A corporation has many benefits as a vehicle for Canadians who carry on small businesses. In addition to the benefits of limited liability protection, Canadian small business corporations are granted a variety of tax advantages under the Income Tax Act (the “Act”). These corporations enjoy a tax rate of appox. 15% on active income from business (compared to the top personal tax rate of approx. 54%), which provides tax-deferral opportunities when the after-tax funds are left in the corporation and which can lead to a lower tax bill on distribution of profits to Canadian shareholders. Nevertheless, the Act does not all for these tax benefits to all small businesses that operate through corporations. Canadian corporations that operate a “personal services business” (“PSB”) do not benefit from the lower tax rate, ultimately resulting in a higher combined (corporate and personal) tax bill, and are also denied a variety of deductions for business expenses otherwise available to other Canadian corporations. It is important to understand how your corporation will be characterized before the CRA reassesses your corporation’s tax return on the basis that it is carrying on a PSB. The result of being assessed as a PSB by the CRA is punitive.
The definition of a PSB captures a business of providing services carried on through a corporation where the individual providing services on behalf of the corporation or any person related to that individual owns more than 10% of the corporation’s shares and the individual providing services would reasonably be considered an employee of the corporation’s client but for the existence of the corporation. In other words, a PSB contemplates situations where an individual who would otherwise be considered to be an employee has incorporated in order to access the tax benefits of running a business through a corporation.
A key element in determining if a corporation is carrying on a PSB is often whether an employment relationship would exist but for the corporation. The test established by case law and accepted by CRA involves multiple factors, with no one factor being determinative. These factors include the degree of control exercised by the corporation over the manner its services are provided, the corporation’s risk of loss and opportunity to profit from the provision of the services, whether the corporation owns the tools used to provide the services and the extent to which the corporation is operating a business independent from the business to which it provides the services.
It is important for Canadians who operate their business through a corporation to be aware of the potential for CRA to re-characterize their corporations as operating a PSB. For additional assistance and an assessment of your situation, contact one of our tax lawyers for a consultation. For more information on other tax traps refer to Shareholder Benefits/Loans; When Is It Safe to Pay a Dividend?; 21 Year Time Bomb; 160 Assessments; Capital Gain or Full Rate Income?