Up Close And Personal
More Companies May Soon Be Eligible For The Small-Business Tax Rate
The House Of Commons Standing Committee on Finance just over a year ago held a hearing about the taxation and characterization of personal services businesses (PSB) by the Canada Revenue Agency. Should the government adopt the committee's recommendation, many entrepreneurs would benefit.
Under the Income Tax Act, private Canadian corporations that are engaged in an active business can take advantage of the small-business rate on the first $500,000 of net income earned annually. This special rate is only available to businesses that incorporate and does not apply to sole proprietors, who face tax on their self-employment business income at personal-income tax rates.
As a result of the low small-business corporate tax rate, and the added benefit of being able to indefinitely defer personal tax on amounts not yet paid out to the shareholder in the form of dividends, many individuals who may otherwise be considered to be employees have been tempted to incorporate. The risk here is that if the CRA determines that the relationship between the incorporated individual and the "client" to whom the individual is providing services to is similar to an employer-employee relationship, the CRA may classify the small business as a PSB.
A PSB cannot claim the small-business deduction and, consequently, has to pay tax at the higher corporate rate. In addition, expenses of PSBs are restricted to salaries and wages paid to the "incorporated employee," and a number of very limited other expenses that an employee is permitted to claim. Companies that purchase the services of an incorporated business (and their employees) rather than hire employees directly don't have to pay health benefits and don't remit payroll deductions such as Employment Insurance and Canada/Quebec Pension Plans.
The consequence of the PSB designation is that the "incorporated employee" is denied the benefits of owning a small business, such as access to the small-business tax rate, the ability to claim a variety of business expenses, and the benefits of being an employee, such as having the employer make contributions to the CPP/QPP and EI, and, ultimately, being able to collect EI. The standing committee concluded that this outcome "was not the original intent of [the PSB rules]." It recommended the legislation be amended "in such a manner that reflects the realities of the modern labour market… in order to ensure tax fairness for those small-business owners who are deemed to be 'incorporated employees.'"