Are you an information technology (IT) contractor or a consultant working as an employee or on a contract basis? If so, here is a summary of a few tips that professionals could benefit from and be mindful of the traps from the changes in recent years in the Canadian Tax system.
With a recent influx of tech professionals and multinational companies, Canada has experienced a fast growth in the technology sector, creating a huge demand for professionals primarily in Waterloo, Ontario – the “Silicon Valley” of Canada. Amid changes in the tax landscape and other economic events , the multinational companies are transitioning from the traditional employer-employee model to a employer-subcontractor model, a one which not only benefits the employer but also offers considerable tax benefits for the professionals, making it a win-win for both parties involved. As a result, many IT Consultants have been incorporating their businesses, and working as independent contractors while supporting their clients.
How can IT Contractors benefit from incorporating ?
- IT Contractor corporations get access to tax deferral opportunities (Small business rate, tax splitting with spouse or another family member);
- limited liability;
- Creditor proofing of assets;
- various tax write-offs for general expenses (marketing, meals, travel, office and administrative, legal and accounting fee etc.) as any other corporation in Canada. For example – A small business corporation pays a corporate tax at 12.2% (up to $500,000 in net income) compared to an individual employee who would pay a marginal rate of 53% on salary over $235,000 in Ontario – the significant difference in tax rate is in itself quite attractive why a professional would rather incorporate their practice vs work an an employee.
- Use of lifetime capital gains exemption (LCGE) to eliminate tax on a significant portion of capital gain (approx. $950,000 in 2023 indexed annually for inflation) on sale of their qualified small business corporation shares (QSBC) in the future.
The Scientific research and experimental development tax credit (SR&ED)
Many technology companies do not realize that they may be eligible for the SR&ED tax credit. This tax program provides them with an enormous credit for expenditures related to research and development. Canada’s high tech boom owes much of its success to Waterloo, Ontario. which is home to hundreds of tech startups and companies. What a lot of these companies do not realize is that they are eligible for one of the most favorable refundable tax credit in Canada, the scientific research and experimental development tax credit (SR&ED). The Canadian Government has long recognized the importance of research and technological innovation. These tax credits for technology companies is simply part of an initiative to help foster and facilitate this technological boom, by providing billions of dollars every year.
Incorporated Canadian-controlled private corporation (CCPC) can generally claim an investment tax credit (ITC) of 35%, a 100% refund on qualified SR&ED current expenditures and 40% refund for qualified capital expenditures up to a limit of $3 million of research & development expenses and 20% on any excess amount. Qualifying expenditures include not only materials and equipments, but also salaries and wages, third party payments, SR&ED contracts, and some overhead costs. Additionally, there is also a provincial investment tax credit, in Ontario this rate is 10%.
The TRAP
However, there is a risk that the Canada Revenue Agency (CRA) may deem your corporation to be a ‘Personal Services Business’ (“PSB”) Corporation. This simply means that you are deemed an incorporated employee or, in other words, you are seen as an employee of the business that you do work for. In this case, the CRA believes that you should be taxed as such, instead of as a corporation.
If you are deemed as a PSB corporation, your corporation would be subject to a tax rate of 44.5% (penalty in addition to being denied small business rate) Also, many of the normal business deductions such as supplies, office space, legal and accounting fees are not available, which essentially means that any revenue earned by the corporation has to be paid out as a salary to the incorporated employee and pay personal tax on the full amount – therefore, nullifying any advantage of incorporating. This would be rather disadvantageous due to significant costs (Accounting/legal) of maintaining the corporation annually.
An example of a Personal Service Business
James is an IT consultant who is hired as a self-employed consultant and not an employee by a Bank A.
James incorporates “James Inc.” and is the only shareholder and worker. James Inc. has no other sources of income.
Bank A pays James Inc. based on James’s time. Bank A controls when and how James works (just like an employee).
Accordingly, James Inc. is considered a Personal Service Business since it meets the 4 defined criteria:
- James provides IT consulting services on behalf of James Inc.
- James is the shareholder of James Inc.
- If it were not for James Inc., James would be considered an employee of Bank A
- James Inc. does not have any other employees
How To Avoid This Classification
The employee versus independent contractor determination is a question of fact and the factors to be considered in any given case will be different. The main factors considered by the courts in the above cases are as follows:
- How much control over the work does the owner or contractor (I’ll refer to this person as the worker) have? This refers to the flexibility that the worker has over the work being done. In other words, is how the work is being done dictated by the worker or is the worker taking direction on how the work should be done.
- Who has ownership of the tools being used? This refers to who owns the physical tools being used by the worker to perform the work. A Welder who owns his own welding truck and equipment has a better argument to being an independent worker as does a welder who shows up to a certain company’s job site and has to use that company’s tools to perform the work.
- The chance of profit or risk of loss that a worker is exposed to. This refers to if the worker’s potential compensation is variable. For example, an IT company may pay an IT consultant a set price to perform a project. The IT consultant in this example has a better chance to be deemed an independent corporation than if the IT consultant was paid an hourly wage by the IT company.
- The degree of integration. This refers to the intention of the relationship between the worker and the customer business (company for which the work is being performed). This is a subjective test but generally refers to if the customer business has to meet the needs of the worker, then a legitimate business relationship likely exists. Or if the worker has to change his commercial activities to suit the needs of the customer business, then it’s more likely that an employer-employee relationship exists.
The above items are only guidelines in determining if a corporation be considered a PSB. Generally, a good way to avoid this classification is by:
- Having more than one regular employee than yourself.
- Performing work for more than one client or customer.
- Substantiating work agreements with a written contract that sets out the intentions of yourself and the customer or client.
- Having a comprehensive business website indicating the services offerings
- Promoting business and services using various advertising strategies and online presence.
Even if your corporation is classed as a personal services business, you don’t have to dissolve your corporation if you don’t want to. The corporation is simply taxed at a higher rate of tax which reflects that the small business deduction is not used.
The whole area of personal services business corporation is subjective so it’s not a clear cut set of rules. Individuals who operate as incorporated contractors, or who are considering establishing a corporation should seek expert tax guidance and understand the possible adverse tax consequences. In recent years, the CRA has been looking more closely into corporations that IT consultants own, to determine if the company should be deemed a Personal Services Business. CRA has published detailed guidance with respect to IT Consultants and how their practice could fall into the PSB rules.
We at AccoTax CPA Professional Corporation help our clients understand the benefit of incorporating your IT consulting practice and work with them to perform an analysis for their unique situation whether these rules are applicable and steps they can take to strengthen their tax position. From incorporating your new IT business to providing complete bookkeeping, accounting and tax advisory services, we offer a comprehensive solution for your business and personal tax needs while you focus on growing your business. Contact us today to book an appointment and we’d be happy to help.
Sources:
https://www.cpacanada.ca/en/news/canada/personal-services-businesses
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