Before anyone's mind starts to wander, the term "Personal Services Business" is simply a term defined under the Income Tax Act Canada. Without going into the technical details of the definition, it essentially means a business carried on by a corporation where the services performed by the corporation are provided by an individual who would otherwise be considered an employee of the recipient of the services. The individual in this situation is often referred to as an "incorporated employee".
In the classic example, an employee of a corporation leaves employment and then starts a corporation to provide services to his or her former employer. The motivation behind this structure is to take advantage of the small business deduction rate for Canadian controlled private corporations and the numerous deductions available to a corporation, as opposed to an employee.
Back nearly thirty (30) years ago, in an effort to curb these arrangements, the Department of Finance enacted legislation to deal with income earned by a personal services business. The effect of the original legislation was to deny the small business deduction as well as the deduction of most ordinary expenses. The result was that the incorporated employee would be taxed at the higher corporate tax rate and would have most expenses disallowed. At the end of the day, this legislation was punitive in that it put the individual in a worse after-tax position than they would have been had they earned the employment income directly.
Although it is not directly related the introduction of the so called "Kiddy Tax" was aimed at the same type of tax planning. The focus there too was on attacking planning schemes to reduce the overall tax rate to families by income splitting with minors. The Kiddy Tax essentially took away any advantage of allocating income to children.
Most recently, the trend has been to lower the overall tax rate for corporations. As the corporate tax rate has come down relative to individual employment income, one of the unintended results was that the punitive effect of the Personal Services Business provisions has in many circumstances been negated. As a result, we have seen an increase in individuals deliberately setting up Personal Services Business corporations to take advantage of the tax deferral that is now available even without the additional advantage of the small business deduction rate.
In order to combat this new planning opportunity, new rules have been proposed in the draft legislation introduced on October 31st, 2011. Effectively, the new legislation takes away the corporate tax rate reductions on personal services business income. This is in addition to the denial of the Small Business deduction and expense deductibility. This new legislation will once again re-instate the punitive effect of being classified as a Personal Services Business.
Along with the legislative trend, we have also seen a parallel trend in the audit practices of the Canada Revenue Agency ("CRA") to aggressively attack businesses with the Personal Services Business label. The experience has been to see various industries, such as IT contractors, being the subject of extensive audits to asses corporations based on the Personal Services Business characterization.
The best line of defense in these situations is to argue that the individual is an independent contractor as opposed to an employee of the recipient corporation. This line of defense is easier where the targeted corporation is providing services to a number of customers. This makes it difficult for CRA to argue that the individual providing the services in the corporation would be an employee of any one of those customers. The situation gets more complicated where there is in fact just one recipient of the services for extended periods of time.
One of the classic examples which we see quite often, particularly in this business community, is IT consulting firms engaging numerous corporations to provide services to government departments. In these circumstances CRA often takes an interesting approach in analyzing the test for whether or not an individual is an employee by using factors present in both the IT consulting firm and the government department, effectively treating both as a composite employer. While we might question this reasoning from a legal standpoint, it is important to keep in mind that even though this approach may ultimately be defeated in a court of law, the process can be very expensive, time consuming and a distraction from the otherwise productive activities of the individual involved.
Commencing with the 2012 tax year, it will once again be detrimental from a tax perspective to be categorized as a Personal Services Business. In the event that there are any risks that you may be considered an incorporated employee, you should consult your tax advisor to help you asses and manage those risks.
Harold J. Feder is a partner with the law firm of BrazeauSeller.LLP. He practises in the areas of tax and estate planning for individuals and business owners. Harold can be reached at 613-237-4000 ext. 242 or firstname.lastname@example.org. For more information about Harold, please visit www.brazeauseller.com.