Tax Bulletin - Self-Employment: Is it for you?

The advantages and disadvantages of being your own boss

There are definite tax advantages to being a self-employed individual. The biggest tax advantage is being able to deduct expenses from your income when you prepare your tax return each year. We’ll review the type of expenses you can deduct, starting at page 6.

You shouldn’t be blinded by the tax advantages; however, there are many other factors you need to consider. These include:

We’re not trying to convince you that you should be an employee rather than an independent contractor. You just need to understand all of the factors you have to take into account — in addition to the tax advantages — to determine whether it makes sense for you to be self-employed. And, keep in mind that one of the reasons independent contractors generally make more money than employees for equivalent work is to compensate them for the fact that they don’t get any of the benefits of being an employee.

Incorporating your own business can also provide certain tax advantages. For example, you will be allowed the small business deduction on active business income up to certain income thresholds.

Under Employment Insurance (EI) measures, self- employed individuals can, on a voluntary basis, choose to pay EI premiums to be eligible to receive EI special benefits. There are several types of special benefits available to self-employed individuals including maternity, parental, sickness and compassionate care benefits and benefits for family members of critically ill children or adults. To participate, you must enter into an agreement with the Canada Employment Insurance Commission through Service Canada and pay the annual premium with your personal income tax return.

Currently, if you are a self-employed person in Québec, you are required to make contributions to the Québec Parental Insurance Plan with your annual Québec tax return, and you can also receive maternity, paternity, and parental benefits through this plan. As a resident of Québec, you can also choose to participate in the federal EI program for sickness and compassionate care benefits.

If you decide to become self-employed and also incorporate your business, you need to be aware of the Personal Services Business (PSB) rules.

Generally, the PSB rules will apply if the following conditions are met:

• Income of the business is from services rendered by an individual, referred to as an “incorporated employee”;
• The “incorporated employee” rendering the services, or a related person, is a specified shareholder. Generally speaking, a specified shareholder is a person who 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;
• The incorporated employee might reasonably be regarded as an officer or employee of the entity for which the services are provided if the corporation is ignored (we discuss this in more detail in the next section); and
• Throughout the year the corporation does not employ in the business more than five full-time employees.

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. Generally, deductions are limited to salaries paid and employment benefits provided to the incorporated employee. The PSB also will be allowed a deduction for amounts that would have been deductible by an employee for selling property and negotiating contracts, as well as legal expenses incurred by the corporation in collecting amounts owing for services rendered. Note that the PSB rules do not apply where services are provided to an associated corporation.

In addition to these restrictions on deductions, the corporate rate of tax paid on PSB income is higher than both regular business income and income eligible for the small business deduction. This higher rate makes the integration cost of earning PSB income in a corporation greater than if the income was earned personally, and not through the corporation. The integration cost combines the corporate tax rate and the personal tax cost of paying corporate profits as dividends to the owner manager. Where a PSB exists, it will usually be to your advantage to pay the PSB income out to the owner-manager in the form of a salary. If you are self-employed and are also considering incorporating your business, consult your BDO advisor.

Can I become an independent contractor?

You can’t just state that you are self-employed and expect to be treated that way for tax purposes. A series of common law tests have evolved from decisions in the Canadian courts that are used to determine whether you are an employee or an independent contractor. So, if the tests currently indicate that you are an employee, you’ll have to make fundamental changes to your arrangements with payers to be considered self-employed.

You should note that the factors to be considered when determining whether or not you are an independent contractor differ in Québec. In particular, the rules in Québec under civil law generally place a much greater emphasis on the control the employer has over an employee, although the courts in Québec have not always ruled consistently on this issue.

No matter where you live, you should always consult with your BDO advisor before attempting to become an independent contractor.

If you want to be considered self-employed, it’s important that the Canada Revenue Agency (CRA) also views your arrangement in that light. If it doesn’t, you could find yourself being disallowed all the tax deductions available to independent contractors, which means your tax bill could be substantially higher. In addition, the organizations you work for have a lot at stake if they treat you as self-employed and you’re really an employee. They are responsible for paying a number of federal and provincial taxes on your salary, including EI premiums, CPP contributions, Workers’ Compensation levies and other payroll taxes. Also, they are responsible for collecting and remitting employee income tax and the employee portion of EI premiums and CPP contributions. If they mistakenly treat you as an independent contractor, they will not have deducted and remitted income tax or your EI and CPP contributions. When these remittances have not been properly made on behalf of an employee, the CRA will apply a penalty from 10%-20% of the amount owing, in addition to interest on the late payments.

We have noted below six key factors that have evolved from court cases, and which the CRA also considers to be important in determining your status as either an employee or an independent contractor. We have made a brief note of the key element of each factor and have also provided a more detailed chart of some key indicators of status as an employee or status as an independent contractor for each of these factors in the Appendix.

As workers’ relationships with hirers continue to evolve, the courts and the CRA may also consider the intention of both a worker and a hirer when a working arrangement is entered into. Specifically, consideration is given to whether you both intend to enter into a contract of service (employer- employee relationship) or a contract for services (a business relationship). In this regard, it is important for both you and your hirer to clearly define your working arrangement and ensure that you have a common intent at the time you enter into an agreement. Note that this test is really more of a tiebreaker when the results of looking at factors 1–6 are inconclusive.

Remember — no one test will determine whether you are considered to be an employee or an independent contractor. One or more of the above tests may not apply when analyzing all the facts surrounding a particular relationship or they may require different weightings in particular cases. For example, the test of control may be difficult to apply to professionals, knowledge workers and skilled trades-people, as their expertise and specialized training tends to allow them to work independently, but they can still be considered employees when the tests are applied to all of the facts.

In order to avoid reassessments, it’s important to ensure that the CRA will consider you to be self-employed based on the tests noted above. However, as there is an element of variability in applying the tests and in the weight given to various facts, it is possible that the CRA may conclude differently than you. The good news is that you can ask the CRA to determine if your relationship with a particular hirer is one of an independent contractor or an employee. By filing Form CPT1 with the CRA, they will rule on your status for purposes of payment of CPP and EI premiums. You should consider filing this if it's important for you and your hirer to be absolutely certain of your status in their eyes. You should note that the factors to be considered when determining whether or not you are independent contractor differ in Québec so you should always consult with your BDO advisor before attempting to become an independent contractor.

Improving your chances

With these tests in mind, there are a number of steps you can take to improve the likelihood you’ll be considered an independent contractor in the CRA’s eyes. If you’re self-employed, make sure you do the following:

The tax advantages of being self-employed

You’ve heard people talk about tax advantages of being self-employed. They’re right — self-employed individuals have many more possibilities in the expenses they can deduct for tax purposes.

However, always keep in mind that if you don’t have a lot of expenses, being able to deduct them will not mean that much to you. If you are self-employed, you’ll have to keep track of your income and expenses. Generally, for tax purposes you will need to report your income and expenses by using the accrual method of accounting. This means you will include in income all the income you’ve earned for your fiscal year, whether you’ve received a payment or not, and you will deduct the expenses you have incurred in the fiscal period, whether or not you’ve paid them.

Deducting expenses

Self-employed individuals can deduct any reasonable expense they incur to earn their business income, unless the expense is specifically denied under our tax law.

In this part of the bulletin, we’ll review a number of expenses you will be able to deduct from your business income. We will also look at some specific tax rules that deny you the ability to deduct all or a portion of certain expenses.

Keep in mind that this list is not exhaustive. If you incur a reasonable expense, you usually are able to deduct it. Remember, however, that personal expenses are not deductible.

Selecting a business year-end

Choosing a business year-end for tax purposes is a critical decision for you. The selection of your first year-end is governed by the date you first commence business. The business year cannot exceed twelve months for a proprietorship or partnership.

Most self-employed individuals are now required to have a December 31st year-end. However, self-employed individuals, as well as partnerships that only have individuals as partners, have the option of selecting an off-calendar year-end provided they use the “alternative method” when calculating income for tax purposes. Let’s look at how this might work.

• You, as a self-employed individual, started your business on February 1, 2021. You choose to have an off-calendar year-end of January 31, 2022.
• In 2021, you wouldn’t have an income inclusion because your fiscal period ended in 2022.
• In 2022, you would have to include income for the period February 1, 2021 to January 31, 2022, as well as an estimate of income for the period February 1, 2022 to December 31, 2022. The estimate is based on a proration of your income for the year ending January 31, 2022.
• In 2023, in addition to reporting your actual income for the fiscal year ending January 31, 2023, you would also have to include a new estimate to December 31, 2023. You will be able to deduct the previous year’s estimate of income to December 31, 2022.

Note that you can elect to include some income from the January 31, 2022 fiscal year in the 2021 taxation year to maximize your RRSP contribution or to “even out” your tax burden. Any amount included in 2021 would be deducted on your 2022 tax return.

Once you start using the calendar year-end method you can’t change to the alternative method. However, you can switch from the alternative method to the calendar year method at any time.

If you qualify for an off-calendar year-end you should consider whether the timing of your year-end can defer or save income taxes or can be used to coincide with a cyclical slow period in your business.

Business losses

Though you don't go into business to lose money, tax relief is generally available if losses do arise. Court cases have set out a framework for determining whether losses can be deducted against other income for income tax purposes. First, consideration must be given to whether the business has been undertaken in pursuit of profit, or whether it is a personal endeavor. Where the nature of an activity is clearly commercial, your pursuit of profit is established. It will then be necessary to determine whether the source of the income is from a business or property. However, if there is a personal element to the activity, you will need to provide evidence to support your intention to carry on the activity for profit. The CRA may argue that you don't have a reasonable expectation of profit if your business has a personal element — a good example might be a hobby-type business. In such cases, in order to deduct business losses you will need evidence that:

• you have a genuine commercial operation;
• your profit expectations are reasonable;
• you have done your homework in preparing to go into the venture; and
• you have appropriate training or have hired staff that have the appropriate training to run your business.

You should always be prepared to demonstrate that your venture is undertaken in a sufficiently commercial manner, particularly if you are currently experiencing losses.

GST/HST and QST

As an independent contractor, you will have to deal with the GST/HST. Although there are some differences, the Québec Sales Tax (QST) essentially functions in a manner similar to the GST/HST.

GST/HST and QST rates for 2022

• Nova Scotia, New Brunswick, Newfoundland and Labrador, and Prince Edward Island — 15%
• Ontario — 13%
• Québec — 9.975%; combined rate — 14.975%
• Other provinces and territories — 5%

As an independent contractor, you will generally be in the business of supplying goods and services to your customers or clients. Therefore, you will likely have to collect the GST/HST on your revenue and remit it to the government.

The GST/HST does not have to be collected on all goods and services (known as “supplies” under the rules). Certain supplies are exempt or zero-rated from GST/HST — if you’re in the business of making these types of supplies you do not have to collect and remit the GST/HST. Your BDO advisor can help you determine the GST/HST implications of your particular business.

If you are in the business of making taxable or zero- rated supplies, you will have to register for the GST/HST with the CRA. However, the news isn’t all bad. If you have to collect and remit the GST/HST on your revenue, you can claim a refund (known as input tax credits — ITCs) for the GST/HST you pay on your expenses, including capital purchases. You have to file GST/HST returns with the CRA to remit the GST/HST you have collected, less any ITCs you are entitled to. The QST works essentially the same way except that the registration and filing of QST returns are administered by Revenu Québec. The QST paid on business purchases is referred to as input tax refunds (ITRs) and can be refunded to QST registered businesses.

There are special GST/HST rules for small business, including the following:

Recordkeeping

You should keep all records of your income, as well as your expenses. If your records are organized, not only will this save you time (and accounting fees) when you prepare your tax return, it will also help ensure you are prepared should the CRA decide to review your return. Write down the purpose of the expense on your receipt and keep it in an organized filing system, such as by type of expense (e.g. meals and entertainment, car and insurance expenses, etc.).

Receipts are crucial for all of your expenses. Here are some additional points to keep in mind.

• If you're claiming a deduction for meals and entertainment expenses, it's a good idea to write on the receipt who you took to lunch and why.
• Make sure you only claim your business expenses. The CRA will likely review your expense claims and compare them to the norms of your particular industry to see if they are reasonable. For example, if your meals and entertainment expense is 5% of your revenue, but the norm for your industry is only 2%, you will need to be able to explain why your expenses are so high. If your expenses are abnormally high you can expect an auditor to pay you a visit. You do not need to worry, however, if you have receipts and your records are organized.
• You should document your automobile expenses well. It’s extremely important to keep a logbook of your driving to support the number of kilometres you drive for business purposes. Your BDO advisor can provide you with a BDO logbook you can use to keep track of your driving.
• Generally speaking, for income tax purposes, you must keep your receipts for six years from the end of the last taxation year to which they relate. If you wish to destroy them before this time you need permission from the CRA.

Miscellaneous matters

You also need to consider whether any of the following apply to your business: