On October 31, 2011, Canada Revenue Agency (“CRA”) released draft legislation that imposes further punitive rules on Personal Service Businesses (“PSB’s”) by removing the general rate reduction previously allowed. These new rules will become effective for taxation years beginning after October 31, 2011.

The rules for PSB’s deal with incorporated employees. Essentially, an incorporated employee is when a corporation has been placed between what one would normally consider an employee-employer relationship, the employee becomes an “incorporated employee”. By using a corporation, under the old PSB rules, it provides access to the small business deduction and the related low income tax rate, a possible deferral of income tax, limited liability, and potential access to the $750,000 capital gains exemption on the sale of qualifying small business corporation shares.

Income Tax Consequences Once New Legislation Passed

The corporation will be prevented from claiming the small business deduction, both federally and provincially. In Ontario, that means the corporation will be subject to an income tax rate of 39.25% for 2012 instead of the current small business deduction rate of 15.5%. As a consequence, when taking money out of a PSB by way of dividends, the ultimate combined personal and corporate tax rate will approach 58%. This is approximately 10% higher than what an employed taxpayer at the high rate would pay.

In determining the taxable income from a PSB, the only eligible deduction for the corporation would be any salary and benefits paid to the incorporated employee. This means that no other expenses such as travel, office supplies, auto, etc. would be allowed. However, if the incorporated employee is a salesperson receiving commissions, expenses paid by the corporation that would have been allowed as a deduction to the individual personally as a commissioned salesperson will be allowed.

Minimization of Personal Service Business Risk

To minimize your risk of being characterized as a PSB, you must employ more than five full-time employees, have more than two clients, and meet the following criteria by the CRA:

Control Test:
An employer-employee relationship is evident when there is a lack of control over how work is done.  For example, the payer determines how the work should be done, what should be done, and provides training. In a business relationship, the contractor would work independently and have the ability to accept or refuse work at his/her own discretion.

Ownership of Tools Test:
Contractors usually supply their own tools which include instruments, computers, vehicles, and any other items that the worker uses to perform their job.

Detailed Written Contract:
A business relationship is evident when there is a proven ability to hire assistants or contract work.

Chance of Profit or Loss:
These are indicators that there is a business relationship.

Integration Test:
This examines whether the payer’s activities are incorporated into the worker’s business or whether the worker is integrated into the payer’s activities.

Opportunities
While generally a PSB is not desirable, there may be some instances where using a PSB makes sense. For some high rate taxpayers, using a PSB can result in a deferral of taxes if the funds are not required immediately by the owner or it can also allow for some opportunities for income splitting with certain family members.

If you are concerned that your corporation may be a PSB, a conservative approach would be to pay yourself a salary rather than using a dividend remuneration strategy. You may want to avoid some income splitting with family members who are not shareholders, however, your other business deductions are still at risk of being disallowed.

The proposed PSB rules are very punitive. If you may be an “incorporated employee”, and would like more information, then please contact a Millards representative at (519) 759-3511.