Becoming an independent contractor would mean that you probably have a personal service company.
Many of you are leaving your full-time jobs to become independent entrepreneurs. This can be for a variety of reasons: you may decide that you want the freedom that comes with self-employment, or your company may decide that it no longer wants to retain employees. In some cases, you will be fired and find another opportunity, but the company only offers contract positions. This type of situation is especially true for people in the IT industry, but it can apply to a number of other skill types as well.
What is a personal services company?
This type of employment arrangement may cause the company you have formed to be considered a “personal service business (PSB)” by Revenue Canada (CRA). The CRA definition of PS is:
There is a personal services business where the individual would be considered an employee of the payer if the company did not exist.
The PS (or incorporated employee) classification was introduced by the CRA to prevent employees from forming companies and taking advantage of lower tax rates and deductions without actually running a business.
Get in touch with a personal tax accountant or an income tax preparer for more clarity on the information provided.
Criteria for Determining Whether Your Company Is PS
The CRA sets out some specific criteria for assessing whether your company can be considered a PS:
- You are a shareholder of a company that directly or indirectly owns more than 10% of the company’s shares;
- If not for your company, you would be paid and considered an employee of your “client” (who could also be considered your employer)
- your company has no more than 5 full-time employees
- the services provided and related payments do not come from an affiliated company
What Are the Consequences of Being Considered A PSB
If you meet the criteria for PSB, the consequences include:
The corporate income tax rate for PS is higher. One of the reasons many small businesses incorporate is to take advantage of the Small Business Allowance, which is a reduction in the general corporate tax rate. PS is subject to a full federal tax rate + 5% + applicable provincial rate. This can be as high as 49% (in PEI) and in Ontario it is about 44%.
The costs that can be claimed at PS are significantly limited. The only expenses expressly permitted by the CRA are wages paid to its registered employees and related benefits/allowances, expenses related to the sale of real estate or the negotiation of contracts, and legal costs incurred in the recovery of bad debts.
Your company may be subject to reassessments and fines if it was registered as a small business and is later determined to be a PS by a credit rating agency.
Get in touch with a personal tax accountant or an income tax preparer for more clarity on the information provided.
What Kind Of Criteria Does the CRA Use to Determine If You Are A PSB
In many cases, an individual incorporates at the request of an employer, who then considers you an independent contractor. However, it is not enough for the person paying you to determine your classification. Many employers may want the flexibility that comes with their “employees” being contractors rather than employees, as they no longer have to adhere to labor regulations that can be restrictive. Or they simply don’t want to go through the administrative hassles and expenses associated with paying employees. Consequently, it is important to review the criteria of being an employee vs. being self-employed and ensure that the client business meets the self-employment criteria rather than being an employee who is merely registered (and therefore PSB).
Criteria for Determining Whether You Are Self-Employed and Not Employed
- Do you have control over how the work is done, for example, do you work independently, with no one supervising your work?
- Do you have control over where your work is done? Do you have your own office where you can work whenever you want?
- Do you have more customers? Are you actively looking for other customers?
- Are you allowed to take on additional clients without restrictions from your current client?
- Can you opt to subcontract your work?
- Can you refuse to work?
- Do you provide your tools and equipment: do you use your computer, are you responsible for paying for software subscriptions, and are you responsible for repairing or replacing your work tools if something breaks?
- Are you advertising your business?
- Can you hire someone else to do the work without someone else’s consent?
- Do you take the risk and responsibility for the work done, i.e. if it is not done correctly you will not get paid?
- Is there a written contract with detailed terms of employment?
- Do you invoice your client?
- You are paid in the same way as a contractor (rather than receiving a fixed regular payment similar to an employee)
- Do you charge sales tax on your invoices?
- Have you been hired for a specific job?
- Can you specify your working hours and when the work will be done?
- Do you have a contract that specifically covers the above criteria?
If you can answer yes to most of these questions, you will be in a better position to defend yourself with a credit rating agency that will evaluate all factors related to your transaction should it be the subject of an audit (which has increased in recent years). Ideally, you should ensure that your client agreement is structured to include these criteria. Negotiating the terms of service provided to your client so that your role as an independent contractor/consultant is clear in accordance with the above criteria can save the cost, hassle, and stress of being classified as a PS.
Get in touch with a personal tax accountant or an income tax preparer for more clarity on the information provided.