Personal Services Businesses

Transcription

1 ln the oil and gas industry, it is not uncommon for individuals to provide contract services through a personal business corporation to oil and gas companies. From a tax perspective, one important consideration is whether or not these personal business corporations are considered "personal service businesses", or PSB's, for income tax purposes. On October 31, 201'1, the federal government released proposed legislation that, if enacted, can have a significant impact on the income tax rates of these PSB's, and in turn, on how oil and gas companies contract with these corporations. A typical client-contractor arrangement generally works like this: an individual contractor sets up a corporation, the corporation enters into work contracts with one or several oil and gas companies (the clients), and the contracting company pays a salary or dividend to the individual contractor. ln certain instances, a family member of the individual contractor may also be employed by the corporation. The arrangement typically provides some benefits to all parties involved. Clients are able to reduce some of the administrative and financial costs of having a contractor on its payroll, are able to remain flexible to deal with the cyclical nature of the industry, as well as reduce their liability in respect of services provided by the contractors by requiring contractors to carry their own insurance. From the contractor's perspective, they are afforded the flexibility of "being their own boss", they can grow their own business and, in certain instances, can access certain income tax advantages. Some of the advantages include lower corporate income tax rates (if eligible for the small business deduction), a possible deferral of personal income tax if excess cash is kept in the corporations, and the deductibility of business expenses, as well as the ability to pay salaries or dividends to family members. From the contractor's perspective, it is important to consider whether or not the activities of their corporations are considered PSB's for income tax purposes. Generally, unless a PSB employs more than five full-time employees or provides services to an associated corporation, income from a PSB is not eligible for the lower small business tax rates. PSB income would be subject to the general corporate income tax rates, which are 8 to 19 percent higher than the small business rates (varies by province). What exactly is a PSB? A PSB provides the services of an "incorporated employee" to a client, where the incorporated employee would otherwise be considered an employee of the client in the absence of the corporation. The determination of whether a contractor is an incorporated employee or an independent contractor is fact specific and will be different for every contractor as well as every contract entered into. lf income from a contract is recharacterized as income from a PSB, several of the potential benefits mentioned earlier would be eliminated, as PSB income would be subject to the general corporate tax rates and the deductibility of business expenses would become much more restrictive. There are two large disadvantages of being recharacterized by the Canada Revenue Agency (the CRA) as a FSB. Firstly, the tax rate will change. lf the corporate tax return was filed using 14% small business deduction rates and the CRA assesses the company as a personal service business, the corporate tax rate would increase to the rates as indicated below. These changes will more than double the corporate taxes from what was filed.

2 Year ends after October 31, o/" 26.50o/" 25o/" 38o/" The second disadvantage is the restriction of expenses. Most expenses will be denied at the company level. Meals, travel, salaries to spouse, advertising, etc. will be restricted. lt may be possible to still deduct expenses for vehicle, cell phone, computers, etc. if the contractor can show they have been billing these items separately. The CRA has been adding the restricted expenses onto the individual shareholder's personal income. The result of being reassessed is a very large tax assessment by the CRA. lf the CRA reassesses a company as a personal services business, it is possible to fight the assessment. However, in our experience, in order to win, it will be necessary to go to court on the issue. The CRA has not been willing to negotiate on these issues. The CRA considers these factors to indicate an employee-employer relationship.. The client has the right to control the amount, nature, and direct of the work time (h ou rlylwee kly/m o nth ly) ;. The client pays for work performed by the contractor based on time (hourly/weekly/monthly);. The contractor is required by the client to work specified hours;. The contractor provides services only to one particular client; and. The client provides tools, materials, and office space or other facilities to the contractor. As the above listing is not exhaustive, there may be other factors to consider in addition to the criteria listed above. lf the contract terms lean towards the contractor being an employe e and lhe contractor or someone related to him/her owns 10 percent or more of the issued shares of the corporation, income earned by the contractor will generally be viewed as income from a PSB. Under the proposed rules, income from a PSB earned in a tax year beginning on October 91, 2011 will be subject to maximum federal and provincial corporate tax rates, which are even higher than the general corporate tax rates that PSB income is currently taxed at. This effectively removes the potential for income tax deferral as mentioned above. Not only do the new proposed rules impact the corporate rate, once the retained earnings are paid out as dividends, the effective flowed-through tax rate rises substantially. The table below shows the comparison effect of taking salaries versus having the income taxed inside the company. Prior to the October 31, announcements, the effect of being reassessed as a PSB could be costly in that expenses would be denied, it was not as punitive as the new rules will be, as there will be a tax cost plus a loss of expenses. Salary No PSB ord PsB New PSB Rules Rules Alberta 39/" 37.83o/" 39.47o/" 49.96/o BC 43.7Oo/" 42.66/" 44.58o/o 54.18

3 ln order to be considered a contractor and not a PSB, it will depend on the facts of the case. Many contractors in the oil and gas industry are at some level of risk as most contracts have some items that weigh more heavily towards a PSB and other items would be more indicative of a contractor relationship. ln order to mitigate the risk of being reassessed as a PSB, have the contractors do the following:. Own all of their own tools required for the job.. Carry all own insurances. They cannot be part of the group benefit or other insurance plans for their client. They must carry their own liability, well-head, etc.. They should have more than one client.. They must have control over their own hours, whether they accept jobs, how and when the jobs are completed.. They should be able to hire others, but this should be paid by their own company.. The contract should clearly show this is a contract for a specific job, and it is not an employee-employer relationship.. They should carry their own business cards.. The invoicing should be set up with day rates, truck charges per hour, cell phone charges, meal charges, etc. This will substantiate the expenses in the company.. They should ensure that their expenses are reasonable.. They should reconsider the salaries being paid to their spouses. The relationship must be one of independent contractor, and should not look like an em ployment relationship.

4 So, where does this leave us? Personal Services Businesses F ttre four-in one test is still the gold standard. Control. Ownership of tools. Chance of profit. Risk of loss F Look to the "combined force of the whole scheme of operations" F Ask: Is the person who has been engaged to perform the services performing them as a person in business on his own account? F The intention of the parties plays a role > A written agreement is very useful in determining intent and should contain the clear intent of the parties F The actual arrangement between the parties will override the written intent if not consistent with that intent > NO UNIVERSAL TEST EXISTS - It is looked at on a case-bycase basis

5 Practical Application To avoid being a PSB: Personal Seruices Businesses > HAVE A PROPERLY DRAFTED CONTRACT (essential). Ensure that the terms of the agreement have far more factors in favor with the finding of being an independent contractor and not an employee (see factors below). Remember, it's the entirety of the relationship that counts, not just one single factor. > ACT IN ACCORDANCE WITH THE CONTRACT Issues to Consider F pecrors whrch wrll HELp. Avoid set hours. If possible, avoid set hourly or monthly rate. Avoid open ended terms - set a specific term. Have the ability to control your own work hours, your own working conditions, etc.. Have the ability to work without supervision. Use as many of your own tools as possible. Avoid having paid vacations, sick days, overtime etc. ' Build these costs into the overall fee - Avoid being on the employers employment benefit plan ' If necessary, directly reimburse employer for any premiums paid for benefit plans

6 . Do not accept employee stock options. If you are no an employee anyway, there are some potential tax issues that need to be addressed by having employee stock options. Stock option plans need to be drafted differently for independent contractors than they are for employees as they are treated differently for tax purposes. Avoid "exclusive services" arrangements unless it is for a defined period of time, preferably a short period. Have the ability to work for other clients ' Actively solicit other clients and work for them. Have your own business card. Avoid using the employers business cards unless it clearly states that you are an independent contractor - Have a phone number for your corporation in the name of your corporation, put it on your business card. Have the ability to sub-contract work. Have your own employees, preferable fulltime. Have the ability to use your own employees to do the work. Try to link pay to performance or to specific jobs. Submit regular invoices and charge GST. Where possible, bill the employers' clients directly. If possible, have employer stipulate that the use of its premises for your work is provided for the more efficient provision of your services, and that you can choose to work there, from home, or from your own office. Consider building in a rent for the use of the employers' premises or equipment

7 F Other Strategies Personal Seruices Businesses ' Have more than five fulltime employees throughout the year ' They must be real employees doing real work, not just family members being paid for a fulltime job, without doing a fulltime job ' May not be practical in most situations F Strategies ' Incorporate a colporation with one or more co-workers (the more the better) to provide services to the employer ' Such corporation should enter into the contracts with the employer and should be able to choose which of the shareholders gets which job rather than the employer ' May be a way of having more than five fulltime employees (but must be fulltime employees of the corporation throughout the year). Similar to a law firm with one major client?. Market firm to other clients to avoid being called a sham ' If you have more than ten equal shareholders, no one will be a "specified shareholder" ' Consider the cost of running the corporation as a separate business, the disadvantages of dealing with a number of business partners, the practicalities of splitting up profits, etc.. Switch back to being an employee. Avoids cost and time of running a business through corporation. Allows access to employee benefits. Allows access to employee stock options. Avoids possibility of "reassessment". 'othe simple life!" ' If you are running all of the income through into your hand already, there is no advantage to being incorporated anyway

8 Other Questions F When do the new PSB tax rates commence?. Taxation years that being after October 3'l.,2OlI ) What do I do if the CRA wants to audit me?. Call atax advisor (tax lawyer, accountant) to assist you. l,awyers have solicitor - client privilege, accountants do not. Don't panic! It may be a routine audit and nothing to do with being a PSB. Make sure you understand the PSB rules before speaking to the auditor. The wrong answer to a question can be difficult to overcome. Gather and organize your documentation to show the best possible circumstances ' The more business like your operations look, the more like a business you will look. Deliberately manufacturing or destroying evidence at this stage is illegal