Table of Contents:
Introduction: Why Classification Matters
Are you self-employed or an employee? This question has far-reaching tax and legal implications in Canada. The Canada Revenue Agency (CRA) uses specific criteria to classify individuals, and understanding these distinctions is critical, as it impacts your tax treatment, employment benefits, and risk exposure.
The CRA’s Framework: Employee vs. Independent Contractor
The CRA evaluates the relationship between payers and workers using several factors that evolved through case law. These Economic reality tests include the Control Test, Ownership of Tools Test, and Risk of Profit or Loss Test, which collectively reveal the economic reality of the relationship. No single factor is conclusive; instead, courts examine the totality of the relationship.
Control Test
The control test evaluates the degree to which the payer has authority over the worker’s activities. Specifically, it considers:
Who has the right to give orders and instructions to the worker on how the work should be carried out?
Who controls how the work is performed?
Who decides when the work is performed?
The CRA views control as existing if the payer has the right to direct the amount, nature, and management of the work. This test, however, can be less conclusive in cases where workers are professionals or highly skilled tradespeople who bring specialized expertise.
Ownership of Tools Test
This test examines whether the worker provides the tools, equipment, and resources necessary for the job and assumes financial risks. Key markers include:
The worker’s responsibility for supplying their own tools.
Whether the worker bears the cost of maintaining or replacing these tools.
The financial risks associated with performing the job.
Ownership of tools often implies that the worker operates as an independent contractor. However, this test is less definitive for professionals whose main "tool" is their expertise. For example, a consultant providing strategic advice without physical tools could still qualify as a contractor based on other factors. Courts have repeatedly acknowledged that this test carries less weight in cases involving knowledge-based professionals.
Risk of Profit or Loss Test
This test focuses on the worker’s financial engagement in the work relationship. Indicators of independent contractor status include:
The opportunity to make a profit based on efficiency or cost management.
The risk of incurring losses, such as unpaid invoices or damaged assets.
The responsibility for covering operating costs.
Being hired for a specific project or deliverable rather than for ongoing work.
Independent contractors assume greater financial risks and have a direct stake in the profitability of their work. Conversely, employees receive guaranteed payments regardless of the financial performance of their employer. In Wiebe Door Services Ltd. v. MNR, the court highlighted that assuming operational expenses and financial risk was a defining trait of an independent contractor.
Integration test
The Integration Test is a legal principle used to determine whether a worker is classified as an employee or an independent contractor. It focuses on whether the worker is economically dependent on the organization, which helps assess the degree of control and integration within the business. If the worker does not have other clients, relies solely on the organization for their income, or receives employment-like benefits such as vacation pay, health insurance, or pensions, they are likely to be economically dependent. This dependence suggests that the worker is integrated into the organization's operations rather than operating independently, supporting their classification as an employee. Conversely, workers with multiple clients, independent workflows, and no entitlement to employee benefits are more likely to be considered independent contractors.
Personal Service Business (PSB)
Imagine this: Alex, a skilled IT consultant, worked for a software company for several years as an employee. One day, the company approached Alex with a proposition—to save costs and streamline operations, they suggested Alex leave his employee position and instead bill them as an independent contractor. Eager to maintain the relationship and assuming potential tax savings, Alex incorporated a small business to provide his services. Months later, Alex received a letter from the CRA. The CRA suggested that his corporation might be classified as a Personal Service Business (PSB), a designation with significant tax implications.
A Personal Service Business (PSB) is often referred to as an "incorporated employee." It arises when a Canadian-controlled private corporation (CCPC) provides services to a client in a manner that mirrors an employer-employee relationship. Specifically, a business is classified as a PSB if:
An individual performing the services owns 10% or more of the CCPC, and
The individual would reasonably be considered an employee of the client if not for the corporation.
Implications of PSB Classification
Denied Small Business Deduction
A PSB does not qualify for the small business deduction (SBD) or the general rate reduction (GRR), which significantly impacts the overall tax burden.
Higher Tax Rates
An additional 5% federal tax is applied to PSB income. Combined with the base corporate tax rate, this leads to a higher federal tax rate than normal.
Normal: 38% base rate - 10% Federal tax abatement - 19% SBD = 9%
PSB: 38% base rate - 10% Federal tax abatement + 5% PSB surcharge = 33%
Please note this is the federal Rate, Provincial taxes aside
Restricted Expense Deductions
Deductions against PSB income are limited primarily to:
Wages and benefits paid to the individual performing the services.
Employment-related expenses deductible under Section 8 of the Income Tax Act.
Notably, "normal" business expenses, such as office supplies, travel costs, and advertising, are not deductible, further increasing the financial strain on PSBs.
Employee vs. Independent Contractor: A Comparison Table
Aspect | Employee | Independent Contractor |
Income Type | Employment income | Business income |
Tax Basis | Taxable on a cash basis | Taxable on an accrual basis |
Deductible Expenses | Limited (Section 8) | Not limited |
Tax Responsibility | Employer deducts income tax, EI, and CPP | Pays own income tax, EI, and CPP |
Economic Risk | Lower: Job security, severance, pensions, etc. | Higher: No job security or severance |
Work Termination | Can be fired for bad work | Can be sued for bad work |
Ownership of Tools | Employer provides tools | Uses their own tools |
Chance of Profit/Loss | No risk of loss | Potential for profit or loss |
FAQs
What is a Personal Service Business (PSB)?
A PSB is a corporation that provides services in a way that mirrors an employer-employee relationship. It typically applies when the individual performing the work is effectively considered an employee of the client if not for the incorporation. This designation leads to limited tax benefits and increased liabilities under the Income Tax Act.
What deductions are allowed for a PSB?
Under Section 18(1)(p) of the Income Tax Act, PSBs can only deduct wages and benefits paid to the individual providing the services, as well as limited employment-related expenses outlined in Section 8. "Normal" business expenses such as travel, advertising, or office supplies are not deductible.
What happens if my corporation is classified as a PSB?
If classified as a PSB, your corporation will:
Lose access to the Small Business Deduction (Section 125(7)).
Be subject to a federal tax rate of 33% (38% base rate minus 10% Federal tax abatement, plus a 5% PSB surcharge).
Have restricted expense deductions, significantly increasing taxable income.
How does the CRA determine if a business is a PSB?
The CRA evaluates whether the individual performing the services would reasonably be considered an employee of the client without the corporation. Factors include:
Control over work methods and hours.
Ownership of tools.
Financial risk and chance of profit.
The number of employees within the corporation (more than five full-time employees can negate PSB classification).
Can I avoid PSB classification?
To avoid PSB classification, ensure that:
Your corporation employs more than five full-time employees throughout the year.
Services are provided to an associated corporation.
The working relationship does not closely resemble traditional employment.
Relevant ITA Sections and Case Citations
Income Tax Act (ITA) Sections
Section 125(7): Small business deduction exclusions for PSBs
Section 18(1)(p): Deductibility limitations for PSBs
IPG-069: Determining the Employer/Employee Relationship
Notable Case Law
Wiebe Door Services Ltd. v. MNR, [1986] 3 FC 553 - This case introduced the importance of evaluating economic realities, particularly operational expenses and financial risk, to distinguish between employee and contractor statuses.
Royal Winnipeg Ballet v. MNR, [2006] FCA 87 - The court ruled that dancers, while under significant artistic control, were independent contractors due to their professional autonomy and lack of integration into the employer's core operations.
Insurance Institute of Ontario v. MNR, 2020 TCC 41 - This case stressed the importance of clear contractual documentation in determining worker classification, while actual practices must reflect the stated relationship.
Montreal v. Montreal Locomotive Works Ltd. et al – In this case the court suggested that a fourfold test would in some cases be more appropriate, a complex involving: control, ownership of the tools, chance of profit, and risk of loss.
Contact Us!
Determining whether you or your corporation falls under the classification of an employee, independent contractor, or Personal Service Business (PSB) can have significant tax and financial implications. Misclassification could result in lost deductions, higher tax rates, and penalties from the CRA.
At Elkhanagry Accounting, we specialize in guiding individuals and businesses through the complexities of worker classification and PSB implications.
Contact us for a consultation to ensure your arrangements are compliant and optimized for tax efficiency.
Disclaimer
This article provides general information that is current as of the posting date and is not updated, which means it may become outdated. The content is not intended to provide accounting, tax, or financial advice and should not be relied upon as such. Tax and financial situations are unique to each individual and may differ from the examples discussed in this article. For personalized advice, please consult a qualified tax professional.
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