What Independent Contractors Should Know About Personal Service Businesses

Many of you leave your full time jobs to become independent contractors.  This could be for a variety of reasons: you might decide you want the freedom that comes with self employment, or your company might decide that they no longer want to maintain employees.  In some cases, you are laid off and find another opportunity , but the business only offers contract positions. 

This type of situation is particularly applicable to people in the IT industry but can also apply to a variety of other types of skill sets.  Often, your client will require that you set up a corporation which then contracts with the client to provide services that are very similar to those you would provide if you were an employee.  The corporation then bills your client either directly or through a third-party (often a recruiting agency). 

What is a Personal Services Business?

This type of employment arrangement might result in the corporation , that you have set up, is that being deemed a “Personal Services Business (PSB)” by Revenue Canada (CRA). The definition of a PSB according to CRA is:

a personal services business exists where the individual would be considered to be an employee of the payer if it were not for the existence of the corporation.

A PSB (or incorporated employee) classification was established by CRA to prevent employees from setting up corporations and taking advantage of lower tax rates and deductions, without actually running a business. 

Criteria To Determine if your Corporation is a PSB

CRA lays out some specific criteria to evaluate if your corporation might be considered to be a PSB:

• You are a shareholder of the corporation that directly or indirectly owns more than 10% of the shares of the corporation;

• If it weren’t for your corporation you would be paid and considered to be an employee of your “client”  (who could also be considered to be your employer)

• your corporation does not have more than 5 full-time employees

• the services provided and related payments are not from a related corporation

Source

What are the Implications of Being Deemed a PSB

If you meet the criteria of a PSB, the implications include:

• The corporation tax rate for a PSB is higher.  One of the reasons many small businesses incorporate is to take advantage of the small business deduction, which is a reduction of the general corporate tax rate.  A PSB subject to the full federal tax rate + 5% + the applicable provincial rate.  This can be as high as 49% (in PEI) and is about 44% in Ontario.   

• Expenses that can be claimed in a PSB are significantly restricted.  The only expenses that are specifically allowed by CRA include salaries paid to its incorporated employees and related benefits/allowances, expenses relating to selling property or negotiating contracts, legal expenses incurred to collect on any bad debts. 

• Your corporation might be subject to reassessment and penalties if it has been filing as a small business corporation and CRA later determines that it is a PSB.

What Type of Criteria Does CRA Use to Determine if you are a PSB

In many cases, an individual incorporates at the request of the employer who then deems you to be an independent contractor.  However, It is not enough for the person paying you to determine your classification.  Many employers might want the flexibility that comes with having their “employees” be contractors rather than employees as they no longer have to adhere to employment regulations, which can be restrictive.  Or they might simply not want to deal with the administrative hassle and expense that comes with having to pay employees.  Consequently, it is important to review the criteria of being an employee vs being self employed and ensure that your arrangement with your client adhere to the criteria of self employment rather than being an employee that is simply incorporated (and therefore a PSB).

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Criteria to Determine If You’re Are Self Employed and not an Employee

• Do you have control over how the work is done, i.e., do you work independently without anyone overseeing your work?

• Do you have control over where your work is done? Do you have your office space from which you can work when you choose?

• Do you have more than one client? Are you actively looking for other clients?

• Are you allowed to take on other clients without restrictions from your current client?

• Can you decide to subcontract your work?

• Can you decline to do work?

• Do you provide your own tools and equipment - do you use your own computer, are you responsible for paying for software subscriptions, are you responsible for repair or replacement of your work tools if something breaks?

• Do you market your business?

• Can you hire someone else to do the work without approval from someone else?

• Do you bear the risk and responsibility for the work done, i.e., if it is not done properly will you not get paid?

• Is there a written contract detailing the terms and conditions of the work?

• Do you invoice your client?

• Are you paid in the same way a vendor would be paid (rather than receiving a fixed periodic payment similar to an employee)

• Do you charge sales tax on your invoices?

• Have you been hired for a specific job?

• Can you determine your own hours and when the work is performed?

• Do you have an agreement in place that incorporates the above criteria specifically. 

If you are able to answer yes to most of these questions, then you will be in a better position to defend yourself to CRA who will evaluate all the factors that surround your arrangement, in case of audit (which has increased in frequency in recent years).  Ideally, you would want to ensure that your agreement with your client is structured in a way that incorporates these criteria.  Negotiating the terms of the services provided to your client so that there is clarity on your role as an independent contractor/consultant, in line with the criteria above, can save expenses, hassle and the stress of being classified as a PSB

Further Reading:

This article discusses specific cases and how the tax court determined if a business was deemed to be a PSB. 

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