tax-planning-man

The government wants more small businesses. So it’s reduced taxes on business income and made some business-related expenses deductible.

But not all businesses are entitled to this relief.

Tax rules are not as favourable if your client has a Personal Services Business (PSB). In fact, thanks to proposed changes announced on October 31, 2011, operating a PSB is now even more inefficient than in the past.

What is a PSB?

A PSB is a business relationship between an incorporated business and a customer or client whereby, in the absence of the corporation, the person providing the service would be considered an employee of the customer or client. In other words, if the relationship can be viewed as an employer-employee relationship (rather than independent contractor-client), CRA would likely consider the business a PSB.

An exception applies for businesses employing more than five full-time employees.

Read: Independent contractor or PSB?

What defines an “employer-employee” relationship?

It depends on a number of factors, including:

  • control over the nature and direction of work performed
  • funding of applicable expenses
  • the ability to engage multiple clients

See this article for more information on employment versus contractor status.

What’s changed?

On October 31, 2011, the Department of Finance proposed changes to PSB taxation. PSBs have been entitled to a general tax rate reduction that applies to many private corporations. If the legislation (Bill C-48) passes, as most expect it will, the reduction will be nixed, resulting in a 13% increase to PSB tax rates. (The legislation says the changes are effective October 31, 2011.)

What hasn’t changed?

PSBs are not entitled to the small business deduction, which allows many Canadian-controlled private corporations to benefit from an 11% to 19% tax rate on business income, depending on the province in which the business operates. This won’t change when the new rules take effect.

Expense deductibility for PSBs continues to be limited. While non-PSBs are entitled to a broad range of deductible expenses, the rules for PSBs will continue to be in line with the more restrictive requirements for employees.

Why are the changes significant?

It means a 13% tax increase. And there are other important consequences, depending on the corporation’s activities. Consider the following example:

Mary’s worked for a large corporation in British Columbia for the past 10 years. After attending a conference in her community on entrepreneurship, she felt inspired to establish her own business. She approached her employer about severing her employment relationship, but continuing to work with the firm as an independent contractor. The terms of the contractor relationship would require Mary to work for only one client – her former employer – and her hours would be defined by the client. Her employer would also provide the tools required for Mary to do her job, and would control the nature and direction of her work.

While the nature of her work would not change, Mary believes that working as an incorporated contractor will provide her with tax benefits to which she’s not currently entitled. Also, although Mary will give up benefits typically associated with employment (e.g. medical benefits, company pension, etc.), she plans to make up for this loss in her negotiated fee for service.

To determine if Mary’s understanding is correct, let’s look at the taxable status of an employee. Assuming taxation at top personal tax rates, employees are taxed in each province as follows (current to January 2013):

BC AB SK MB ON QC NB NS PEI NFLD
43.7% 39.0% 44.0% 46.4% 46.4%1 50.0% 43.3% 50.0% 47.4% 42.3%

1Ignores 2% tax increase on income beyond $509,000

As a resident of B.C., if Mary continues as an employee her tax rate would be 43.7%. Also, while Mary’s employer would cover many employment-related expenses, tax deductions for expenses Mary pays for would typically be limited to certain legal and accounting fees, and in some cases, supplies and motor vehicle expenses – a more restrictive situation than business owners face.

Read: Tips for small business

If Mary established an incorporated business, its tax-efficiency would depend on a number of factors, including the amount of business income earned each year; the amount of income remaining in the corporation over time (as opposed to being immediately paid as a taxable dividend); and whether or not the business is a PSB.

When an incorporated business is not a PSB, corporate tax rates (for business income up to $500,000 for most provinces) are as follows (current to January 2013):

BC AB SK MB ON QC NB NS PEI NFLD
13.5% 14.0% 13.0% 11.0% 15.5% 19.0% 15.5% 14.5% 12.0% 15.0%

If Mary’s business isn’t a PSB, she could gain a 30.2% (43.7% less 13.5%) tax deferral by earning her business income through a corporation (as opposed to being an employee). This assumes she can retain the after-tax corporate income in her corporation and doesn’t immediately pay herself a taxable dividend.

This cash flow can be used to earn additional business income, or for investment purposes. In addition, businesses are generally entitled to a broader range of tax-deductible expenses, provided they’re not PSBs.