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Taxes Beware the rules that apply to incorporated employees

I was at a CFL football game a few weeks ago, between the Toronto Argonauts and the Hamilton Tiger-Cats. A fan next to me pointed out that one man, in particular, left his mark on both franchises in his time. That man was Ralph Sazio. He was an important figure in the CFL in the 1960s through the 80s, as a player, general manager and executive. Mr. Sazio was inducted as a builder into the Canadian Football Hall of Fame in 1988.

But if you’re a tax geek, you may also be aware that Mr. Sazio won an important tax court case against the government in 1969. His record as a coach was 50-20-1 if you count the victory against the taxman in his totals. You see, Mr. Sazio figured out that offering his coaching services to the Tiger-Cats as an independent contractor, through a corporation he set up, would save him tax over simply taking payment as an employee. The government tried to tax Mr. Sazio on the income personally, as an employee, but the court ruled that his corporation was entitled to pay the tax.

Since that time, others have tried the same tactic. But in 1981, the Personal Services Business (PSB) rules in our tax law were introduced.

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The rules

The PSB rules are designed to ensure that you won’t gain any tax benefit if you’re earning your income through a corporation, but you’re really viewed as an employee by the taxman. You might be caught under these rules if you may “reasonably be regarded as an officer or employee of the hirer, but for the existence of the corporation," and you or a related person owns 10 per cent or more of the company providing the services.

If the PSB rules apply to you, then your corporation will be subject to full federal and provincial tax rates on all taxable income, with no ability to claim the small business deduction (which normally reduces the corporate tax rate for small businesses to an average across Canada of about 11.6 per cent). Further, the corporation won’t be entitled to deductions other than salaries paid and employment benefits provided to the incorporated employee, and certain other specified expenses that generally include amounts that would have been deductible by an employee.

When are you regarded as an employee of the hirer? Our tax law doesn’t define what an employee is (versus an independent contractor), so we have to look to court decisions for guidance. The ultimate test, as set out by the Supreme Court of Canada in Sagaz Industries Inc. (2001 SCC 59), is whether you are performing services “as a person in business on his own account." How is this determined? Four tests have really evolved from the case Wiebe Door Services Ltd. (87 DTC 5025), as follows:

  • Control test: The degree of control exercised by the hirer over the duties of the contractor;
  • Integration test: The degree to which the work performed by the contractor is integrated with the hirer’s business;
  • Tools test: Whether the hirer provides the tools to be used to perform the services;
  • Financial risk test: Whether the contractor reaps the rewards of profit, and assumes the risk of loss.

In recent cases, the courts have also considered the intention of the hirer and the individual providing the services. The problem? The court decisions have not looked at the concept of “intention” in a consistent manner, so it’s tough to put much weight on this factor.

The strategies

So, how can you avoid the ugly tax consequences of the PSB rules if you’re providing services through your own corporation? Consider these three ideas:

Pay yourself salary. You can minimize the taxable income of your corporation, and therefore avoid the high rate of tax on PSB income, by paying all income out to yourself as salary in the year it’s earned by your corporation.

Employ more than five. If your corporation employs more than five people, you’ll avoid PSB status, and the nasty tax implications. Note: If you employ fewer than five so that you’re still considered a PSB, you won’t be able to deduct the salaries of the other individuals (only salaries paid to yourself). Bad idea.

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Ensure good facts. Build the argument that you’re truly an independent contractor to avoid PSB status. How? Through evidence such as: a contract showing your intention to be independent, proper invoicing and GST/HST registration, revenues from multiple clients, controlling your own work, providing your own tools and equipment, not accepting any employment-like benefits and standing to suffer a loss for inefficiency or poor performance, for example.

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at tim@ourfamilyoffice.ca.

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