Be aware: New CRA campaign targets Personal Services Businesses (PSBs)
The CRA is increasing their scrutiny of personal services business corporations (PSBs), and the consequences if the applicable tax rules apply to your business can be harsh.
The focus of the CRA’s new campaign is on a number of industries such as trucking, IT consulting, accounting, construction and catering, but many other industries or occupations could be affected. A director or officer of a company that is providing their services through their own company could be subject to additional tax on their income if the business is deemed to be a PSB.
As more individuals and sole proprietors in Canada choose to incorporate, it’s important to review whether your corporation is operating as a PSB, as it can significantly increase the company’s taxes. With that in mind, what should you be aware of to protect yourself and your business?
Determination of a PSB
Rather than hiring employees directly, many taxpayers retain non-employees to provide services—whether to fill a short-term need, obtain specific expertise or otherwise fill a role that is not suited to a full-time position.
These situations carry significant income tax risk, and that risk depends on whether an individual or corporation is providing the services. When the service provider is an individual, the key income tax issue is whether the individual is employed or self-employed. Both the payer and payee bear tax risk in these situations.
But where the payer engages a corporation to provide services, the income tax risks associated with the proper calculation and payment of tax rest mainly with the service provider (the corporation that may or may not be a PSB). Assuming the provider is a Canadian-controlled private corporation, the tax rules require a determination as to whether the income is:
- income from an active business that is eligible for the small business deduction; or,
- income from a PSB
If the payee treats the service income as eligible for small business tax rates but the CRA characterizes the income as earned from a PSB, a significant tax liability could arise for the payee.
For example, the corporation’s tax rate can increase from 11% (if claiming the small business deduction on its income) to 45% (rather than 27%) and certain corporate expenses would be denied a deduction. The payer is in no way affected by the income determination, however, which is one reason why many payers prefer to deal with service providers that are incorporated.
The PSB rules generally apply when these 4 tests are met:
- the individual providing services, or a person related to them, is a specified shareholder of the corporation (the employee or a family member together own 10% or of the corporation);
- if the individual had provided services directly (i.e., without using a company), the individual would be considered an employee of the taxpayer (i.e., an “incorporated employee”);
- the corporation does not employ more than five (5) full-time employees throughout the tax year; and,
- the corporation’s income is from services performed by the provider on the corporation’s behalf
Tax consequences for corporations with PSB income
When the PSB rules apply, there are two main tax consequences: a higher corporate tax rate on the PSB income, and a limitation on the corporation’s expense deductions.
Any income of the corporation that is determined to be from a PSB would not be eligible for the small business deduction. An additional federal tax of 5% and additional provincial tax would apply on that income.
The deductions that the corporation could claim when computing PSB income are limited to:
- salary paid to the “incorporated employee”
- employment benefits for that individual
- expenses that would be allowed if the individual were a commissioned salesperson
- legal expenses incurred by the corporation to collect amounts owing to it
Other expenses would be disallowed even if they were paid to earn income.
Strategies to avoid the PSB rules
Since tax consequences of unexpectedly earning PSB income in a corporation can be harsh, here are some suggestions for managing PSB risk:
- Pay out corporate earnings as a salary instead of dividends, as the salary will reduce the corporate income and the impact of a PSB tax assessment
- Clearly document the relationship between the parties in a written agreement that states the parties have not agreed to an employment relationship
- To support that the corporation is carrying on a business and not just an incorporated employee, demonstrate that it has economic risk and upside (chance of profit but also loss) by bearing some of the costs
- Consider providing services to more than one entity to also support that it’s not an employer/employee relationship.
There are other items that should be reviewed to support that your corporation is carrying on its own business and not just the business of the entity to which it’s providing services. Contact your DMCL advisor if you would like more information on whether the PSB tax rules may affect your company and how we can help protect you from any unforeseen tax impacts.
Article written by Janice Hutchison, CPA, CGA