The Canada Revenue Agency (CRA) is escalating its scrutiny of personal services business, and the consequences for breaching these rules can be severe. It is important, therefore, to understand these rules, to avoid falling foul of them.

A personal service corporation is a company which provides personal services, and the person who performs the work would be considered an employee of the payer if the services were provided directly. They are often referred to as incorporated employees.

Many businesses retain non‑employees to provide services to fill a short‑term need, obtain specific expertise or otherwise fill a role that is not suited to a full‑time position. There are often tax advantages to the payer to engage non‑employees instead of employees. The payer may avoid the various payroll costs such as CPP, EI, Employer Health Tax (EHT), vacation pay, etc. during the period of service and the need to pay severance on the termination of service. Administration is often limited to writing cheques based on amounts on invoices provided by the service provider.

If the CRA decides the service provider is in fact an employee, the payer may be on the hook for the employer’s and the employee’s share of payroll withholdings in addition to penalties for failing to make these withholdings. If the payer engages a corporation to provide services, the income tax risks rest mainly with the service provider. The payer is not affected by the income tax risks faced by the service providers, and the payer may prefer to or insist on dealing with corporations instead of individuals.

It appears to be advantageous to the “employee” as well. The corporation generally takes the position that it is carrying on an active business and is entitled to a low rate of tax on the first $500,000 of income. In addition, the corporation can generally deduct a wider range of expenses than those available to employees. However, if it is determined that the corporation carries on a personal services business, the corporation will be faced with negative tax consequences.

When do the personal services business rules apply?

There are four tests which must be met to trigger the personal services business rules:

• The person providing the services must own at least 10% of the issued shares of any class of shares of the corporation or a related corporation
• The service provider would be considered an employee of the payer, if the services are provided directly
• The corporation does not employ more than five full‑time employees throughout the tax year
• The corporation’s income is from services performed by the service provider on the corporation’s behalf

When the personal service business rules apply, there are two principal tax consequences. The corporation will be subject to a higher corporate tax rate on the income in addition to a limitation on the corporation’s expense deductions.

High corporate tax rate on personal services business income

The tax rate for a corporation which carries on an active business is 12.2%. For corporations earning personal services business income, the tax rate is 44.5%.

When the after‑tax corporate income is distributed to the shareholder, the shareholder will face another level of tax. If the after‑tax income were paid as an eligible dividend, the combined corporate and personal tax would be 66.3%, which is substantially higher than the tax payable by the service provider if the services were provided directly, and the top personal tax rate of 53.53% applied.

Limitation on expense deductions

If a corporation earns personal services business income, the only deductions the corporation may claim are limited to:

• Salaries and benefits paid to the incorporated employee
• Expenses that are allowed if the individual were a commissioned salesperson
• Legal expenses incurred to collect amounts owing to it

All other expenses would be denied even if they were incurred to earn income.

Ways to manage your risks if you are unsure whether personal services business rules apply

• Reduce income otherwise subject to the personal services business rules by paying out corporate earnings as salary to the service provider:
  • Only salaries that have been paid qualify as a deduction, so no deferral is available
  • Should be considered if a payer insists on working with incorporated service providers and service provider is unsure of status
• Clearly document the relationship:
  • Make sure the intentions of both parties are clearly spelled out
  • Make sure the service provider has, to the extent possible, control over when and where the services are rendered
  • If the service provider works for more than one person
  • If the service provider provides own tools to perform the services
  • Document will form support in case of CRA challenge
• Assess risks of treatment as personal services business in remuneration planning:
  • Salaries are deductible, whereas dividends are not
  • Dividends may be taxed as eligible dividends, but may require a late eligible dividend designation

If you have any questions, you should contact your Segal advisor to discuss how you may manage your risks.

Understand the rules, avoid penalties