Some individuals choose to offer their services via a corporation rather than as an employee in order to benefit from the low tax rates enjoyed by corporations. To discourage individuals from doing this, the Minister of National Revenue (the "Minister") introduced the concept of "Personal Services Business" ("PSB") in order to place restrictions on certain expense deductions and disallow the "Small Business Deduction" ("SBD"), which allows businesses to be taxed at a reduced corporate rate. Until recently, despite these restrictions, PSBs still offered certain fiscal advantages. However, on October 31, 2011, the Minister introduced a new deterrent, effectively increasing the corporate tax rate for PSBs and thereby considerably reducing the fiscal advantages of operating a PSB.
First of all, it is important to understand what factors cause a corporation to be considered a PSB. The Income Tax Act 1 (the "Act") provides that a corporation is considered a PSB when the following conditions are met:
- an individual performs services on behalf of a corporation and holds, alone or together with non-arm's-length persons, 10% or more of any class of the corporation's issued shares; and
- the individual could reasonably be regarded as an employee of the person to whom the services are provided but for the existence of the corporation.
Despite the foregoing, the corporation is not considered a PSB if it employs more than five full-time employees for business operations. Note that the expression "more than five employees" has been exhaustively defined by case law and that several criteria, such as number of hours worked, frequency and type of work (e.g., seasonal employment), must be met in order for this exception to apply. In this respect, the concept of an employee is a factual issue, and determining the status of an employee generally requires thorough analysis that will not be addressed in this article.
THE EXISTING PSB PLAN
The Act provides two deterrents that apply to corporations that are considered PSBs. Firstly, a PSB is not entitled to the low tax rate enjoyed by businesses eligible for the SBD, because the PSB is not considered to carry an "active business". Secondly, the Act provides that only certain expenses incurred by a PSB can be deducted when calculating its income. Generally, these expenses include salaries paid out to the incorporated employee, as well as any expenses for which a deduction against employment income would be allowed.
Before the October 31, 2011 announcement, an employee providing services through a PSB could benefit from the principle of integration and could take advantage of tax deferrals by keeping the earnings in the corporation rather than paying them to the employee-shareholder in the form of dividends. Basically, as a result of the principle of integration, the income earned by an individual through a corporation should be taxed at a similar effective tax rate that the one applicable to income earned directly by an individual. In the case of a PSB, this meant that deferring an individual shareholder's dividend payment to subsequent years allowed a tax deferral as the income taxed at the corporate level was still taxed at the lower general corporate rate.
PROPOSED CHANGE TO THE ACT
On October 31, 2011, the Minister proposed a bill for an additional measure to discourage employees from providing services via a PSB. For taxation years beginning after October 31, 2011, PSBs are no longer eligible for the reduction in the general corporate tax rate, which stands at 13% for 2012, a measure that essentially raises the corporate tax rate for PSBs and prevents application of the principle of integration.
As a result, income earned by a PSB in Quebec in 2012 is now taxed at a combined (federal/provincial) rate of 39.9%, rather than the previous rate of 26.9%. For 2012, any income paid by a PSB to an individual in the form of dividends will now be taxed at a combined marginal effective rate of 59.62%. Thus, in addition to eliminating the possibility of deferring taxes through a PSB, the Minister is taxing PSB income at a considerably higher rate than individual employment income (48.2% marginal rate in 2012).
For example, Mr. X is employed by Canco, who pays him an annual salary of $500,000. In 2012, Mr. X is taxed on his salary at a marginal rate of 48.22%, leaving him with a net amount of $258,900. On the other hand, we have Mr. Y, who provides the same services as Mr. X via a PSB, to which Canco pays fees totaling $500,000 per year. In 2012, the $500,000 income of the PSB will be subject to a rate of 39.9%, resulting in $199,500 in taxes. If the PSB pays the balance to Mr. Y as a dividend, Mr. Y will be taxed at the marginal rate of 32.81% on the dividend, and must therefore pay $98,590 in taxes, leaving him with a net amount of $201,900 in his pocket. Mr. Y pays $57,000 more in taxes than Mr. X.
In order to mitigate the negative tax implications of this measure, it may be wise to reorganize certain corporate structures that cause the corporation to be considered a PSB. In addition, for PSB taxation years beginning after October 31, 2011, it may be advantageous to pay the entire annual income in salary to the individual, in order to benefit from a deduction of the same amount and therefore reduce the PSB's taxable income down to zero.
If you operate a PSB, or if you think that a corporation in which you own shares is a PSB, it may be wise to review the legitimacy of the expenses claimed by the corporation and the existing corporate structure as soon as possible in order to minimize any negative tax and financial consequences.
Footnote
1. R.S.C. (1985), c. 1, 5th Supp., c. 1 as amended. The provisions of the Act are considered to be the same as the provisions in the Taxation Act, R.S.Q., c. I-3 as amended (Quebec) unless specifically indicated otherwise.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
