In Are you walking into a tax disaster – Incorporated contractors & taxes, we discussed when an incorporated contractor could be considered to be carrying on a personal services business (“PSB”) and the adverse tax consequences that follow. To recap, a PSB is a business of providing services where an individual who performs services on behalf of the corporation (the “incorporated employee”) or a related person is a specified shareholder, and the incorporated employee would reasonably be regarded as an officer or employee of the hirer but for the existence of the corporation. The law provides few exceptions such as where the corporation employs more than five full-time employees. A PSB corporation is subject to strict limitations on deductions and pays tax at a punitively high corporate rate.
An incorporated service provider should arrange their affairs so as to avoid these rules or to mitigate their effect. Judicial and legislative development since the introduction of the PSB regime in 1981 have limited taxpayers’ ability to circumvent these rules, but creative planning may still be possible. The following will explore some of these.
Mitigation using salary
Effective for tax years beginning after October 31, 2011, the fully-distributed tax rate on PSB income in Alberta is approximately 50% at the top marginal rates. An obvious mitigation strategy for a PSB corporation is to minimize corporate income to the extent possible. Paragraph 18(1)(p) of the Income Tax Act (the “Act”) imposes restrictions on what is deductible against PSB income but specifically allows the corporation to deduct salaries paid to the incorporated employee. This covers only salary that is ‘paid’ – thus preventing a PSB corporation from obtaining a deduction for salary accrual while the incorporated employee defers the income personally until it is received. Therefore, a PSB corporation should pay all income to the incorporated employee as salary before the end of its fiscal year and comply with the corresponding payroll/remittance requirements.
Double taxation arises if the PSB corporation hires someone other than the incorporated employee since the person will be subject to tax on the remuneration but the corporation would not be permitted to deduct the amount.
Avoiding PSB by having ‘good’ facts
For small service corporations who are truly acting as an independent contractor, documentation should be prepared annually to support an independent contractor relationship. Examples of evidence that may serve to bolster this assertion could include:
- A contract that describes a relationship congruent with an independent contractor per the Sagaz/Wiebe Door factors (see Part I of this series)– merely stating that the engagement is with respect to an independent contractor relationship is insufficient;
- Actual behavior that follows such contract;
- Proper invoicing and GST/HST registration;
- Revenues from multiple clients per business stream (significant revenue from one client while receiving only nominal amounts from other clients will likely not suffice);
- There should be no reference to or concept of ‘overtime’ – in fact, volume discounts should be considered and the worker should be able to choose own hours;
- Hiring of staff or subcontractors to satisfy the services to be provided;
- The worker should be able to work independently free of control;
- Compensation per specified result solely from the worker’s effort (e.g. a bonus calculated based on the hirer’s annual results clearly suggest an employer-employee relationship) – interestingly, a fixed monthly retainer was not found to preclude an independent contractor relationship in Criterion Capital and S&C Ross;
- The worker should stand to suffer a loss for inefficiency, poor performance or poor business decisions;
- The worker should not be able to sign contract on the hirer’s behalf;
- The worker should provide their own equipment (beyond transportation and basic tools) and pay rent for any office space;
- The worker should be responsible for maintaining his own skills and business networks;
- The worker should not be entitled to any employment-like benefits;
- The services provided should be outside of the normal capacity of an officer or employee.
Avoiding PSB by employing more than five
The PSB rules do not apply if the corporation employs more than five full-time employees throughout the year in the business. If a group of workers cooperate to form a corporation and provide their services through that corporation, the corporation may fall into this exception. The PSB limitations will not apply and they would be entitled to all tax benefits associated with operating the business through a corporation. However, this is often not practical in industries where independent contractors are prevalent due to turnover, short duration of projects, and the required long term commitment between shareholders.
Getting creative with trusts
a) Traditional business trust plan
Only a corporation can carry on a PSB. As such, if a service arrangement is structured as a trust, the PSB rules should not apply. For instance, a family trust may be set up for the benefit of the worker and his or her family members. The family trust then enters into a service contract with the intended service recipient and the worker will perform the services on behalf of the family trust. The family trusts may deduct reasonable expenses incurred in earning such business income and may allocate the net profits to the beneficiaries who are the worker and family members. Down the road, as the business grows to more than five full-time employees, the business can be transferred on a tax-deferred basis to a corporation.
Since the PSB rules do not apply, the family trust is not limited in terms of expenses to the extent they are reasonable. Income allocation is also not subject to payroll withholding and remittance requirements. Where certain family members are in low tax brackets, the effective tax rate can be reduced by allocating trust income to those family members. However, the income-splitting aspect of this plan has been significantly curtailed recently. Beginning 2014, a minor beneficiary receiving income that is reasonably considered to be income derived from a source that is a business in which a related person is actively engaged on a regular basis would be subject to kiddie tax, i.e. taxed at the top marginal personal rates. This legislative change has rendered this plan substantially less attractive, particularly once any remaining tax benefits is balanced against the administrative burdens and fiduciary duties involved with maintaining a trust.
b) Using an intervening subsection 75(2) trust
Warning: the following is admittedly a very aggressive plan that we are aware of and may not hold up in court under a challenge by the CRA, so consider it at your peril.
Subsection 75(2) of the Act is an anti-avoidance provision designed to prevent income splitting using trusts in certain circumstances. If a trust holds property on condition that the property may revert back to the settlor or pass to persons to be determined by the settlor subsequent to the creation of the trust, subsection 75(2) would deem any income from the property to be income of the settlor.
If a worker’s corporation settles a trust by contributing to it the service contract and purposely triggers subsection 75(2) so that all of the trust’s income from the service contract attributes back to the corporation, the corporation’s income should technically not be subject to the PSB rules. This is because the corporation does not carry on any business and nobody performs services on behalf of the corporation. All of the corporation’s income is attributed from the trust and subsection 75(2) does not appear to deem the corporation to carry on the trust’s activities or business. The corporation would not be entitled to the small business deduction since it did not carry on any active business. However, personal tax can be deferred if the income is retained in the corporation, and there may be an absolute tax reduction if there are shareholders in a low tax bracket who are not minors.
Any tax benefits associated with this plan needs to be weighed against the risk of reassessment. The CRA has publicly commented that it will challenge tax plans that rely deliberately on subsection 75(2) under the general anti-avoidance provision (GAAR).
Being a small incorporated contractor can be rewarding in many ways, but such endeavor is viewed suspiciously by the CRA. Taxpayers affected by these rules need to be aware of their nuances and be vigilant of not falling offside.