Over the past few years, Alberta energy and construction sectors have seen a sharp increase in the number of incorporated contractors. The benefits of incorporating provide incentive to many hard working individuals- but what are the risks? This article will review the reasons individuals incorporate, the risks, and how you can reduce your chances of being offside when it comes to filing your taxes.
Benefits to Hiring Incorporated Contractors vs. Employees
Large companies in the energy and construction industries have been steadily replacing employees with incorporated contractors in an effort to reduce costs. The savings come in many forms such as the elimination of CPP and EI employer contributions, WCB and other insurances, health benefits, and retirement and severance packages. For these companies, the cost savings from reducing their workforce is enormous. It also allows more freedom for these companies to hire contractors as needed, eliminating the time, money, and paperwork that goes with the hiring, supervising, and laying off of employees. In industries that are tied so closely to the market, there is a lot of flux in the employment needs of these companies and hiring contractors is a much simpler way to have “as-needed” labour.
For the individuals, incorporating a one-person company often seems attractive due to the perceived increase in freedom, additional eligible expenses that are not usually available to an employee, and the lower tax rate applied to small businesses in Canada (Canadian Controlled Private Corporations). In addition, in many cases companies will offer a premium to incorporated contractors as an additional incentive, paying them a higher wage than their employed counterparts.
“Personal Services Business”- What is it?
Section 125(7) of the Income Tax Act describes it as follows:
“personal services business carried on by a corporation in a taxation year means a business of providing services where
(a) an individual who performs services on behalf of the corporation (in this definition and paragraph 18(1)(p) referred to as an “incorporated employee”), or
(b) any person related to the incorporated employee
is a specified shareholder of the corporation and the incorporated employee would reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of the corporation, unless
(c) the corporation employs in the business throughout the year more than five full-time employees, or
(d) the amount paid or payable to the corporation in the year for the services is received or receivable by it from a corporation with which it was associated in the year;”
In layman’s terms, it refers to a situation where an incorporated contractor would be considered an employee, given all relevant factors, if it wasn’t for the fact that they were operating through their corporation. Just because you have a “company” it does not automatically make you an independent contractor. For example, many employees choose to incorporate and then stay on with the same company- just switching from being on payroll to being a supplier of services. Other times, a newly formed corporation will seek out work but will work for a company in a context very similar to an employee. These situations are growing in popularity in Alberta and are increasingly the focus of scrutiny by the CRA.
Personal Services Business- What does it mean to me, the contractor?
Because the Income Tax Act considers PSBs to be essentially “incorporated employees” it seeks to equalize the tax treatments of both parties. As such, PSBs face certain restrictions not applied to other small businesses (CCPCs):
1) Limited Eligible Deductions– Instead of being able to deduct a wealth of expenses like other corporations, ITA 18(1)(p) restricts PSBs to the following deductions:
(i) the salary, wages or other remuneration paid in the year to an incorporated employee of the corporation,(ii) the cost to the corporation of any benefit or allowance provided to an incorporated employee in the year,
(iii) any amount expended by the corporation in connection with the selling of property or the negotiating of contracts by the corporation if the amount would have been deductible in computing the income of an incorporated employee for a taxation year from an office or employment if the amount had been expended by the incorporated employee under a contract of employment that required the employee to pay the amount, and
(iv) any amount paid by the corporation in the year as or on account of legal expenses incurred by it in collecting amounts owing to it on account of services rendered
The rationale is that the incorporated contractor or incorporated “employee” should not be able to receive an advantage over employed individuals in the same positions. It ensures everyone is taxed at a similar rate and receives equal treatment, no matter which path they choose.
2) Income earned by the PSB is deemed not to be Active Business Income. ABI is the regular income a corporation earns from selling goods and services, basically it’s income it has to work for. Unlike income from property and investments that face a higher corporate tax rate, active business income is treated to a small business deduction to the corporate rate. Federally, that means the tax rate is reduced from 28% to 10.5% in 2016 (this includes the general rate reduction and small business deduction). However, since Personal Services Businesses are considered not to have active business income, they are not eligible for these deductions. As such, they are subject to the full 28% federal corporate tax rate. As of January 1, 2016 income earned in a PSB faces an increased tax rate of 33%. This generally renders any previous tax advantage of operating through a corporate form obsolete.
Factors in Determining Status as
Independent Contractor or “Incorporated Employee”
Recent court cases have created precedence which the CRA uses to help determine the status of a corporation on a case by case basis. Generally, four main factors are considered to help determine whether an individual should be considered an independent contractor or an employee (and thus a Personal Services Business).
1) Control- Does the payor or the contractor decide what and how the work will be done? Can the contractor refuse certain jobs?
2) Ownership of Tools- Does the payor or the contractor provide the tools used in the work? Has the contractor made a significant investment in tools and is responsible for their maintenance, repair, and insurance?
3) Chance of Profit and Risk of Loss- Will the contractor make a profit or loss, or is the contractor paid a wage in a structure similar to an employee?
4) Integration- Is the contractor essential for the operation of the payor’s business or an integral part of that business?
The CRA also considers other factors such as whether or not the contractor may hire subcontractors or replacements to do the work in their stead. There is a pretty comprehensive discussion of situations that constitute one status or the other available on the CRA website at http://www.cra-arc.gc.ca/E/pub/tg/rc4110/rc4110-e.html#resp_invest_man.
It is important to note that one or two of these factors alone does not put a contractor in one category or the other. Rather, it is the combination of facts from all the considerations listed above that both the CRA and the courts review to determine the status of a contractor. Though agreements and written contracts may help to show the intentions of the parties, the courts have recently rules that intention does not override fact. Secondary factors may also affect the determination and will be considered on an individual basis.
Risks to Incorporated Contractors
The main risk to contractors filing as a regular CCPC with active business income is the reassessment of corporate tax filings by Canada Revenue Agency. If it is determined that the business is in fact a PSB the reassessment will result in taxes owing due to the claiming of ineligible expenses and a reduced tax rate not available to Personal Services Businesses. For most contractors, this would be a financial hit they could not afford.
I’m an Incorporated Contractor- Now What?
If you currently provide services in a corporate structure, similar to that described in this article, you may be feeling a little nervous. This is a shock to a lot of contractors who weren’t aware of the distinction when they decided to incorporate. While the desire to save money and taxes is a common goal, the priority should be to do so within the parameters set out in the Income Tax Act. If you are concerned that you fall within this gray area, or are pretty certain you would be considered a PSB, I would encourage you to speak with your tax accountant to help determine the correct status of your corporation. The CRA does provide some good reading material to help you decide if you would be considered an independent contractor or an employee, which you will find links to below this article. You can also request a ruling by CRA here: http://www.cra-arc.gc.ca/E/pbg/tf/cpt1/README.html
Take the time to talk to your professional tax accountant or tax lawyer about your intentions with the corporation. I think a lot of the time the reason people get caught off guard with this issue is because they incorporate on their own instead of through an accountant or lawyer and miss out on some really important information in the process. With the proper guidance, you may also be able to structure your business in a way that it will not be considered a PSB.
Since many large companies in the industry have shifted focus to hiring contractors instead of employees, some individuals must incorporate to get the jobs they want. It may be unavoidable for you to be a Personal Services Business, but at least you will know ahead of time and not make the mistakes others often make by deducting expenses that will be deemed ineligible in a future audit. As long as you are doing it right off the start, you have nothing to worry about!
Is It worth being a Personal Services Business?
It really depends on your individual situation. Do you need to be incorporated in order to get the job you want? For most individuals, there is little incentive for tax deferral within a PSB given the high corporate tax rate, but other factors may still make it a beneficial structure for you. Don’t make this decision lightly, get the advice you need!
-Candy M. Davis, CPA, CGA
Davis Accounting & Tax Professional Corporation
CRA “Employee or Self Employed?” http://www.cra-arc.gc.ca/E/pub/tg/rc4110/rc4110-e.html#resp_invest_man
CRA “Canada Pension Plan and Employment Insurance Explained- Workers engaged in construction – Employees or self-employed workers?” http://www.cra-arc.gc.ca/tx/hm/xplnd/cnstrctn-eng.html
Other great articles you may wish to check out:
“Incorporated Contractors: how to avoid the Canada Revenue Agency’s nasty double-taxation classification” By Brandon Holden, Burnet, Duckworth & Palmer LLP
“OLD NEWS, NEW TREND: PERSONAL SERVICES BUSINESSES ON THE RISE” by Sophie Virji, Associate with the Calgary office of Dentons Canada LLP
“Canada: Are You Walking Into A Tax Disaster – Incorporated Contractors & Taxes (Part I)” by Kenneth Keung at Moodys Gartner Tax Law LLP