One of the first blogs I wrote was "I am a Contractor Unless CRA Says Otherwise" (Note: the link is being temperamental, so if you want to read that blog, either google it or it is listed as a favourite post on the right hand side-bar). In that blog I discussed the various criteria the CRA and the courts use to determine whether a person is an employee or a contractor. I then further discussed the income tax withholding issues that arise when the CRA attempts to re-characterize a contractor as an employee. Finally, I touched upon the concept of a personal service business (“PSB”) and the risk of incorporating if you are a contractor. In today’s post, I will expand on the PSB discussion.
For CFL fans of my vintage, the PSB rules came about because of the despised Ralph Sazio (despised if you were a Toronto Argonaut fan). Mr. Sazio, a member of the CFL Hall of Fame who led the Hamilton Tiger-Cats to three Grey Cup championships, decided he would incorporate a company to provide his services to the Tiger Cats to benefit from the low corporate tax rate. The CRA took Sazio to court, but Mr. Sazio won his case prompting the CRA to implement the PSB rules.
The PSB rules have reared their ugly head recently because of a CRA crackdown on IT consultants as discussed in this Ottawa Business Journal article by Peter Kovessy titled Taxman cracks down on IT consultants.
In addition, on October 31, 2011 the CRA released draft legislation that imposes further punitive rules on PSB's by removing the general rate deduction previously allowed. These new rules will become effective for taxation years beginning after October 31, 2011 and are discussed below.
The PSB rules deal with incorporated employees. Essentially, when a corporation has been interposed between what one would normally consider an employee-employer relationship, the employee becomes an "incorporated employee". As I have discussed in many prior blogs, incorporation is advantageous because it provides the following: access to the small business deduction and the related low income tax rate, a possible deferral of income tax, limited liability, and potential access to the $750,000 capital gains exemption on qualifying small business corporation shares.
In reviewing the PSB rules, you essentially need to ask yourself if you would reasonably be regarded as an employee or officer of the person or partnership to whom you are providing the services, but for the existence of your corporation . If you only have one or two clients and your corporation does not employ more than 5 full-time employees, and you do not meet the criteria I discuss in my contractor blog, you risk being characterized as a PSB.
So what are the income tax consequences of being considered a PSB once the new legislation is passed?
The corporation will be prevented from claiming the small business deduction, both federally and provincially, and as noted above, you will no longer even get the general rate reduction. In Ontario that means the corporation will be subject to income tax at a rate of 39.25% (in 2012). For comparative purposes, the current small business income tax rate is 15.5%. As a consequence, when taking money out of a PSB by way of dividends, the ultimate combined personal and corporate tax rate will approach 58% in Ontario, a very punitive amount which is 12% greater than a high-rate employed taxpayer would pay.
When determining the taxable income from a PSB, the only eligible deduction for the corporation will be any salary and benefits paid to the incorporated employee (yes, that means no other expenses such as travel, office supplies and auto are allowed). If the incorporated employee is a salesperson receiving commissions, expenses paid by the corporation that would have been allowed as a deduction to the individual personally as a commissioned salesperson will be allowed.
If you are concerned that your corporation may be a PSB, a conservative approach would be to pay yourself salary rather than using a dividend remuneration strategy. You may also want to avoid income splitting with family members who are not shareholders, however, your other business deductions are still at risk of being disallowed.
The proposed PSB rules are very punitive. If you may be an “incorporated employee” you should review your situation in detail with your accountant.
For CFL fans of my vintage, the PSB rules came about because of the despised Ralph Sazio (despised if you were a Toronto Argonaut fan). Mr. Sazio, a member of the CFL Hall of Fame who led the Hamilton Tiger-Cats to three Grey Cup championships, decided he would incorporate a company to provide his services to the Tiger Cats to benefit from the low corporate tax rate. The CRA took Sazio to court, but Mr. Sazio won his case prompting the CRA to implement the PSB rules.
In addition, on October 31, 2011 the CRA released draft legislation that imposes further punitive rules on PSB's by removing the general rate deduction previously allowed. These new rules will become effective for taxation years beginning after October 31, 2011 and are discussed below.
The PSB rules deal with incorporated employees. Essentially, when a corporation has been interposed between what one would normally consider an employee-employer relationship, the employee becomes an "incorporated employee". As I have discussed in many prior blogs, incorporation is advantageous because it provides the following: access to the small business deduction and the related low income tax rate, a possible deferral of income tax, limited liability, and potential access to the $750,000 capital gains exemption on qualifying small business corporation shares.
In reviewing the PSB rules, you essentially need to ask yourself if you would reasonably be regarded as an employee or officer of the person or partnership to whom you are providing the services, but for the existence of your corporation . If you only have one or two clients and your corporation does not employ more than 5 full-time employees, and you do not meet the criteria I discuss in my contractor blog, you risk being characterized as a PSB.
The corporation will be prevented from claiming the small business deduction, both federally and provincially, and as noted above, you will no longer even get the general rate reduction. In Ontario that means the corporation will be subject to income tax at a rate of 39.25% (in 2012). For comparative purposes, the current small business income tax rate is 15.5%. As a consequence, when taking money out of a PSB by way of dividends, the ultimate combined personal and corporate tax rate will approach 58% in Ontario, a very punitive amount which is 12% greater than a high-rate employed taxpayer would pay.
When determining the taxable income from a PSB, the only eligible deduction for the corporation will be any salary and benefits paid to the incorporated employee (yes, that means no other expenses such as travel, office supplies and auto are allowed). If the incorporated employee is a salesperson receiving commissions, expenses paid by the corporation that would have been allowed as a deduction to the individual personally as a commissioned salesperson will be allowed.
If you are concerned that your corporation may be a PSB, a conservative approach would be to pay yourself salary rather than using a dividend remuneration strategy. You may also want to avoid income splitting with family members who are not shareholders, however, your other business deductions are still at risk of being disallowed.
The proposed PSB rules are very punitive. If you may be an “incorporated employee” you should review your situation in detail with your accountant.
Well, now you've got me all paranoid.
ReplyDeleteI am in Ottawa, and have a very common type of setup: I am incorporated, my corporation has signed a contract with a headhunter who won a contract to supply services to DND (using my resume).
DND supplies my computer, telephone and work station, but I have signed nothing with them except a non-disclosure agreement. I appear on their telephone lists, but am clearly identified as a contractor.
I invoice the headhunters, who do not direct me (and who hardly see me).
How could I be considered an employee of either one? And how is it fair to retroactively (!) call me an employee of one or the other or both, costing me significant taxes, without either forcing DND to give me benefits and pension, or forcing the headhunters to cough up CPP, EI and severance?
Anon, fair or not, you may have some income tax risk in this situation. I would speak to your accountant or engage an accounant to review your specific situation and if they feel you have some risk, discuss how to mitigate the risk. I am sympathetic to your plight, but as noted in the Ottawa Journal link above, there are many IT consulants who probably feel the same. Again, get some advice, your situation needs to be reivewed.
ReplyDeleteIf I may pick your brain for free:
ReplyDelete(1) If filed as ABI but later deemed PSB, which of the following corporate deductions would be disallowed:
-accrued wages payable to the "incorporated employee", but not paid in the corp tax year
-bonus declared and paid within the 180 day limit, but
not paid in the corp tax year
-actual wages paid in the corp tax year to spouse/shareholder for actual time spent bookkeeping and researching nasty topics such as this
-accrued wages for said spouse for actual work performed in corp tax year but not paid until after the year end
-expenses paid for travel to perform work at special work site for which a valid TD4 was completed. includes mileage, housing, meal allowance.
-WCB premiums and liability insurance
(2) Does the phrase "tax years beginning after Oct 31, 2011" include for example a corporation with a tax year running from Sep 1, 2011 to Aug 31, 2012? Meaning that all of the income in the tax year ending Aug 31, 2012 continues to qualify for the general rate reduction if denied SBD?
Thanks!
Anon, since you were so polite; see my comments below each of your questions.
ReplyDeleteIf filed as ABI but later deemed PSB, which of the following corporate deductions would be disallowed:
-accrued wages payable to the "incorporated employee", but not paid in the corp tax year
BBC says: the wages must be paid in the year to the incorporated employee to be deductible, thus the accrued wages would be denied. However, the wages would be deductible in the year of payment, so timing issue, not an absolute deduction loss.
-bonus declared and paid within the 180 day limit, but not paid in the corp tax year
BBC says: same as above, the bonus accrued would be denied. However, again the bonus would be deductible in the year of payment.
-actual wages paid in the corp tax year to spouse/shareholder for actual time spent bookkeeping and researching nasty topics such as this
BBC says: wages to shareholder are deductible, wages to spouse not allowable unless he/she is an incorporated employee.
-accrued wages for said spouse for actual work performed in corp tax year but not paid until after the year end
BBC says: not deductible, would only be allowed when paid if spouse is incorporated employee
-expenses paid for travel to perform work at special work site for which a valid TD4 was completed. includes mileage, housing, meal allowance.
BBC says: Not 100% clear, but I would argue deductible since benefits and allowances to incorporated employee are allowable
-WCB premiums and liability insurance
BBC says: not allowable
(2) Does the phrase "tax years beginning after Oct 31, 2011" include for example a corporation with a tax year running from Sep 1, 2011 to Aug 31, 2012? Meaning that all of the income in the tax year ending Aug 31, 2012 continues to qualify for the general rate reduction if denied SBD?
BBC says: it means the year has to start after Oct 31, 2011, so the new rules would apply to your Aug 31, 2013 year end. For your Aug 31, 2012 y/e, you would not be subject to the general rate reduction.
Thank you Blunt, you'll be pleased to know you are the only person I've been polite to all day.
DeleteWith respect to wages for polite spouse: if spouse is shareholder/director and also actually performs real bookkeeping, tax prep and corporate records maintenance duties, and has dutifully recorded all such time spent, does that make the spouse an incorporated employee and therefore reasonable wages are deductible?
My concern is that if I T4 myself on these wages, and at some future date the corp is deemed PSB, the wages could be treated as shareholder appropriations and therefore non-deductible to corp but taxable to me? Therefore double taxed.
DeleteAnon:
ReplyDeleteGreat question whether a spouse shareholder who is paid a salary for corporate duties is an incorporated employee.
I have never had to deal with this question and thus, I only provide guidance, you need to confirm with your accountant.
In reading the Income Tax Act(125(7)),it would appear your spouse would probably not be considered an "incorporated employee" since s/he does not perform services on behalf of the corporation. Note, although s/he performs services for the corporation, s/he does not perform services on behalf of the corporation to the client/employer.
In respect to T4 wages being double taxed, there is a specific exclusion for wages paid to an incorporated shareholder, so that should not be a concern.
The Government sent me a questionnaire, which was filled then they coined me to be an 'incorporated employee'. Regardless of the contract and the documentation my lawyer has provided, this has mostly been ignored and they appear to be pushing the this through.
ReplyDeleteMeanwhile there are several other consultants out there including several in my work area that are in the same situation but continue to be allowed full deductions and benefits. It would seem that the government has to close this grey area and apply the rules to either everyone or no one. Picking one small company at a time, that cannot afford to defend themselves leagally [or it would not be viable to attempt to do so] in itself seems unjust.
A question I have is: My company pays me personally in both dividends and salary. The dividends portion is taxed as ineligible dividends for a CCPC corporation. If it is determined that my company is acting as a PSB, since the full corporate tax rate is applied for the year in question, would it be true that dividends should now be treated as eligible for that tax year ? (otherwise double taxation would occur).
The implication of double taxation would be serious where we are talking about over 10k in dividends per year in my case -- where CRA has gone back a few years, long after the dividends have been declared, to re-assess.
so basically, would eligible dividends apply in the case of a PSB ?
Anon, sorry to hear you are potentially being re-assessed. You ask a great question. The dividends would qualify as GRIP (the account for eligible dividends). However, the issue, for which I have not had any actual experience is whether the CRA would allow you to change the ineligible dividend to an eligible dividend in the year you actually paid the dividend(my guess is it could be problematic, since to pay an eligible dividend certain documentation must be put in place at the time). So my concern is yes you will have GRIP, but that GRIP may only be used going forward. This would make the issue more painfull as the benefit of eligible dividends vs ineligible dividends was 10% in 2009, 7% in 2010, 5% in 2011 and is now only 4% in 2012. Sorry, cannot provide definitive answer, only the concern I have.
ReplyDeleteThey re-asessed for 2007 and 2008, and I now assume they will apply the ruling for additional years going forward once a decision is made (2009 thru 2011). At this point I am reluctant to contact CRA regarding the Dividends as the file is currently in the Objection stage (Since late 2010).
ReplyDeleteMy Lawyer informed me they had delayed a decision on the file as they were looking at pooling a number of these together to decide how to handle. The outcome should be interesting - I can only assume a large number of IT consultants may be impacted, if not this year, then in the upcoming years.
Thank you for your Reply.
The Cra won't allow a retroactive eligible dividend designation as per several of their technical interpretations.
ReplyDeletefrom: Original Anonymous (Feb 17)
ReplyDeletein reply to: The CRA won't allow a retroactive eligible dividend designation as per several of their technical interpretations.
Although it is very likely true with regards to someone
intentionally attempting to change the designation,
in this situation, as a result of an audit - a number
of things have changed. Since the tax rate is increased
and CCPC for small business disallowed for the tax
year in question, as with all other adjustments, the
eligible dividend may also be considered -- otherwise
double taxation would occur.