FINA Committee Report

Government Response to the Standing Committee on Finance “Servant Or Master? Differing Interpretations of a Personal Services Business”

In June 2010, the Standing Committee on Finance tabled the report titled “Servant or Master? Differing Interpretations of a Personal Services Business”. The report recommended that the Government review the Income Tax Act to ensure tax fairness for small business owners, particularly those in the information technology (IT) sector, who are determined to be “incorporated employees” of “personal services businesses”.

The Government recognizes the importance of small businesses to the Canadian economy and is committed to ensuring tax fairness for all Canadians. 

The personal services business provisions in the Income Tax Act apply to all industries to ensure that individuals, who would otherwise be employees, are unable to avoid paying their fair share of tax by interposing a corporation between themselves and a service recipient that would otherwise be the individual’s employer.  The personal services business provisions are intended to ensure that “incorporated employees” are treated comparably to actual employees for income tax purposes. 

Given the varying circumstances in which income may be earned, the Income Tax Act has specific rules to ensure that different types of income are treated fairly.

Business income is generated by an entrepreneurial venture in which investments are made (e.g., capital assets are purchased, workers are hired and trained) with a view to earning revenue by bringing goods or services to the market.  An entrepreneur undertakes risks as part of an independent venture seeking to earn a profit in unpredictable market conditions that may affect the venture’s performance and even lead to losses.  The income tax system recognizes the risk inherent in business enterprises by taxing the resulting profits appropriately, which means allowing for the deduction of reasonable expenses incurred in generating those profits.

In the case of certain small business income, the small business deduction provides a reduced rate of income tax on the first $500,000 of qualifying business income earned in a year by an eligible Canadian-controlled private corporation.  The federal small business income tax rate for 2010 is 11%.  This lower rate helps these small businesses retain more of their earnings for reinvestment and expansion, thereby helping to create jobs and promote economic growth.

In contrast, employment income is subject to a progressive income tax rate structure with rates increasing as income increases. Employment expenses incurred by employees are generally not deductible for income tax purposes since employers typically provide employees with the items required to perform their duties or reimburse their employees for the work-related expenses they incur.  To recognise that employees incur some costs personally, employees are eligible for the Canada Employment Credit, introduced in Budget 2006, which provides a 15% tax credit in respect of up to $1,000 of employment income. 

Corporations that operate a “personal services business” do not qualify for the small business deduction and are not eligible for the 11% federal small business income tax rate.  The objective of the personal services business provisions in the Income Tax Act is to ensure that individuals (“incorporated employees”) who would otherwise be in an employment relationship, if they had not interposed a corporation between themselves and the service recipient, are treated comparably for income tax purposes as if they had provided their employment services directly (in other words, as if they had not interposed the corporation).  Without the personal services business provisions, incorporated employees could reduce their income tax liability unfairly.

The small business deduction was not intended to be available to individuals who have essentially converted an employment relationship into a business relationship through the interposition of a personal services business corporation.

Whether an individual would be an employee (employment relationship) or an independent contractor (business relationship), if the corporation had not been interposed, is determined on a case-by-case basis.  In making this determination, the Canada Revenue Agency takes into account a number of factors, for example: the extent of the service recipient’s control over the individual concerning the manner in which the services are performed and what services are performed; the amount of risk the individual has of bearing an economic loss; and the individual’s responsibility for providing the tools required to perform the services for the service recipient.  The Canada Revenue Agency’s determination, of whether an individual is an employee or an independent contractor, may be appealed to the Tax Court of Canada.

Amending the personal services business provisions to exclude corporations of information technology (IT) professionals would result in such professionals receiving preferential treatment compared to employees who are not incorporated, for that portion of their remuneration that is taxed inside the corporation.  For example,

• in Quebec, the province of residence of many of the individuals who made presentations to the Committee, it could result in the income of a corporation of an incorporated employee earning $150,000 in 2010 being taxed at a combined federal and provincial small business income tax rate of 19% (11% federal plus 8% provincial) while an unincorporated employee carrying out similar work for the same company and earning the same amount would be taxed at an average federal/provincial personal income tax rate of 37%.

• in Manitoba, where the small business tax rate is 0% in 2011, it could result in the income of a corporation of an incorporated employee earning $150,000 in 2011 being taxed at a combined federal and provincial small business income tax rate of 11% while an unincorporated employee carrying out similar work for the same company and earning the same amount would be taxed at an average federal/provincial personal income tax rate of 35%.

The Standing Committee’s Report also expressed concern that individuals who provide services through a personal services business corporation (“incorporated employees”) are not eligible to participate in the Canada Pension Plan (CPP) and the Employment Insurance (EI) regimes. 

The provisions in the Income Tax Act that apply to incorporated employees do not prevent them from participating in the CPP and EI regimes. 

Individuals are required to participate in the CPP regime if they receive a salary.  The income tax provisions concerning personal services businesses would, therefore, not prevent an incorporated employee from participating in the CPP regime where the incorporated employee receives a salary from the personal services business corporation.

The Government recognizes that some incorporated employees have not been eligible to participate in the Employment Insurance regime because the individual controls more than 40% of the voting shares of the corporation.  However, since the Committee met on December 3, 2009, the Fairness for the Self-Employed Act received Royal Assent.  As a result, the Employment Insurance special benefits provisions have been extended, on a voluntary opt-in basis, to the self-employed and to employees whose employment by a corporation was previously excluded from insurable employment because the individual controls more than 40% of the voting shares of the corporation.  Employment Insurance special benefits include maternity benefits, parental benefits, sickness benefits, and compassionate care benefits.

The Government recognizes the importance of the IT sector in fostering innovation and creating jobs and business opportunities.  The Business Development Bank of Canada provides financial support for business innovation, often to small firms involved in the IT sector. Small and medium-sized firms in the IT sector also benefit from the improvements to the Scientific Research and Experimental Development Tax Incentive Program that were introduced in Budget 2008. Canada’s Economic Action Plan, announced in 2009, also included a number of initiatives that assist firms in the IT sector, including small businesses. For example, businesses may benefit from the temporary two-year 100-per-cent capital cost allowance rate for computers.  As well, additional funding was provided to the National Research Council’s Industrial Research Assistance Program to enable it to temporarily expand its initiatives for small and medium-sized firms and to Industry Canada to develop and implement a strategy to extend broadband coverage. Further, the Government has indicated it would develop a Digital Economy Strategy to position Canada’s information and communications technology sector to establish a global advantage.