that your corporation was a personal service business, the re-characterization of the corporation’s income would mean that the corporation could have issued eligible dividends instead, thereby resulting in a lower tax rate to you as a shareholder. However, the CRA’s policy is usually to disallow past ineligible dividends to be re-characterized as eligible dividends.
As a result, the corporation would have amounts in its General Rate Income Pool (GRIP) which can be used for declaring eligible dividends in the future which is less favorable tax planning strategy than if the qualified dividends had been claimed from the beginning.
In the light of the aforementioned discussion, you should reconsider any planning that involves the use of a corporation to earn income from a Personal Services Business. If you provide or receive independent contractor services through a corporation, you should review all the contracts and terms of engagement and reassess the characterization of the independent contractor’s employment.
If it is still not entirely clear whether your corporation is operating a personal service business, it is essential to get a professional analysis and determination to identify the best course of action.
If there is a risk that your corporation is a personal service business and that the tax returns had been misfiled in the past, the voluntary disclosure may be an attractive option. If a taxpayer makes a disclosure through the voluntary disclosures program and is accepted, the CRA will provide relief based on which one of two possible streams your situation falls under.
Under the general stream, the CRA will waive all penalties and provide partial interest relief of 50% for tax years older than the most recent three years. On the other hand, if you are accepted under the limited stream, the CRA will only waive the gross negligence penalty (worth 50% of the tax owing) and guarantee that there will be no criminal prosecution but offer no interest relief and no relief of other penalties such as the late filing penalty.
The obvious way to ensure that your small corporation is not deemed to be a personal services business at some point is to ensure that your corporation has more than five full-time employees throughout the year and/or that your corporation only provides its services to an associated corporation, as these are the two things that the Canada Revenue Agency lists as clear evidence that a small corporation isn’t a personal services business. Even if you don’t have five, having any employees is the help and something that the CRA considers when determining a small corporation’s status.
If you are considering the incorporation of services or are entering into a work arrangement that requires you to incorporate, contact Cloudiverse CPAs to discuss whether the Personal Service Business rules could apply and how we can help you to produce the best tax strategy to fit your situation.
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