How to ensure compliance with personal services business rules

PSB rules seek to ensure those acting as employees do not obtain a tax benefit by using a corporation (Getty Images/Thomas Barwick)

The Canadian Revenue Agency (CRA) recently launched a new campaign focusing on personal services businesses (PSB). Bruce Ball, FCPA, vice-president, taxation, CPA Canada, summarizes the key things service providers need to know.

CPA Canada: Can you explain why the CRA initiated their PSB campaign?

Bruce Ball (BB): Corporations generally pay less tax than individuals, at least high-rate individuals, so it is quite common to use a corporation to carry on a business which would include a business where you provide services.

The issue that the government’s worried about are situations where an individual who would generally be considered to be acting as an employee chooses to offer their services to the “employer” through a corporation to take advantage of the lower corporate rates and get a tax deferral. The PSB rules are designed to deal with this.

If you form a corporation and provide services, the PSB rules will apply if four conditions are met. Three of the tests will generally be met for incorporated service providers. The fourth test is the incorporated employee test and it will usually determine whether your corporation is a PSB or not. That is, if you provided your services directly, without using a corporation, would you be considered to be employed or self-employed for tax purposes?

CPA Canada: What are the two main tax consequences with PSBs?

BB: If it is determined that a corporation is carrying on a PSB, then there will be two issues with respect to that income.

Firstly, the rules aim to eliminate the tax deferral benefit by denying the small business deduction, so you do not get the small business rate, and an additional 5 per cent tax on the PSB income will be applied. When a future distribution of corporate income is made to the individual, the combined corporate and personal tax is generally higher than the personal tax that would have been payable if the income had been received directly without using a corporation.

The second issue being addressed, is that businesspeople are allowed a wider range of expenses when compared with employees. So if the corporation is carrying on a PSB, corporate expenses deductible against PSB income will generally be limited to those that an individual could have deducted themselves plus salary and benefits that the corporation pays to the “incorporated employee.”

CPA Canada: What are the practical issues that should be considered?

BB: Businesses often prefer to hire incorporated consultants or service providers. Where the service provider is unincorporated, the business hiring them must determine whether they are providing services as a businessperson or as an employee. If the individual is an employee, then the business is supposed to withhold tax, CPP, EI and so on. That is why it is quite common for businesses to only engage incorporated consultants—the employed vs. self-employed issue is a key factor in determining whether a PSB exists and is the service provider’s issue to deal with.

Factors used to decide the employed vs. self-employed issue include the degree of control exercised by the payer over the service provider’s duties, whether the payer uses their own tools to perform the services, whether the service provider must carry out the work personally or if they can hire or subcontract the work (see the full list).

It is also a good idea to have a written agreement which describes the intended relationship. However, the underlying facts must back it up—an agreement may not be determinative if not.

Being subject to the PSB rules because that is the only way you could get work does not mean that you have a tax problem, provided that you understand the issues. As mentioned, a salary paid to you during the year is a deductible expense for the corporation, and that allows you to be treated for tax purposes the same way you would be if you had been working directly for the company as an employee: your corporation’s just acting as a go between essentially. The key is that you do have to pay it during the year, as a salary. Unlike business income generally, an accrued bonus is not deductible when computing PSB income.

CPA Canada: What are the key takeaways for those affected?

BB: It has always been important to make sure that when you are using a corporation to provide services, that you assess whether it qualifies for the small business deduction or not.

What matters now is that you look at your arrangements and satisfy yourself that you are not carrying out a PSB, or if you are, then making sure that you take steps to deal with issues created by the PSB rules.

If the corporation is carrying on a PSB, the objective for many will be to ensure that you pay no more tax than you would have, if you had been an employee directly. If the issues aren’t managed and the PSB rules apply, a significant cost can arise (especially given that more than one taxation year may be open for assessment).

CPA Canada: What is the scope of the CRA’s campaign?

BB: The CRA launched a campaign to help industries that commonly hire incorporated employees understand and comply with their tax obligations. The CRA states that the objective is to inform both payers and payees of their obligations to enable them to make informed decisions on their working relationship. CRA officers started reaching out to the taxpayers in June, and will continue to do so until December 2022.

According to the CRA, no compliance action will result from the review, but businesses will be advised to ensure errors are corrected and that they comply with the Income Tax Act. Beyond this initiative, it is not known if the CRA will be looking at corporations more broadly in the future on the possible application of the PSB rules.

KEEP READING

For more details about the CRA’s campaign focusing on personal services businesses, check out the latest post on CPA Canada’s tax blog.