Businesses may prefer to hire someone through their corporation. However, if a corporation is classified as a Personal Services Business (PSB), it can face higher taxes and fewer deductions. The CRA has recently indicated it may increase enforcement of PSBs. This article discusses what that might mean for taxpayers.
This content was first published by the Canadian Tax Foundation in (2024) 14:4 Canadian Tax Focus / Focus sur la fiscalité canadienne. Republished with permission.
Should businesses hire an employee or pay a corporation for services? Many businesses would prefer the latter for both tax and non-tax purposes (such as liability and creditor protection). These businesses may even require potential service providers to incorporate so that the business can avoid the liability for payroll taxes and failure to withhold penalties that could occur should the CRA later determine that a service provider is an employee rather than an independent contractor.
An incorporated service provider is responsible for the normal corporate tax compliance, GST/HST, and payroll taxes where applicable. However, the bigger issue is that the corporation may be determined to be earning income from a personal services business (PSB). This seems to be a growing concern: as outlined in its PSB pilot report, the CRA is engaging in educational activities before it “move[s] forward with full compliance measures.”
A PSB exists where an individual who would otherwise be an employee is paid for their services through a corporation in which they (or any person related to them) are a specified shareholder. Such a person is referred to as an “incorporated employee” in this article. In general, an individual is a specified shareholder if they own 10 percent or more of any class of the corporation’s shares. Corporations that employ more than five people or are associated with the employer corporation are exempted from the PSB classification.
To prevent employees from incorporating to receive tax benefits, PSBs are denied the small business deduction (SBD) as well as the general corporate tax rate reduction and are subject to an additional 5 percent tax on taxable income. In total, PSBs will normally be taxed federally at a 33 percent rate. In addition, PSBs are denied most expense deductions. They are, nonetheless, entitled to claim a deduction for salaries, benefits, or allowances provided to the incorporated employee in the year. An incorporated employee cannot qualify for EI where that employee owns more than 40 percent of the PSB’s voting shares, but they may register for the self-employed program.
Dividends, commonly seen as a benefit of incorporation for the tax-planning strategies they offer, are often not beneficial to PSBs. PSB income is not well integrated, and the total tax between the PSB and the shareholder receiving dividends is generally greater than the tax on employment income received directly. If the PSB claimed the SBD in error, and hence improperly issued ineligible/non-eligible dividends, a late eligible dividend designation may be a potential resolution. The CRA will accept such designations on a case-by-case basis (see CRA document no. 2013-0495771C6, October 11, 2013, for conditions the CRA will consider).
The CRA’s PSB pilot was an educational outreach program involving 2,100 Canadian corporations that voluntarily submitted their books and records for review regarding PSB issues. PSB activity was found to be concentrated in construction, scientific and technical services, and transportation and warehousing. Most notably, the CRA found that 64 percent of potential PSBs identified were incorrectly claiming the SBD. Though the CRA does not indicate why these errors may be occurring, it could be that the CRA has a different interpretation than the individual involved as to whether they are an incorporated employee. Alternatively, it may suggest that incorporated employees do not understand that they have a PSB or that PSBs are not eligible for the SBD.
So how can potential PSBs reduce the risk of adverse results from compliance action? Many disputes over classifying a corporation as a PSB centre on the issue of whether, absent the corporation, the incorporated employee would be an employee of the business or client. Documentation can assist—not only documentation on the relationship between the incorporated employee and the business, but on any work the incorporated employee performs for competitors and other entities. If it appears more likely than not that a PSB exists, the voluntary disclosure program should be considered, since it offers proactive correction of tax reporting in exchange for penalty and interest relief.
