PERSONAL SERVICES BUSINESS
A “personal services business” is excluded from the definition of
“active business” and, therefore, income from such a business is not eligible
for the small business deduction.
A personal services business consists of providing the services of an “incorporated employee” to an entity of which the incorporated employee would otherwise reasonably be regarded as an officer or employee. [Sec. 125(7) personal services business; Interp. Bul. IT-73R6.] Accordingly, it will be necessary to determine whether the corporation is providing the services of an employee or an independent contractor. The critical issue is whether there is a contract of services (an employee) or a contract for services (an independent contractor). Paragraph 3 of Interpretation Bulletin IT-525R [Interp. Bul. IT-525R.] states that “a contract of service generally exists if the person for whom the services are performed has the right to control the amount, the nature, and the management of the work to be done and the manner of doing it. A contract for services exists when a person is engaged to achieve a defined objective and is given all the freedom required to attain the desired result.”
To have a personal services business, the incorporated employee or a person related to the incorporated employee must be a “specified shareholder” of the corporation providing the services. Specified shareholder is defined [ITA Sec. 248(1) specified shareholder.] as a person who owns directly or indirectly 10% or more of the issued shares of any class of the corporation at any time in the year and includes a person who owns at least 10% of the shares of a “related corporation”. Shares owned by someone who does not deal at arm's length with a person are deemed to be owned by the latter person. Similarly, shares owned by a trust are deemed to be owned by the beneficiaries in proportions based on the fair market value of their interests in the trust. In cases where different beneficiaries have interests in the income and capital of a trust, it may be difficult to determine the relative fair market value of their interests. As well, shares owned by a partnership are deemed to be owned by the partners in proportions based on the fair market value of their interests in the partnership. In addition, an individual is deemed to be a specified shareholder of a corporation carrying on a personal services business if the individual performs services for the corporation and the individual, or a person or partnership not dealing at arm's length with the individual, may under some arrangement become entitled to at least 10% of the assets or shares of the corporation.
However, a corporation will not be regarded as carrying on a personal services business in a taxation year if throughout the year it employs “more than five full-time employees” or if the amount paid to the corporation for the services rendered is received by it from an associated corporation. Accordingly, if an individual wishes to provide services to a corporation which the individual controls through a corporate entity, the corporate entity would not be carrying on a personal services business because the two corporations would be associated.
The case law is inconsistent on whether the requirement of “more than five employees” is satisfied by five full-time employees plus one part-time employee. A recent case concluded that it is. [489599 B.C. Ltd., 2008 DTC 4107.] However, in a previous case, it was decided that “more than five full- time employees” means at least six full-time employees. [Hughes & Co. Holdings Limited, 94 DTC 6511.]
In addition to a personal services business being excluded from the definition of an “active business”, the Act also contains a provision to limit deductions in computing the income from such a business. [ITA Sec. 18(1)(p).] All such deductions are disallowed except:
(a) salary, wages, or other remuneration paid to an incorporated employee;
(b) selling and similar expenses that would have been deductible in computing employment income if the individual had expended them; and
(c) legal expenses incurred in collecting amounts owing for services rendered.
Income from a personal services business is not eligible for either a small business deduction or a refund of tax on the basis of taxable dividends paid. It will therefore be taxable at the highest corporate rate and, on distribution to the shareholders, there will be double taxation, i.e., the total tax paid will be more than if the shareholders earned the income directly. Thus it will normally be advisable for a corporation carrying on such a business to pay all of its income to the “incorporated employee” by way of salary or bonuses.
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A personal services business consists of providing the services of an “incorporated employee” to an entity of which the incorporated employee would otherwise reasonably be regarded as an officer or employee. [Sec. 125(7) personal services business; Interp. Bul. IT-73R6.] Accordingly, it will be necessary to determine whether the corporation is providing the services of an employee or an independent contractor. The critical issue is whether there is a contract of services (an employee) or a contract for services (an independent contractor). Paragraph 3 of Interpretation Bulletin IT-525R [Interp. Bul. IT-525R.] states that “a contract of service generally exists if the person for whom the services are performed has the right to control the amount, the nature, and the management of the work to be done and the manner of doing it. A contract for services exists when a person is engaged to achieve a defined objective and is given all the freedom required to attain the desired result.”
To have a personal services business, the incorporated employee or a person related to the incorporated employee must be a “specified shareholder” of the corporation providing the services. Specified shareholder is defined [ITA Sec. 248(1) specified shareholder.] as a person who owns directly or indirectly 10% or more of the issued shares of any class of the corporation at any time in the year and includes a person who owns at least 10% of the shares of a “related corporation”. Shares owned by someone who does not deal at arm's length with a person are deemed to be owned by the latter person. Similarly, shares owned by a trust are deemed to be owned by the beneficiaries in proportions based on the fair market value of their interests in the trust. In cases where different beneficiaries have interests in the income and capital of a trust, it may be difficult to determine the relative fair market value of their interests. As well, shares owned by a partnership are deemed to be owned by the partners in proportions based on the fair market value of their interests in the partnership. In addition, an individual is deemed to be a specified shareholder of a corporation carrying on a personal services business if the individual performs services for the corporation and the individual, or a person or partnership not dealing at arm's length with the individual, may under some arrangement become entitled to at least 10% of the assets or shares of the corporation.
However, a corporation will not be regarded as carrying on a personal services business in a taxation year if throughout the year it employs “more than five full-time employees” or if the amount paid to the corporation for the services rendered is received by it from an associated corporation. Accordingly, if an individual wishes to provide services to a corporation which the individual controls through a corporate entity, the corporate entity would not be carrying on a personal services business because the two corporations would be associated.
The case law is inconsistent on whether the requirement of “more than five employees” is satisfied by five full-time employees plus one part-time employee. A recent case concluded that it is. [489599 B.C. Ltd., 2008 DTC 4107.] However, in a previous case, it was decided that “more than five full- time employees” means at least six full-time employees. [Hughes & Co. Holdings Limited, 94 DTC 6511.]
In addition to a personal services business being excluded from the definition of an “active business”, the Act also contains a provision to limit deductions in computing the income from such a business. [ITA Sec. 18(1)(p).] All such deductions are disallowed except:
(a) salary, wages, or other remuneration paid to an incorporated employee;
(b) selling and similar expenses that would have been deductible in computing employment income if the individual had expended them; and
(c) legal expenses incurred in collecting amounts owing for services rendered.
Income from a personal services business is not eligible for either a small business deduction or a refund of tax on the basis of taxable dividends paid. It will therefore be taxable at the highest corporate rate and, on distribution to the shareholders, there will be double taxation, i.e., the total tax paid will be more than if the shareholders earned the income directly. Thus it will normally be advisable for a corporation carrying on such a business to pay all of its income to the “incorporated employee” by way of salary or bonuses.
SEE ELSEWHERE ON THIS SITE:
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See this recent case, "Ivan Cassell Limited v. Her Majesty the Queen", for good information and details as to how these circumstances are viewed by CRA and decided by the courts.
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