As a part of DSF’s ongoing Employment Law seminar series, I was asked to participate and provide a tax lawyer’s perspective as well as some anecdotal experience. For tax law purposes, the question of employee vs. independent contractor can be a very nuanced issue; provincial labour laws are not determinative as the Canada Revenue Agency (“CRA”) is tasked with applying the framework of federal legislation, such as the Income Tax Act[1], under which specific rules have been developed by the Tax Court of Canada, the Federal Court of Appeal and the Supreme Court of Canada.
How is an “Employee” Defined under the Income Tax Act?
It may come as some surprise for a piece of legislation as complex as the Income Tax Act (“ITA”), but the act itself contains no specific definition for “employee”. Subsection 248(1) simply reads
employee includes officer;
So while the definition in the ITA deems a corporate officer to be an employee, it goes no further in providing specific guidance. But where the statute remains silent, the common law has developed over time to fill in the gaps.
The main distinction that can be drawn between an employee versus an independent contractor is often summarized as a contract of service vs. a contract for service. To determine the difference, each factor in the relationship ought to be examined. A dash of common sense is often in order, but the concept is defined almost completely by the common law in the taxation sphere.
The Common Law Definition of “Employee” for Tax Purposes
Although the common law is a creation of judges of Canada’s various Courts, for most taxpayers, the CRA is the ultimate decision-maker with respect to the determination of employee vs. independent contractor. That being said, the CRA must apply the law, and thus the decisions of the Courts when making such a determination.
The first and perhaps most important case of note with respect to the contractor versus employee distinction is Wiebe Door v MNR.[2] In Wiebe Door, the Federal Court of Appeal was tasked with reviewing the Tax Court of Canada’s trial decision. The Tax Court judge had ruled that the contractors working for the appellant corporation must have been employees because of the “integral nature” of the workers to the employers’ business. The FCA overturned this decision on the basis that the Tax Court judge had made a mistake by placing too much emphasis on the “integration” test, and had failed to properly consider and weigh other relevant factors.
But what are these “relevant factors”? In 671122 Ontario Ltd. v Sagaz Industries[3], Justice Major of the Supreme Court of Canada summarized the relevant factors that are generally to be considered:
- control – more control is generally exercised by an employer over an employee than by a client over a self-employed person. This control can be time of work, order of tasks, place of work and other similar factors;
- chance of profit versus risk of loss – self-employed persons usually take some degree of financial risk, and more opportunity for profit than employees;
- integration – as per the Tax court in Wiebe Door, an employee’s job will be an integral part of an employer’s business, whereas the tasks performed by a self-employed worker will likely be less integrated into the client’s day-to-day operations; and
- tools and equipment – self-employed contractors are more likely to supply their own tools and equipment, as well as being responsible for their maintenance.
Justice Major also summarized the proper approach to reviewing the relationship holistically:
“The central question is whether the person who has been engaged to perform the services is performing them as a person in business on his own account. In making this determination, the level of control the employer has over the worker’s activities will always be a factor. However, other factors to consider include whether the worker provides his or her own equipment, whether the worker hires his or her own helpers, the degree of financial risk taken by the worker, the degree of responsibility for investment and management held by the worker, and the worker’s opportunity for profit in the performance of his or her tasks.”
The basics laid down in the above-referenced cases have been modified slightly over the years, though arguably not substantively. For example, in 1392644 Ontario Inc. v Canada[4], the Federal Court of Appeal introduced a “two-step” approach to the determination of employee vs. independent contractor for the purposes of the ITA. The two-step approach requires that the decision-maker first examine the parties’ written contract to determine if it creates an independent contractor relationship and if so to move on to considering the underlying “objective reality” of their actual behaviour. In the author’s opinion, this two-step approach makes a procedural, but arguably not a substantive change to the analysis – it has always been the case that all factors (including the written contract) are to be examined from an objective perspective, though forcing a decision-maker to refer first to the parties’ written contract may signal at least some form of deference to intention, though this was not helpful to the appellant in the instant case.
It should also be noted that the traditional tax law adage of “form matters” could perhaps be utilized to some effect in “overriding” the finding of an employment relationship. For example in TBT Personnel Services Inc. v Canada[5] the CRA had determined that the appellant corporation’s truck drivers were employees and not independent service providers. Some of the impugned employees however had been operating through their own corporations. The Tax Court of Canada originally ruled that the incorporated drivers were not and could not be employees due to the use of the corporate form. On Appeal to the Federal Court of Appeal, the Crown conceded from the outset that the drivers who had provided services through their corporations could not be deemed to be employees in accordance with the lower court’s decision. Since the Crown conceded this fact from the outset, the FCA technically did not issue any ruling on this point, though in its reasons it appears to react favourably to the Crown’s admission. It seems likely on this basis that had the Court had a chance to rule substantively on this point that its conclusion would have been the same as that of the Tax Court, and that absent some form of sham the use of the corporate form will be determinative.[6]
As an aside, those considering incorporation to avoid an employee/employer relationship should be wary of the “personal services business” rules in the ITA and plan accordingly with a professional advisor.[7]
Why Does the CRA Care About Employee vs. Contractor?
Canada’s system of income taxation is based upon the concept of self-reporting. A taxpayer earns income in the year, calculates their taxes payable by filing a return and pays their balance. While this works in a perfect world, the reality is that most people do not put taxes top of mind; in particular, getting a large bill at the end of the year that could be upwards of half of your earnings may put most in the position of not being able to pay the balance.
Administering the taxation system, including collections is time-consuming and expensive, so the payroll system was designed as a first line of defense to protect Canada’s tax base. By placing the obligation to withhold and remit income tax, CPP and EI on employers, the vast majority of Canadians become automatically compliant with their obligations. This of course means that when a payroll amount is not remitted, the employer, not the employee is responsible for the shortfall.
In an independent contractor situation, the employer simply makes gross payments to the contractor, and it is the worker’s job to prepare and file their return, as well as pay their taxes by the due date. Although the vast majority do just that, enforcing the obligations of those that don’t require major manpower. Thus it seems obvious that the CRA does have an administrative incentive to classify as many workers as possible as employees.
What Can Trigger a CRA Audit?
The CRA conducts payroll audits in the normal course of its operations just as it does for all taxes and programs it is tasked with administering. Payroll auditors are referred to as “Trust Examiners” and will often attend the business premises to conduct their payroll reviews. A normal payroll audit will encompass a review of the business’ income tax withholdings as well as amounts required to be withheld and remitted under the Canada Pension Plan[8] and the Employment Insurance Act[9].
While no two audits are identical, based on the author’s anecdotal experience there are a number of common reasons why a business may be selected for a payroll audit:
- The CRA may have an ongoing project focussing on a certain sector of the economy;
- There may be a tip provided from a disgruntled former worker or a provincial labour authority that alerts the CRA to investigate;
- Certain high-risk industries such as construction, spas or hair salons, are often selected for payroll and other types of tax audit, normally owing to those sectors’ large volume of cash transactions;
- An audit of a different tax account, such as GST/HST reveals discrepancies in payments to contractors or other third parties that will result in a referral to the payroll division; and
- The ever-present element of random selection or chance, combined with computer algorithms in the CRA’s internal system that analyze irregularities may trigger a closer look.
In the course of a payroll audit, the Trust Examiner may come across ambiguities in the business’s relationship with any independent contractors, and possibly some indicia of an employment relationship and decide that further investigation is necessary. If so, the Trust Examiner will refer the issue to the CRA’s “Rulings Directorate” to further investigate the facts and make a final determination on the worker’s status.
The Rulings Directorate is a specialized division of CRA that has the task of reviewing all of the evidence and circumstances and issuing an administratively binding opinion on the status of a particular worker as either employee or independent contractor. The Rulings Directorate does not conduct audits itself but acts in a supporting role for the Trust Examiner in these scenarios.
The referral of a particular case to the Rulings Directorate is normally done at the behest of a payroll Trust Examiner in the course of an audit, but they will also review proactive requests; in some scenarios, the “employer”, the worker or both may request a ruling on their relationship proactively to avoid future payroll issues. Whether or not an unfavourable decision on such a request could trigger a further review or full payroll audit of the “employer” is not something the author has seen in practice, but could be a potential area of concern if one is considering such a proactive approach.
What Happens in an Audit/Ruling?
When a referral is made to the Rulings Directorate the assigned officer will generally begin by way of sending a written notice to the business owner. This letter will explain the purpose of the investigation and request that preliminary documentation, such as the contract with the worker, be provided for review. Normally the assigned officer will also ask for a telephone interview to be convened to discuss the relationship with the employer. In some cases, they may also conduct a field visit although this is becoming rarer as the CRA has moved to centralize these specialized divisions at certain specific Tax Services Offices to serve a large geographic area.
The rulings officer will then normally contact the workers in question directly, initially via telephone and then to supplement their responses ask that a written questionnaire be answered. They may also ask for some proof of expenses paid related to their work, evidence of reimbursements or similar payments and any other documentary evidence that may be helpful in determining the form of the relationship.
Based on the responses and the evidence provided by both the business and the worker, the rulings officer will then summarize the facts, apply the Wiebe Door and Sagaz factors and come to a determination. If a ruling is made that the workers were actually employees, this will normally trigger a full payroll trust examination if one is not already in progress. If an audit is in progress the Trust Examiner will use the ruling as the basis for increasing the income tax, CPP and EI withholdings for the relevant period.
The conclusion of the trust examination will result in the issuance of reassessments for the income tax, CPP and EI withholdings, including interest and applicable penalties. The amounts will be due immediately – payroll assessments are not subject to the typical 90-day hold on collections as they are considered “trust funds” by the ITA, and so a referral will usually be made by the Trust Examiner immediately to the CRA’s collection division for follow-up.
Additional Tax and Legal Considerations
From the “employer’s” perspective, it should be noted that if the newly deemed employee has already reported and paid their taxes this will not relieve the employer of the obligation to pay which is mandated under the ITA; the reassessed amounts will be due and payable regardless. The result is a potential double tax that can be thought of as more akin to a penalty.
One way to mitigate this may be to work together with the employee to refile their previous year’s tax returns to claim back a refund, though legal advice in this regard is paramount – if you are considering attempting this type of arrangement with an employee, advice from an experienced employment lawyer is advised due to the possibility of running afoul of the various employment or labour codes. This is beyond the scope of the author’s professional experience, but it is not hard to imagine a dispute arising, particularly in such a stressful context, if the employee is suddenly asked to refile their taxes in a particular way and to forward refunds to their employer – this could be taken by the employee as coercive behaviour for example. How such an issue would be treated under the labour codes and employment statutes is also not immediately clear to the author, but as with any dispute could end up being adding even more costs if litigation, arbitration or a workplace investigation ensues.
From the “employee’s” perspective, the ability to deduct many typical business expenses from their income will be severely restricted. Unlike the rules applicable to business income, deductible expenses for employees are limited by section 8 of the ITA to those that are expressly permitted by that section. In addition, the employee will not be capable of claiming any deduction at all if they are not provided with a duly executed Form T2200 by their employer each year, setting out the specific expenses and nominal justification for their incurrence by the employee. This can lead to a higher tax cost for the employee overall and will require the employer’s active participation in creating and issuing the prescribed forms. It may also require that the parties redraft their written agreement. If there are any disputes, it may be wise for the aggrieved party to seek legal assistance in the same manner as advised above in the employers’ scenario.
What if You Disagree with a Reassessment or Ruling?
While a ruling that one is an employee is a formal administrative decision by the CRA, a taxpayer cannot object directly to the said ruling, rather the resulting reassessment and by extension, the underlying amounts imposed must be disputed. As stated above, a payroll audit encompasses the amounts of income tax withholdings, CPP and EI. Thus, when a “payroll” reassessment is issued, pursuant to a ruling or not, there are technically speaking three reassessments being created simultaneously, one under each of the three respective acts.
Disputing these assessments is similar in concept to any other tax debt – a formal Notice of Objection must be filed within a 90-day period beginning on the date of the reassessment. For income tax assessments, as well as GST/HST assessments, it is common knowledge for practitioners that there is also a relieving provision that allows the taxpayer to request an extension of time to the 90-day objection period – so long as a formal extension request is filed within one year of the expiry of the initial 90-day period, the CRA can accept the objection as valid.
What is not so widely known is that the Canada Pension Plan and the Employment Insurance Act have no corresponding mechanism; those acts contain no provision for the extension of time to file an objection and so if the initial 90-day period is missed, the reassessed amounts of CPP and EI will be deemed final and payable. The payroll amounts related to income taxes can however still be the subject of an extension of time request, though doing so will only solve part of the problem. Thus, taxpayers need to be extremely cautious with respect to the 90-day deadline to ensure that the amounts of CPP and EI, if incorrect, are objected to on a timely basis.
Once the objections have been filed, from experience, the CRA will initially refer the CPP and EI portions of the objection to an Appeals Officer with specific knowledge of those particular acts for an initial decision, and that officer will then forward the file to a second Appeals Officer to handle the income tax portion. This can lead to longer than normal resolution times and may exacerbate collections issues if the account remains delinquent in the meantime.
If the taxpayer is unsuccessful, they still retain a statutory right of Appeal to the Tax Court of Canada as with all other tax issues, though the 90-day period is strict for CPP and EI at this stage as well.
Is Any Other Relief Available?
If the taxpayer is not successful in the dispute process or does not wish to dispute, they can consider filing a Taxpayer Relief request to ask the CRA to cancel penalties or interest associated with the reassessments. Underlying principal amounts are not capable of being eliminated as a matter of law by a Taxpayer Relief request, so depending on the amount of interest and penalties this may or may not be worth the time and expense.
The Taxpayer Relief Program and the cancellation of the penalties or interest are completely at the discretion of the CRA, and a high bar for relief is imposed. Those who may be considering such an application should seek legal advice and representation to ensure that their request is as effective and convincing as possible – CRA has published guidelines for when it will offer relief and so a good advocate can ensure the best chances of success.
As Always, Seek Professional Representation
From experience, a payroll trust examination, and if applicable the involvement of the Rulings Directorate can be an extremely confusing and stressful process. Those businesses that have concerns that there is a potential for the CRA to find an employment relationship, or that are in the midst of a payroll audit should seek advice from a professional that has experience managing the process. Proactive planning to avoid such a situation is obviously the most ideal scenario. That being said, if an audit is already in progress, professional advice and experience can often truncate the timeline and significantly reduce fees if help is brought in at the earliest possible stage. If you have questions about taking proactive steps or are in the midst of a payroll audit the author is happy to discuss how DSF can assist you to achieve the best possible outcome.
“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 contact a lawyer. Each case is unique and different and a lawyer with good training and sound judgment can provide you with advice tailored to your specific situation and needs.”
References:
[1] Income Tax Act, RSC 1985, c 1 (5th Supp.).
[2] Wiebe Door Services Ltd. v Minister of National Revenue, [1986] 2 CTC 200 (FCA).
[3] 671122 Ontario Ltd. v Sagaz Industries, 2001 SCC 59.
[4]1392644 Ontario Inc. [Connor Homes] v Canada (National Revenue), 2013 FCA 85.
[5] TBT Personnel Services Inc. v Canada (National Revenue), 2011 FCA 256.
[6] The original Tax Court decisions were issued under the “Informal Procedure” rules, which are akin to a provincial small claims court with a similar relaxed procedure and rules of evidence. Thus, while the Tax Court’s decision, in this case, is “persuasive” it technically did not set any binding legal precedent.
[7] A detailed review of the “personal services business” rules are beyond the scope of this article, but in sum, the rules operate to ensure that those who are connected to a corporation cannot incorporate to achieve income deferral where they otherwise would have been an employee.
[8] Canada Pension Plan, RSC 1985, c C-8.
[9] Employment Insurance Act, SC 1996, c 23.