In Canada, for the past few years, the CRA (the Canadian version of the IRS), has been cracking down on IT contractors and reassessing their status to something called a "incorporated employee" AKA the dreaded Personal Service Business .
How does this effect the Canadian developer community? Many IT contractors are required to be incorporated in order to do business with larger enterprise organizations. In addition, being a IT contractor has numerous tax benefits such as:
- Claiming businesses expenses
- Claiming the Small Business Deduction for tax purposes
- Varying methods of payment: Salary vs Dividends
If you are labelled as a Personal Service Business(PSB), then you can no longer claim most business expenses other then salary. As an additional penalty, your income is taxed at the combined: highest corporate tax rate + personal tax rate
This results in a tax rate even higher then if you were a employee in the highest tax bracket!
You might already personally know at least one person whose been hit by the PSB label. Because of this, I wanted to share some of the ways us contractors can reduce the risk of being labeled as such.
What puts you at risk? If you are a IT contractor doing work in a similar fashion to that of your employee counterparts, the CRA does not care if your contract between you and your client explicitly states your status as a contractor. CRA focuses on behavior and commonly applies a few metrics to determine if you are a PSB or not.
So I wanted to list them and illustrate some ways you can lower your risk of reassessment. As a word of note, I'm not a lawyer or accountant. I am however, a contractor, who had to do my own research. So I wanted to share some of my findings to make others aware of how we are at risk for being labeled a PSB and how it can cost us.
If it looks like a duck... 🦆
Here are some of the metrics used by the CRA:
1. The level of control exercised by the client over the duties the contractor performs.
Freelancers with multiple clients are OK. But the CRA considers a standard 9-5, Monday thru Friday work schedule, employee like behavior (regardless of contractor status).
2. Do you provide your own equipment? or is it provided by the employer?
Many banks and government organizations provide work computers to their contractors. Receiving company equipment to complete daily tasks is considered employee like behavior.
3. Do you hire your own employees or subcontractors?
The CRA is specifically targeting one-person corporations. Companies with 5 or more employees are not considered PSBs.
4. What is the business's opportunity for profit or loss
In other words, does your business keep inventory or have other expenses such that if you earn no revenue, your business takes a loss. Many IT contractors (especially the ones who are provided equipment), have very few expenses -almost all of the contractor's per hour rate becomes profit. As a result, most IT contractors do not incur significant losses if they earn no revenue. Businesses with little risk of loosing money are at risk for a PSB status.
5. Nature of the payment structure
The CRA wants to know if you invoice your client after a period of time or if the client simply pays you every two weeks (which is very employee like behavior).
I sound like a employee! What can I do?
Most IT contractors who work on-site must work client business hours. In most cases, we unfortunately cannot change this. That being said, CRA considers the above factors in combination to make their determination. So if you are "employee-like" in one factor, you can attempt to make up for it in another.
Always send a invoice to your clients and be sure your invoice includes the charges levied. Though a monthly invoice on a per hour rate is acceptable, the safest types of payment are ones after a certain project milestone is reached.
Make sure your business spends 'some' money on marketing and has a web-presence. You need to show the CRA that you are seeking additional clients (and operates as a normal business). These expenses also show the CRA that you can incur a loss if you do not earn revenue.
Most contractors only work one client at a time. This is very employee like behavior to the CRA so you need to try and diversify your clientele. If you have lucrative anchor clients you don't want give up, then try to do some side gigs as a freelancer.
Employees switching to a contractor status but not changing jobs is one of the most frequent ways people become contractors. Unfortunately, the CRA also knows this and explicitly looks for this behavior.
Other things you can do to lessen the risk include:
- Minimize the profit of your corporation by expensing most of your company revenue as your salary. However, this may not make financial sense for all contractors.
- Complete the required business paperwork (balance sheet, income statement, etc - which is required by law).
- Keep business bank accounts and cash separate from your personal ones.
- Ensure all business expenses are truly business related and reasonable.
- Avoid at all costs being listed as a employee on client email-lists or staff directories. Avoid company perks given out to employees (like meal vouchers and gym memberships).
Navigating the world of IT contracting has been made considerably difficult the last few years. What was once considered an easy path for guaranteed tax savings has become a landscape where developers must constantly be aware of their outward appearance as a employee. A PSB label is year-to-year, so if you get labeled as a PSB, it's not the end of the world. You can be a PSB one year and be safe the next.
It's frustrating at times that this knowledge is horded by layers and accountants who charge exorbitant fees to discuss this. Hopefully my few tips will help you save some money and stay out of trouble.
Are you a Canadian contractor? Do you know about PSB status? What do you do to avoid that? I'd like to know more tips too!
I'm JayC and I like to write about career development, Java/JS dev, and rant 😑.
I also write articles with a group of friends to help others - follow @CanosieLabs labs for more developer-tips and help articles.
Photo Credit: Uunsplash- Loic Leray
Top comments (10)
Great article. I asked an accountant recently and was suggested not to be a contractor! I said that this won't work, then the suggestion is to admit to be a PSB directly to avoid the risk... I am quite disappointed by this system, since it's the truth that we are on ourselves and take all the risks normal employees own't. Your article just showed me some more specific info on this issue for software developers.
Since the nature of contracted developers looks like employees a lot, I guess that a safe strategy is to apply your advice of 'Minimize the profit of your corporation by expensing most of your company revenue as your salary' while deducing some expenses and keep some profit (like a portfolio in terms of investment)? In this way, even if the company is regarded as PSB eventually, the penalty (I suppose that it's based on company's profit?) will not be so big and can be affordable.
BTW, I also thought of the idea of doing some small side projects, but the accountant said that the revenue of these are too small comparing with your main payer, so it won't help...
hi Idog
Sorry for the late reply. I just wanted to share some of the things I've researched and forward the information I've gotten from accountants.
Technically speaking, not all penalties are prorated to how much profit a company makes (i.e. a company can get penalized for x amount regardless of their net profit/loss). That being said, even as a PSB, you can write off salary as an expense. Since most developers have low operating costs, if you write off most of your income as salary, then the amount of bad-business deductions you can get penalized for is low.
Though I have heard similar concerns regarding side projects, I'll share with you what I've been told. You have to show that you are 'putting in effort' in obtaining additional clients. It is very normal for legit freelancers to have 1 or 2 major anchor clients and a number of other small clients. The income distribution between their anchor clients and 90% of the rest can be quite significant- but they are still non-PSB. It comes down to how you operate and carry out business.
As a contractor I know what you might be going though. Many companies require contractors to become incorporated. If your operating costs are low you can take your accountants advice and declare that income as coming from PSB sources. There might not be a significant difference in your take home pay.
Different accountants and lawyers have different perspectives on the subject - but many have their own agenda as well when they recommend different things. In the end, it comes down to the nature of your business and risk tolerance.
If it's your first year as contracting, it is very common for freelancers to have just one client - so the risks of having your corporation be tagged as a PSB is low...unless you have unusual expenses.....
Hi Jay,
Thanks for the information. Till now I've been a freelance developer for more than 1 year, and things have been more clear for me.
As you said, one accountant also expressed the same thing, for example, you need to show that you've been looking for new clients actively, and you can also do some side project, even it is as small as fixing a PC for a friend...
I'd say that this rule itself is not very fare for software developers. For other jobs like plumber, one will have a lot of clients by nature. But for developers, usually one takes a big project, that requires one to sit in client's office working together with other developers or contractors. In this case, it's difficult to keep another major client, unless one finishes one project and goes into another one.
But I will keep doing this anyway, as it gives one a lot of freedom at work (for example, you don't need to attend most of the meetings, and also don't need to consider most of things other than the work itself). I had been working as permanent employees all the time until I started this contract job. I found that I could hardly work in one job for more than 2 years for various reasons, and this new style suits me quite well :-)
I would think they would be penalizing the companies who use contractors like employees without benefits. Not the other way around. Seems a strange way to deal with that problem.
haha yeah.
In this case, the government is really protecting their tax revenue rather then protecting people. Development contracting is one of very few industries where "contractors" make up a large portion of the workforce but do similar work as their employee counterparts...but make more(sometimes)
So as more people get into contracting, the fewer income tax revenue the govt receives from these people.
Edit: removed generalizations.
Anyway, thanks for the informative article! I learned a bit, including the stuff I looked up about CPP and EI before this response.
The government wants their money! that's for sure.
no problem! thank you,
Thanks for writing this ! do the 5 employees need to be full time Canadian residents ?
hmm, I'm not sure about that detail, but if you are paying those staff to do real work for your company, it should be fine.
Thanks for writing this article JayC. I'm considering getting incorporated (more like getting forced by a company lol) and have a few questions. Can I send you a private message somewhere?