For years, businesses have hired contractors rather than employees to fulfill their short-term needs. More recently, businesses in many areas of the economy have taken this practice a step further — hiring contractors on a long-term basis instead of offering permanent employment. In some industries, the hirer will often require these individual contractors to incorporate their services. This reduces the hirer's overall hiring costs and eases the administrative burden of dealing with employees, including complying with source deductions and payroll taxes.
Individual contractors need to understand the income tax implications of these long-term contract arrangements, especially in cases where they are offering their services to just one hirer. In this article, we will explore what this could mean for you and take a close look at the key issues by way of a case study.
Case Study: An 18-Month Contract
Ellie White worked for an in/en-ca/services/tax/domestic-tax-services/income-tax-accounting/surance company as an IT employee in Manitoba for the past 12 years. Last month, Ellie resigned from her position, and is now looking for a similar job in Ontario. Recently, an Ontario company (Techco), offered her an 18-month contract position with full-time hours. The contract comes with the stipulation that she offers her services through a corporation. Specifically, Techco proposed that Ellie set up a company (Ellco) of which Ellie will be the sole shareholder and sole employee. Ellco will bill Techco for her services, and in turn, Ellco will receive the funds and either retain them in the company or, alternatively, disburse them to Ellie. Ellie has approached her advisor at BDO Canada LLP to ask for tax advice before she accepts the contract and agrees to its terms.
Why does Techco want to set up a contract for services through a corporation?
One reason that Techco might want to set up a contract for services with a corporation instead of directly with Ellie is to make it clear to both Ellie and the tax authorities that she is a contractor to the company and not an employee of Techco. If Ellie is not an employee, Techco will not be obligated to pay employee benefits, nor will Techco be required to deduct and remit payroll source deductions to the Canada Revenue Agency (CRA), such as employee income taxes and Canada Pension Plan (CPP) and Employment Insurance (EI) premiums.
Will Ellco or Ellie pay tax on the contract payments?
Provided the contract is signed and the terms are agreed to, Ellco will be considered a business and will pay corporate income tax on the contract payments, after deducting eligible expenses. Ellie will be an employee of Ellco, and the payment of salary or wages to Ellie will be a deduction to Ellco and taxable as income to Ellie personally.
What tax rate will apply to Ellco's earnings?
As Ellco is a Canadian company wholly owned by a Canadian resident individual (Ellie), it is classified as a Canadian controlled private corporation. In this case, assuming that Ellco is operating in Ontario and not in any other jurisdiction, three possible tax rates could apply to business income earned by Ellco in 2022:
- The small business rate (SBR) of 12.2 percent, applicable to active business income of $500,000 or less.
- The general business rate (GBR) of 26.5 percent.
- The rate applicable to a personal services business (PSB) of 44.5 percent.
Income from a PSB is not eligible for the small business deduction or for the general corporate rate reduction. This means that income from a PSB will be taxed at significantly higher levels than regular corporate income, or at 44.5 percent in Ontario in 2022. As well, if a corporation is considered a have a PSB, tax deductions are restricted.
In this case, assuming that Ellco will have less than $500,000 of income in the year, either the SBR of 13.5 percent or the PSB rate of 44.5 percent will apply, depending on whether a PSB exists. Note that the rates shown are Ontario tax rates; different rates will apply in other provinces or territories.
What is a personal services business?
The PSB rules are set out in the Income Tax Act. Generally, they will apply if the following conditions are met:
- Income of the business in the corporation is from services rendered by an individual on behalf of the corporation, referred to as an “incorporated employee.”
- The incorporated employee rendering the services, or a related person, is a specified shareholder. The term specified shareholder is defined in the Income Tax Act, and generally refers to a person who (together with non-arm's length persons) owns—directly or indirectly, at any time during the year—10% or more of the issued shares of any class of the corporation or of any related corporation.
- But for the existence of the corporation, the incorporated employee might reasonably be regarded as an officer or employee of the hirer.
- Throughout the year the corporation does not employ more than five full-time employees in the business.
- The services of the corporation are not being provided to an associated corporation.
In the majority of cases, the most difficult condition to meet is the third—the determination as to whether or not there is an “incorporated employee.” Essentially, this condition provides that when a corporation is interposed between the two parties in what one would normally consider an employee-employer relationship, the employee becomes an incorporated employee.
How would Ellie determine if there is an employment relationship with Techco?
Determining if an employment relationship exists in this type of scenario can be quite difficult. The issue of whether a particular individual is an incorporated employee is a question of fact that must be reviewed on a case-by-case basis. A significant body of case law has developed around this issue. The CRA employs several tests that have evolved from court decisions to determine whether an individual is an employee or an independent contractor. These tests consider:
- The degree of control exercised by the hirer over the duties the contractor performs.
- Whether or not the contractor must carry out the work personally or if they can hire or subcontract the work.
- Whether or not the contractor has any capital investment in their business or a business presence.
- Whether or not the hirer provides the tools to be used to perform the services.
- Whether the contractor has a chance of profit, as well as the risk of loss.
The CRA will also consider the intention of the hirer and the individual providing the services when a working arrangement is entered into. In this regard, the CRA will examine any evidence, including a written agreement where one exists, to decide the parties' intentions.
In our Tax Bulletin, Self-employment: is it for you?, we provide a more detailed analysis of the factors to be considered if you are trying to determine if a particular relationship is one of employer- employee, or one of hirer and independent contractor. Note that we have not been provided with enough facts in this case to determine if Ellie could be considered an independent contractor.
If, upon examination of the facts, it was determined that if Ellco did not exist Ellie would be an employee of Techco under the common law tests, then Ellco would have a PSB in respect of Ellie's services. This in turn would result in the high corporate income tax rate of 44.5 percent applying to the income earned through Ellco. Remember that where the PSB rules apply, income from the PSB will not be eligible for the small business deduction, and deductions claimed by the corporation against PSB income will be restricted as discussed below.
Although the PSB rules can affect how income will be taxed in Ellco, they will not change the characterization of expenses for Techco. Techco will have made a payment under contract for services to another corporation, and this is the case even if the PSB rules apply to the income received in Ellco.
What else does Ellie need to know about the Personal Services Business rules?
The PSB rules were introduced into income tax legislation in order prevent incorporated employees from taking advantage of the lower corporate tax rates that apply when the small business deduction is available. The higher tax rate on PSB earnings is designed to discourage employees from incorporating their services.
If the facts of the situation indicate that Ellco is a PSB, then it is generally advisable to pay out the earnings of Ellco to Ellie in the form of a salary. Wages paid will be allowed as a tax deduction and will be taxable to Ellie as employment income. Under the PSB rules, however, accrued salary is not deductible; salary and wages are only deductible for tax purposes when they are actually paid.
Paying out the contract earnings as salary avoids another issue with the PSB rules as the deductions claimed by a PSB are restricted. Generally, deductions are limited to salaries paid and employment benefits provided to the incorporated employee, and certain other specified expenses. These include amounts that are incurred by the corporation in connection with the selling of property or the negotiating of contracts, if those amounts would have been deductible by an employee, and legal expenses incurred by the corporation in collecting amounts owing for services rendered.
Keep in mind that if instead of paying a salary, the earnings are kept in Ellco and paid to Ellie as a dividend, this will be an expensive option. There will be corporate tax at 44.5 percent applied to the income earned by Ellco, and then tax will be applied on the dividend received by Ellie. While the rate of tax paid on the dividend will depend on Ellie's other income and the amount of the dividend, the total tax paid (corporate tax and personal tax on the dividend) will be much higher than if the earnings were paid out to Ellie as a salary.
What else does Ellie need to know about incorporating Ellco?
To answer this question, Ellie should consult with a lawyer. At a minimum, incorporating a business will likely require the services of a lawyer, to ensure that it is done properly. This will include a fee for incorporation as well as legal fees. In addition, the corporation will need to register for a business account with the CRA. The business account will be used to keep track of income tax payments and other tax records. The corporation will need to file annual income tax returns, even if the company has no income.
Does Ellco have any withholdings, remittances, or reporting obligations?
A PSB that pays wages or salaries should be aware of their withholding and reporting obligations. If Ellie is not sure if Ellco is a PSB, the best option for Ellco is to pay the contract earnings to Ellie as an employee. Ellie can then deduct any eligible employment expenses incurred on her personal tax return. However, in order to do this, Ellco will need to:
- Register for a Payroll Program account with the CRA.
- Calculate income tax and CPP withholdings on each payment of wages.
- Remit the employer portion of CPP contributions and income tax deducted and Ellie's share of CPP contributions to the CRA on a regular basis.
- Complete and file a T4 slip and T4 Summary, which are due on the last day of February that follows the calendar year that the information return applies to.
- Keep records.
As an employer, Ellco would be responsible for the employer portion of the CPP contributions. Therefore, under the proposed arrangement, payments for both the employer and employee portions of CPP will be funded by the contract payments from Techco. However, as Ellie controls Ellco, there is no obligation for Ellco to fund, or withhold or remit, EI premiums. This means, however, that if Ellco's contract with Techco is terminated, Ellie will not be eligible for EI benefits.
How to tackle the PSB tax burden
Where organizations such as Techco will only contract with a corporation, individuals providing their services through a corporation may well be considered an incorporated employee. In these cases, the PSB rules will apply—which may produce negative tax consequences. If you find yourself in this situation, it is likely beneficial for the corporation to pay out the PSB income as remuneration (as earned) to you, the incorporated employee, and comply with any corresponding payroll and remittance requirements. As you can see from the above discussion, accepting the contract work from Techco with the condition that Ellie incorporate Ellco will create an administrative burden, and some additional costs, that would not be required if Ellie were an employee of Techco.
If you have a corporation that has a PSB, there are ways to mitigate the associated tax costs. However, it would be better to avoid the PSB rules completely. In most cases, this means that you have to be considered an independent contractor and not an incorporated employee. You will need to provide documentation to support the common-law tests that prove independent contractor status.
If you are considering the incorporation of services or are entering into a work arrangement that requires you to incorporate, contact your BDO advisor to discuss whether the PSB rules could apply and how we can help you to produce the best tax strategy to fit your situation.
The information in this publication is current as of April 26, 2022.
This publication has been carefully prepared, but it has been written in general terms and should be seen as broad guidance only. The publication cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon the information contained therein without obtaining specific professional advice. Please contact BDO Canada LLP to discuss these matters in the context of your particular circumstances. BDO Canada LLP, its partners, employees and agents do not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.