17 minute read 4 Jul. 2024
EY - Smiling young woman looking at smartphone in funfair at night

TaxMatters@EY: Family Wealth Edition – July 2024

By EY Canada

Multidisciplinary professional services organization

17 minute read 4 Jul. 2024
TaxMatters@EY is an update on recent Canadian tax news, case developments, publications and more. The quarterly Family Wealth Edition focuses on tax strategies and related topics for preserving family wealth.

In an evolving tax environment, is trust your most valued currency?

In this issue of TaxMatters@EY: Family Wealth Edition, we provide updates on tax strategies and related topics for preserving family wealth. In this issue, we discuss:

 


(Chapter breaker)
1

Chapter 1

Personal services businesses: tax considerations to keep in mind

 

Kelsey Horning, Toronto, and Gael Melville, Vancouver

If you provide your services through a corporation, you may have decided to incorporate your business for a variety of reasons. Maybe the company you’re providing services to requires you to have a corporation, or you incorporated your business because you heard about the benefits of limited liability or tax planning opportunities like the possibility of deferring tax by retaining funds in the corporation.

Whatever your reasons for incorporation, you should be aware of the personal services business rules and their implications, which include higher tax rates and limits on expense deductions. Given that the Canada Revenue Agency (CRA) is currently undertaking the second phase of a pilot project on personal services businesses, now is a good time to make sure you understand the rules.

Meaning of personal services business

You may have a personal services business if you perform work, through a corporation, that would otherwise be considered the work of an employee of the entity receiving the services if there was no corporation.

There are a number of criteria for determining whether a corporation is carrying on a personal services business.

You, as the person providing services on behalf of the corporation, or a person related to you, must be a specified shareholder of the corporation. Generally speaking, a specified shareholder is someone who owns 10% or more of the issued shares of any class of the corporation or a related corporation.1 You must also be providing services in such a way that you would reasonably be considered an employee or officer of the entity that ultimately receives the services if there were no corporation.

There are two exclusions for corporations that are not considered to be personal services businesses. If your corporation has more than five full-time employees throughout the year, it is not considered a personal services business. A corporation that receives an amount for your services from an associated corporation is also not considered to be a personal services business.2

As noted, one of the hallmarks of a personal services business is that you as the person providing services on behalf of the corporation would otherwise be an employee of the recipient of the services. This is referred to in the legislation as an “incorporated employee.”

The courts have considered a number of factors in determining whether an individual is an employee or independent contractor. In general terms, these factors include:

  • Ownership of tools: who provides the equipment for the work
  • Chance of profit and risk of loss: whether the worker can make a profit or loss as a result of their work
  • Degree of integration: whether the services are an integral part of the overall business
  • Degree of control: whether the recipient of the services controls how the services are performed3

If the criteria for being a personal services business are met, the various implications of that designation apply.

Implications of being a personal services business

The primary implications of a corporation carrying on a personal services business are that the corporation is subject to a higher income tax rate and may only claim very limited types of expense deductions. These measures are somewhat punitive and are intended to discourage the use of these types of corporations.

Tax rates

Personal services businesses are subject to a higher corporate income tax rate than other corporations. Specifically, personal services businesses cannot claim the 13% federal general corporate tax rate reduction or the 6% federal small business rate reduction. As a result, personal services businesses must pay tax at the full federal and provincial corporate tax rates. Furthermore, they are also subject to an additional 5% federal tax, bringing the total federal rate to 33%, which is equivalent to the top marginal personal income tax rate for individuals. This rate is further increased by the addition of provincial corporate income tax, which varies by province.

The federal corporate income tax rates are as follows:

General

Small business

Personal services business

15%4

9%5

33%6

To illustrate the impact of the tax rate applicable to personal services businesses, consider a corporation in Ontario that is a personal services business but that would otherwise be subject to the small business tax rate. When the Ontario corporate income tax rate is taken into account, the corporation’s combined income tax rate becomes 44.5% — 33% general federal rate plus 11.5% general provincial rate — compared with 12.2% if it were not a personal services business — 9% federal small business rate plus 3.2% provincial small business rate. This means that if the corporation earned $100,000 of income for the year, it would have only $55,500 of after-tax earnings available for distribution to its shareholder, rather than $87,800 if it were not a personal services business and was eligible for the small business rate.7

Similarly, if you consider whether there is an advantage to an individual in Ontario earning income directly as an individual or earning it through a corporation, there’s a significant difference between a corporation eligible for the small business rate and one that is treated as a personal services business. For a corporation carrying on a personal services business, the tax cost of distributing after-tax corporate earnings as dividends rather than paying them out as salary or a bonus is 12.81% and the deferral benefit of keeping funds in the corporation is only 9.03%. This contrasts with a tax cost of 0.59% and deferral benefit of 41.33% for active business income of a corporation that is eligible for the small business rate and is not subject to the personal services business rules.8

Expenses

The second major implication of a corporation being a personal services business relates to the deductibility of expenses. Personal services businesses are generally limited to deductions for:

  • Salary or wages, and benefits or allowances paid to you as the incorporated employee
  • Expenses associated with selling property or negotiating contracts that would have been deductible in computing your employment income as an employee if you had paid for them directly and had been required by an employer to pay them
  • Legal expenses incurred to collect an amount owing for services provided

This is much narrower than the expense deductions available to other corporations, such as rent, utilities and other administrative expenses. It’s also important to note that the corporation may only deduct salary or wages it pays to the incorporated employee in the same year. If the corporation accrues a bonus at the year end that is not paid to the employee until the following year, the corporation cannot deduct that amount in computing its income for the current year.

In addition to the difference in applicable tax rates and the limitations on expense deductions, there are other consequences of a corporation carrying on a personal services business. For example, the shares of the corporation are not qualified small business corporation shares and are therefore not eligible for the lifetime capital gains exemption.

Example

To illustrate how the personal services business rules may apply, consider Alex, a resident of British Columbia, who is offered a full-time 12-month contract position at B Co. The contract specifies that Alex must provide his services through a corporation, so Alex incorporates AlexCo and is the only shareholder and main employee. B Co. is the only client of AlexCo and the two corporations are not associated with one another.

B Co provides Alex with a laptop and a cellphone for business use and Alex works only for B Co during the period of his contract. AlexCo invoices B Co for Alex’s services. B Co pays AlexCo, which uses part of the funds to pay a salary to Alex each month. AlexCo also pays a small salary to Alex’s spouse James, who takes care of invoicing and bookkeeping for the company. The remaining funds are retained in AlexCo. 

Assuming Alex would be considered an employee of B Co without the involvement of AlexCo, AlexCo meets the conditions to be a personal services business.9 As the sole shareholder, Alex is a specified shareholder of AlexCo. Alex is also the only employee, meaning that the “more than five full-time employees” exception does not apply. Since B Co is the corporation’s only source of income and the corporations are not associated, the exemption for associated corporations would not apply either.

As a result, AlexCo would be subject to the higher income tax rate and expense deduction restrictions that apply to personal services businesses. AlexCo. could deduct the salary it paid to Alex in the year when computing its income, but could not deduct the salary paid to James, since he is not the incorporated employee. Note that even though the salary is not deductible for AlexCo, it will still be taxable as employment income for James. Funds remaining in the corporation at the year end would be taxable at a combined federal-British Columbia corporate income tax rate of 45%.10

The CRA pilot project

The CRA is currently undertaking phase 2 of a pilot project related to personal services businesses.11 Phase 1 was completed in 2022 and focused on identifying companies that hire personal services businesses and on collecting data.

One of the trends the CRA identified as a result of phase 1 is that a majority (64%) of potential personal services businesses are claiming the small business deduction despite being ineligible. Furthermore, nearly 74% of potential personal services businesses operate in three sectors: 35% are in transportation and warehousing, 26% are in professional, scientific and technical services, and 13% are in construction.

Phase 2 began in late 2023 and is focused on identifying potential personal services businesses. Specifically, phase 2 concerns the 2022 taxation year and involves voluntary interviews with a random inventory of around 2,100 corporations that were identified as possible personal services businesses. This phase of the review will also include continued education on taxpayers’ tax obligations.

The pilot indicates that the CRA is focusing increasingly on personal services businesses. Although the CRA has begun its activities in this area with outreach and education, compliance measures are expected to follow at a later time. If your corporation may be a personal services business, you should consult your EY tax advisor on the potential application of the personal services business rules.

Tax tips
  • If you provide services through a corporation, review your current working arrangements with your EY advisor so you don’t fall within the personal services business rules.
  • If your corporation may be a personal services business, consider paying out all the corporation’s income for the year as salary instead of retaining funds in the corporation that will be taxed at the rate applicable to personal services business income.
  • Pay salary or wages only to the incorporated employee, since only those salaries or wages are deductible in calculating the income from a personal services business.
  • Pay out any annual bonuses before the year end, since a bonus that is accrued but unpaid in the year cannot be deducted in calculating the income from a personal services business for that year.   
  • Show article references# 
    1. For purposes of this test, the taxpayer is deemed to own shares in a number of situations, including shares owned through a partnership or trust.
    2. A corporation's status of being associated (or not) with other corporations determines its access to certain tax benefits. The most well known of these is the small business deduction. The rules regarding when corporations are associated with one another are complex and beyond the scope of this article.
    3. For example, see Dynamic Industries Ltd. v The Queen, 2005 FCA 211.
    4. The full corporate rate is 38%. However, this is subject to a 10% provincial abatement, resulting in a base federal corporate rate of 28%. The base federal corporate rate is subject to a further 13% general rate reduction, resulting in the federal corporate tax rate shown in the table.
    5. Base federal corporate rate of 28% minus the 19% small business deduction.
    6. Base federal corporate rate of 28% plus the 5% additional tax on personal services businesses.
    7. For more information on federal and provincial corporate income tax rates, refer to EY’s Tax calculators & rates.
    8. The calculations assume the individual is taxed at the top marginal federal-Ontario personal income tax rate for 2024. Payroll taxes at the corporate level, such as CPP and employer health taxes, and CPP contributions and provincial health premiums at the individual level, are ignored.
    9. Factors that may support Alex's characterization as an employee include the fact that B Co provided him with a laptop and cellphone for business use, and that Alex works only for B Co.
    10. General federal rate of 33% plus British Columbia provincial rate of 12%.
    11. For more information on the pilot project, consult the CRA webpage at https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/corporations/corporation-income-tax-return/personal-services-business-pilot.html

  

(Chapter breaker)
2

Chapter 2

Recent Tax Alerts – Canada

Tax Alerts cover significant tax news, developments and changes in legislation that affect Canadian businesses. They act as technical summaries to keep you on top of the latest tax issues.

Summary

For more information on EY’s tax services, visit us at https://www.ey.com/en_ca/tax. For questions or comments about this newsletter, email Tax.Matters@ca.ey.com.  And follow us on Twitter @EYCanada.

Direct to your inbox

Sign-up to receive TaxMatters@EY by email each month.

Subscribe

About this article

By EY Canada

Multidisciplinary professional services organization