PERSONAL SERVICES BUSINESS

Some companies wanting the services of an individual may insist that the individual incorporate rather than provide services as a sole proprietor. This can be risky for the individual.

In 1981 the federal government introduced rules in response to a trend it perceived to be problematic. Specifically, past or potential employees were incorporating and providing services through their company. This turned what the CRA believed should be employment income into corporate business income. Corporate income was eligible for the lower small-business corporate tax rate, and corporations could deduct expenses that they couldn’t as an employee. The CRA introduced the new rules to promote the idea that people in like circumstances should be taxed the same.

Under the new rules (in their current version), a corporation’s business can be classified as a Personal Services Business (PSB) if the individual would reasonably be regarded as an employee of the client if the corporation did not exist. To determine if this employment-like relationship exists, the CRA will look at:^[1]

• degree of control exercised by the client
• who provides the tools and equipment
• whether the individual is allowed is subcontract
• the degree of risk the individual takes
• the individual’s opportunity for profit
• the nature of the working relationship

Individuals having a PSB commonly have one client, but having one client is not itself a relevant factor in determining the relationship. An individual can have one client yet their relationship may not resemble an employer-employee relationship at all.

If a corporation is carrying on a PSB, the income will be taxed much differently, and less favourably, then ordinary small business income. PSB income is subject to a higher corporate tax rate and severe restrictions on expense deductions. As well the corporation cannot claim the small business deduction on its PSB income.

If the CRA conducts an investigation or audit and determines that a corporation is carrying on a PSB, it can reassess the corporation’s tax returns for previous years, subject to the normal reassessment rules and any applicable exceptions. This can result in additional tax plus interest and penalties.

If someone is considering providing services to a company, and that company insists that they incorporate, it is vitally important that they understand the PSB rules and consider the risks.

If an individual doesn’t incorporate, the company hiring the individual risks the possibility of the CRA deciding that therelationship is that of employer-employee. If that happens the CRA could require the company to retroractively pay CPP, EI and other payroll deductions. By requiring the individual to incorporate, the company avoids that risk, which is why they insist it be done. But the risk then shifts to the individual since the CRA may review the relationship and decide that the individual has carried on a PSB.

A CRA pilot study in 2022 found that many individuals were told to incorporate by their hiring company, and many were incorrectly informed that they were entitled to claim various operating expenses and were eligible for the Small Business Deduction.^[2]

References:

• Personal Service Business - CRA webpage
• Income Tax Act, s.125(7) - definition of a PSB
• Income Tax Act, s.18(1)(p) - expense deduction limitations
• Income Tax Act, s.123.4, 123.5 - re: tax rates
• Income Tax Act, s.125 - no small business deduction