As a part of DSF's ongoing Employment Law seminar series, I was asked to participate and provide a tax lawyer's perspective. The question of employee vs. independent contractor can be a very nuanced issue; provincial labour laws are not determinative, and the CRA administers its own set of legislation such as the Income Tax Act1 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. Subsection 248(1) simply reads
employee includes officer;
So while 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 can be 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 bit of common sense is often in order as well, 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 applies the decisions of the various Courts when making such a determination.
The first and perhaps most important case 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 decision that the contractors working for the company 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 placed too much emphasis on the "integration" test, and had failed to consider and weigh other relevant factors.
But what are these "relevant factors"? In 671122 Ontario Ltd. v Sagaz Industries3, 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, though arguably not substantively. For example, in 1392644 Ontario Inc. v Canada4, 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 written contract to determine if it creates an independent contractor relationship and if so to move on to considering the underlying "objective reality" of the parties' behaviour. In the aggregate, this two-step approach does not seem to make any substantive change to the analysis – it has always been the case that all factors are examined from an objective perspective, though putting the parties' written contract (and therefore intention) first may provide some form of "special status" for the parties' intention, though this does not seem to have affected the outcome in the aggregate.
It should also be noted that the traditional tax law adage of "form matters" can be utilized to override the employment relationship – for example in TBT Personnel Services Inc. v Canada5, the Federal Court of Appeal, having had the point conceded by the Crown, appeared to agree with the Crown's assertion that drivers who had engaged in providing services through a corporation could not be considered employees for the purposes of the traditional tests. In that case, a number of truck drivers who had signed independent contractor agreements were reclassified as employees by the CRA. On appeal, the Crown apparently conceded from the outset that the drivers who had provided their services through a corporation could not be deemed to be employees due to the use of the corporate form. It remains to be seen if simple incorporation will continue to override the underlying factors; since the Crown conceded on this point the Court did not actually have the chance to substantively rule on this point, though it seems likely that the FCA's conclusion would have been the same as the Crown, absent some sort of sham.
Those considering incorporation should also be wary of the "personal services business" rules in the ITA and plan accordingly.6
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 and then files a return of income 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 the 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 their 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 is time-consuming and requires major manpower. Thus, it seems obvious that administratively the CRA does have some incentive to classify as many workers as possible as employees.
What Can Trigger a CRA Audit of Contractors?
While no two audits are identical, based on anecdotal experience there are a number of common reasons why a worker's relationship with a business may be investigated:
- There may be an ongoing payroll trust examination of the business, and some ambiguity leads the trust examiner to request a ruling on certain workers;
- There may be a tip provided from a disgruntled former worker or a provincial labour authority that causes the CRA to examine the employment relationship;
- Certain high-risk industries such as construction, spas, hair salons etc. are often the subject of these types of audits and rulings, normally as a result of the large volume of cash transactions;
- An element of random selection or chance, as well as a computer algorithm in the CRA's computer system that analyzes irregularities, may trigger a closer look; and
- In some scenarios, the employer, worker or both may request a CRA ruling on their relationship proactively to be proactive in ambiguous circumstances.
In any of these cases, the file is referred to the CRA's Rulings Directorate which has the task of reviewing all of the evidence and circumstances and issuing its administratively binding opinion on the particular worker.
What Happens in an Audit/Ruling?
When a referral is made 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 preliminary documentation, such as the contract with the worker, be provided. Normally they will ask for a telephone interview to be convened as well. In some cases, they may also conduct a field visit although this is becoming rarer as the CRA has moved to centralize these types of centralized services in particular Tax Services Offices.
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 the work, or other documentary evidence that may indicate the form of the relationship.
Based on the responses and the evidence provided above, the rulings officer will then summarize the facts and 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 payroll trust examination if one is not already in progress.
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 immediately to the CRA's collection division for follow-up.
It should also be noted that if the 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 result is a 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 this advice from an experienced employment lawyer is necessary due to the possibility of running afoul of the various employment or labour codes.
What if You Disagree with the Determination?
Disputing an assessed amount of payroll withholdings as a result of a ruling is similar in concept to any other tax debt – a formal Notice of Objection must be filed within the 90-day time limit starting on the date of the reassessment. Since these assessments are issued under three separate statutes, the rules are modified – unlike with income tax payroll assessments related to CPP and EI have no mechanism to request a late-filed objection beyond the 90-days; the deadline is hard and fasts an allowing it to expire completely eliminates your ability to put those amounts into dispute.
From experience, the CRA will often refer the CPP and EI portions of the objection to a separate Appeals Officer first, followed by the income tax portion to be heard by a different officer. This can lead to longer than normal resolution times and may exacerbate the issue 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 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 principle amounts are not capable of being eliminated, so depending on the amount of interest and penalties this may or may not be worth the 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.
Footnotes
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. 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.
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.
