Accounting and Tax Lessons for IT Consultants, Independent Contractors and Freelancers in Canada
Read this carefully because this blog post may just save you thousands of dollars in tax.
If you are like most independent contractors, you have probably had a close friend, relative or colleague tell you that you should incorporate a business. In fact the prospect of high hourly pay, being treated like a business owner instead of an employee and not being tied down to a long term commitment is what drew you to your current contract in the first place. However, when the Canada Revenue Agency (CRA) set out to provide enormous benefits to small business corporations in Canada such as low corporate taxes and the ability to sell certain shares on a tax-free basis, they had a specific business in mind. The government wanted to award those businesses that were contributing to the economy by hiring employees, borrowing money for expansion and investing in other local businesses. The intention was never to allow independent contractors and individuals to incorporate and then take up an employment position with a company.
If you have incorporated a company and you are working for one employer under contract, you may be deemed a “Personal Service Business”. A Personal Service Business can be thought of as an incorporated employee. If you are grouped into this classification you will be denied the small business deduction that is typically available to Canadian small business corporations and you will not be permitted to deduct any expenses other than those that a regular employee would typically be allowed to deduct.
I know what you are thinking: is there a way I can avoid being classified as a Personal Service Business so that I deduct expenses and be taxed at the low small business corporate tax rate? The quick answer is Yes. In order to avoid Personal Service Business status, the CRA must view you as being self-employed and not an employee. The CRA utilizes 3 distinct tests to determine this and they are as follows:
Economic reality or entrepreneur test
This is a test where the CRA checks for (1) Control (2) Ownership of tools and (3) Risk of Profit/Loss.
In CRA’s view, control exists if the person for whom 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. This effectively means that you can come and go from work as you please and that you can control how you get your work done without taking directions from a boss or superior.
Ownership of Tools
In this test, the CRA is looking to see if the taxpayer is providing their own equipment and tools to complete a job. For example, if you are an IT consultant, bringing your own laptop to complete the work would constitute utilizing your own equipment.
Risk of Profit/Loss
In order to be considered a business, you have to be exposed to risk. For example, a short term contract would imply less stability and predictable cash flows than a long term contract. In addition, this test also relates to the ownership of tools test because if you are required to use your own money to finance your job, this increases your risk, and therefore it appears more likely that you are self-employed.
Integration or Organization Test
This test examines whether the individual doing the work is economically dependent on the organization. Therefore the more companies you invoice throughout the year, the stronger your position is that you are self-employed.
Specific Results Test
Typically, when an employee is hired into a new position, the employer/employee relationship contemplates the employee putting his or her services at the disposal of his or her employer during a given period of time without any specific reference to the exact work or project that will be completed. As an employee, you may be required to perform many different tasks in many different areas of the business. However, the CRA looks for “a person who is engaged to achieve a defined objective and is given all the freedom to obtain the desired result”. In other words, you were hired for a defined purpose that must be completed within a defined period of time.
Finally, if you grow to the point where you have more than 5 full time employees, then the CRA will no longer consider you a Personal Service Business. However, since hiring any staff is impractical for most freelancers and consultants, I would just focus on sticking to the 3 tests summarized above.
The best advice I can give you is that if you decide to incorporate, work through your tax situation with a Chartered Accountant. I’m hoping this blog will give you the basics to avoid being deemed a Personal Service Business, however the complexities of filing corporate taxes can go well beyond the scope of this blog, so I recommend seeking professional advice if you are unsure of how to achieve your tax objectives.