What you need to know from an income tax perspective
In the past few years, and even more so in the current economic environment, it has become common for individuals to set up their own corporations, which can then be used to contract out the services of the principal (or often the sole) shareholder of the corporation to one or more businesses. There are some benefits to this arrangement from an income tax perspective, such as lower corporate income taxes, deduction of business expenses and the ability to pay salaries or dividends to family members, to name a few.
A low corporate tax rate is generally available to a Canadian-controlled private corporation on its active business income earned in Canada, up to its federal and provincial small business limits. Effective January 1, 2009, the federal limit is $500,000 (previously $400,000). The provincial limit varies from province to province – in British Columbia, the limit is $400,000.
Consider the example of Jane Doe. Jane is a business consultant who recently lost her job, and is looking at setting up her own corporation, JaneCo, to provide her consulting services. She has already lined up some work with a large firm, LargeCo, and was considering setting up a corporation to provide her services.
Is it a “personal services business?”
In setting up JaneCo to provide her services, Jane should be mindful of the “personal services business” provisions of the Income Tax Act (ITA). Income from a personal services business is excluded from active business income, pursuant to section 248 and subsection 125(7) of the ITA. As such, income from that business is not eligible for the lower corporate income tax rates. Instead, such income is taxed at the highest federal/B.C. corporate income tax rate of 30 per cent, rather than the lower rate of 13.5 per cent for 2009.
A personal services business provides the services of an “incorporated employee” to an entity, where the incorporated employee would otherwise reasonably be regarded as an officer or employee. Therefore, we have to determine whether JaneCo is providing the services of an incorporated employee or an independent contractor.
Contract of services or contract for services
Is Jane considered to be an incorporated employee or an independent contractor? The critical issue is whether her business consulting services are under a contract of services (i.e. an employment contract) or a contract for services (i.e. an independent contractor). A contract of service generally exists if the person for whom the services are performed has the right to control the amount, the nature and the management of the work to be done and the manner of doing it. A contract for services exists when a person is engaged to achieve a defined objective and is given all the freedom required to attain the desired result.
The Canada Revenue Agency has an excellent guide, RC4110, Employee or Self-Employed, that assists in determining the nature of the contract. Some factors to consider are:
- Did Jane have a set number of working hours each day?
- Did Jane have to account for her time?
- Was Jane given specific job instructions?
- Was Jane a member of LargeCo’s benefit plan?
- Did Jane have use of LargeCo’s computer equipment and office supplies?
- Did LargeCo provide an office to Jane?
- Was Jane given a specific title and business card on LargeCo’s letterhead?
Whether Jane can be “reasonably regarded” as an “employee” or as an “independent contractor” is a question that requires an analysis of all factors surrounding the terms and conditions of her contract with LargeCo. In general, to be considered an independent contractor, JaneCo must have agreed to provide a service with no commitment regarding the number of hours worked. Jane should also be performing the service with little or no supervision. JaneCo must issue its own invoices and receive cheques for work completed. In addition, Jane should not receive any benefits from LargeCo, and should operate from JaneCo’s own office and use its own equipment.
In addition, for JaneCo to be considered a personal services business, the incorporated employee (Jane), or a person related to Jane, must be a “specified shareholder” of the corporation providing the services. Specified shareholder generally means that Jane, or someone related to her, directly or indirectly owns 10 per cent or more of the issued shares of any class of JaneCo.
There are additional rules that include ownership in a related corporation, and similar rules apply for shares owned through a partnership or trust. However, a corporation will not be regarded as carrying on a personal services business in a taxation year if throughout the year it employs more than five full-time employees for that business, or if the amount was received for services rendered to an associated corporation.
In addition to a personal services business being excluded from the definition of an “active business,” paragraph 18(1)(p) of the ITA also limits deductions in computing the income from such a business. All deductions are disallowed, except:
- salary, wages or other remuneration, and any benefits or allowance paid or provided to an incorporated employee;
- selling and similar expenses that would have been deductible in computing employment income if the individual had expended them; and
- legal expenses incurred in collecting amounts owing for services rendered.
Income from a personal services business is also not eligible for a tax refund on the basis of taxable dividends paid. It will therefore be taxable at the highest corporate rate.
Tax planning considerations
Under new rules introduced in 2006, any dividends paid by a corporation from its personal services business would be considered eligible dividends, which are subject to a lower personal tax rate than non-eligible dividends. The maximum tax on eligible dividends received by a B.C. resident is currently 19.9 per cent, compared to a rate of 32.7 per cent for non-eligible dividends. As such, it is no longer essential that all income earned in a personal services business be paid out to the incorporated employee as a salary.
Tax planning can be undertaken such that family members become shareholders of the personal services business corporation, so that dividends can be paid to them. However, it should be noted that the ITA contains various anti-avoidance provisions, such as subsections 56(2) and 56(4), or the General Anti-Avoidance Rules, that could result in such dividends being taxed in the hands of the principal shareholder. As such, care should be taken to ensure that any payments to someone other than the principal shareholder are appropriate.
In summary, while Jane may see some advantages from setting up JaneCo, she should be aware of the tax limitations if JaneCo is considered to be a personal services business. A careful review of her relationship with LargeCo, and any other contracts she obtains, is necessary to determine whether she is an incorporated employee or an independent contractor. Anyone considering incorporation should obtain professional advice before proceeding.
Alladin Versi, CMA, FCMA, CFP is a tax specialist and currently leads the MNP LLP tax group for the Vancouver Island region. Based out of MNP’s Nanaimo office, Alladin specializes in strategic corporate tax planning of businesses, corporate reorganizations, purchases and sales of businesses, as well as estate planning.