The contractor vs. employee assessment rules are also applied to determine the status of Personal Service Business. What is a Personal Service Business? A Personal Service Business is essentially a conduit where an individual has formed a corporation and this corporation is engaged by another business to provide services. The shareholder of a contractor’s corporation would be regarded as an employee of the other business but for the existence of his/her corporation, the contractor’s corporation may be considered a Personal Service Business and subject to punitive tax consequences. The shareholder of the contractor’s corporation is referred to in the Income Tax Act as the "incorporated employee".
The Personal Service Business tax rules have roots in a 1960s tax case. Ralph Sazio, CFL coach for the Hamilton Tiger-Cats, decided he would incorporate a company to provide his services to the Tiger Cats and benefit from the low corporate tax rate. Sazio challenged CRA’s assessment in court and he won the case. Personal Service Business rules were subsequently enacted under subsection 125(7) of the Income Tax Act, to eliminate this tax opportunity.
If a contractor's corporation is characterized as a Personal Service Business, most tax advantages can be denied. Recent legislative changes have dramatically increased the taxes resulting from Personal Service Business status. The "general rate reduction" is no longer available to a Personal Service Business for taxation years starting after October 31, 2011. The result is that income of a Personal Service Business will not be taxed at the small business rate of 14% (in Alberta). It will also not be taxed at the general corporate rate of 25% but at a punitive tax rate of 38%. To further deny any tax benefits, if a Personal Service Business pays dividends to its contractor/shareholder, dividends will be subject to additional personal tax. Your contractor accountant can provide audit assistance, should a corporation is assessed as a Personal Service Business.
Personal Service Business rules were in place for many years. However considering the recent changes in the taxation of a Personal Service Business, one can assume that the Canada Revenue Agency will increase compliance audits of contractors.
The following is an example of the negative tax consequences for a contractor’s corporation assessed as a Personal Service Business (tax rates valid for 2012 and assumes the Small Business Deduction is available to the contractor’s corporation).
Suppose a contractor earns $175,000 per fiscal year through a contractor’s corporation. The corporation incurred $25,000 of deductible business expenses. The contractor prefers to receive dividends as opposed to salary to avoid having to remit $4,612 in CPP (contractor’s company and individual’s portion), so he/she causes the contractor’s corporation to pay a dividend of $120,000. The combined personal and corporate tax paid by the contractor and contractor’s corporation is $40,521. Personal tax is deferred on $25,800, representing cash (after 14% corporate tax) left in the contractor’s corporation.
If the contractor’s corporation is assessed as a Personal Service Business, the corporate tax payable would increase from $21,000 to $66,500 (assumes business expenses are not deductible). As a result of the high corporate tax, the contractor would be entitled to an enhanced dividend tax credit on his/her personal tax return, but the total combined personal and corporate tax would increase to $77,650 (this is approximately 50% of gross earnings). CRA would assess an additional $37,129 of taxes. To further compound the tax problem, CRA may reassess for up to three past years (normal assessment period). In addition, interest will be charged on unpaid taxes for these past years.
Your contractor accountant can help clients navigate the complexities of Personal Service Business tax rules.