In many industries, it is common for workers to incorporate and provide their services through their corporation.^[1] Oftentimes, workers want to take advantage of the tax benefits that come with incorporation, including a lower corporate tax rate and deductions only available to corporations. In other cases, the worker may feel incorporation is necessary to obtain work.^[2]

Although personal incorporation is legitimate, workers who do pursue this incorporation should be wary that the Canada Revenue Agency (CRA) may classify them as a Personal Services Business, a tax classification that effectively strips away the tax benefits a corporation can normally take advantage of.

This article will break down what a Personal Services Business is, how the CRA determines whether your corporation is a Personal Services Business, and the tax implications of a Personal Services Business classification.

What is a Personal Services Business

Personal Services Businesses are defined in section 125(7) of the Income Tax Act (ITA).^[3] As a general rule, a Personal Services Business is a corporation that earns income from services provided by an individual who would otherwise be considered an employee of the payer if the corporation did not exist. In other words, it catches corporations that are really just employees in disguise.

An employment relationship is to be distinguished from an independent contractor relationship. Incorporated workers who would otherwise be independent contractors would not be classified as a Personal Services Business.

Furthermore, even if the incorporated worker meets the definition above, s. 125(7) of the ITA outlines two explicit exemptions where the Personal Services Business classification will NOT apply. First, the classification will not apply if the earning corporation has 5 or more employees. Second, the classification will not apply if the payer is a corporation associated with the earning corporation, such as a subsidiary or parent corporation.

The Personal Services Business classification was introduced by the Canadian Government to prevent certain tax avoidance strategies that were commonplace among incorporated workers. As such, the classification has the effect of preventing certain deductions and applying a higher corporate tax rate – to be discussed in further detail below.

How to Determine if you are a Personal Services Business

The CRA will classify the corporation as a Personal Services Business if the following requirements are met: ^[4]

1. The taxpayer or a related person – i.e. parent, child, sibling, marriage, common law partnership – owns 10% or more of the shares in the earning corporation,
2. The payer is NOT a corporation associated with the corporation – i.e. not within arm’s length,
3. The corporation employs less than 5 full-time employees, and
4. The taxpayer would, but for the corporation, be reasonably regarded as an employee,
   1. For help determining whether a worker would be an employee or independent contractor, see our article here.

If the four conditions are met, the taxpayer can expect that the CRA will classify the corporation as a Personal Services Business.

What are the Tax Implications

As mentioned above, the Personal Services Business classification exists to prevent these businesses from claiming the tax benefits that come with incorporation. As such, the implications of a Personal Services Business classification are to effectively treat the income as personal employment income.

Unlike regular corporations, Personal Services Businesses:

1. Cannot claim the small business deduction,^[5]
2. Cannot claim the general corporate tax rate deduction,^[6]
3. Cannot claim expense deductions generally available to corporations except for:
   1. salaries and wages,
   2. benefits and allowances,
   3. some expenses related to the selling of property or the negotiation of contracts,
   4. legal expenses incurred to collect amounts owing for its services rendered,^[7]
4. Are subject to a 5% surtax on corporate income.^[8]

As a result, Personal Services Businesses will be taxed at the full federal and provincial tax rates plus the additional 5% surtax on their income. For Personal Services Businesses in Ontario, that works out to a 44.5% tax rate, nearly half of all income, all while the corporation cannot claim many expenses it incurs. Furthermore, a Personal Services Business must still comply with payroll obligations such as withholding income tax, CPP contributions, and EI deductions from salaries paid to employees.

Mitigation of the negative impacts arising from a PSB designation is possible, but does not eliminate the greater tax burden. A PSB can reduce its substantial tax burden by paying out as much of its income as salaries/wages as it can, since salaries/wages can be deducted regardless of PSB designation. This can reduce the corporate tax payable down to zero if income is completely paid out. However, this strategy would not reduce other obligations, such as payroll tax, or the income tax of the worker receiving the salary/wages. As such, this strategy is best viewed as damage control.

Conclusion

Personal Services Business classification is an important consideration for any worker who is either already incorporated or thinking of incorporation. In many cases, a Personal Services Business corporation will be subject to a higher tax rate than what the worker would be personally subject to as a regular employee.

Workers in the industries found to have the most potential Personal Services Businesses – Transportation, Professional Services, and Construction – should be particularly careful, as this may increase the possibility of an audit from the CRA. An assessment or reassessment by the CRA that a corporation was not correctly classified as a Personal Services Business may result in large tax arrears and penalties. For this reason, workers should seek guidance from a tax professional prior to incorporation.

If your corporation has been classified as a Personal Services Business by the CRA and you believe this is a mistake, reach out to a Toronto Tax Lawyer at Devry Smith Frank LLP today.

This blog was co-authored by summer student Trevor Herr.

This article is intended to inform. Its content does not constitute legal advice and should not be relied upon by readers as such. If you require legal assistance, please see a lawyer. Each case is unique, and a lawyer with good training and sound judgment can provide you with advice tailored to your specific situation and needs.

[1] A Pilot Study conducted by the CRA revealed that ~74% of potential Personal Services Businesses are found in only three industries: Transportation and Warehousing (35%); Professional, Scientific and Technical Services (26%); Construction (13%). <https://www.canada.ca/en/revenue-agency/services/tax/businesses/topics/corporations/corporation-income-tax-return/personal-services-business-pilot.html>

[2] Such cases may also give rise to concerns about misclassification and tax evasion by the Employer and Employee. For example, the Government of Canada has recently announced an intent to crackdown on this type of tax evasion prevalent in the trucking industry through a well-known misclassification scam known as “Driver Inc.” <https://tc.canada.ca/en/binder/13-pic-driver-inc>

[3] Income Tax Act, RSC 1985, c 1 (5^th Supp), s 125(7).

[4] Income Tax Act, RSC 1985, c 1 (5^th Suppl), ss 125(7), 248(1), 251, 256.

[5] Income Tax Act, RSC 1985, c 1 (5^th Suppl), s 125(1)(a)(i).

[6] Income Tax Act, RSC 1985, c 1 (5^th Suppl), s 123.4(1).

[7] Income Tax Act, RSC 1985, c 1 (5^th Suppl), s 18(1)(p).

[8] Income Tax Act, RSC 1985, c 1 (5^th Suppl), s 123.5.