Canadian corporations enjoy a 13.5% corporate tax rate on the first $500,000 of taxable income from active business due to the small business deduction. Therefore, it makes sense for a corporation to structure its business affairs in ways that can take full advantage of this favourable tax rate.

The majority of Canadian businesses qualify for the above benefit. However, some “consultants” who may have incorporated their service businesses may be taking advantage of the low corporate tax rate, not knowing that their corporate income does not qualify for the favorable 13.5% rate! If this is you, and the CRA audits your business, the final tax costs to you and your corporation could be dire.

CRA Rules for Incorporated Consultants

The CRA has a specific rule for incorporated consultants who provide services to another company. It might be possible that the incorporated consultant providing the services can reasonably be regarded as an officer or employee of the company for which the services are being performed. The tax term for the “incorporated employee” is a “personal services business”.

In order to qualify as a self-employed consultant, one must avoid being reasonably regarded as an employee by CRA. First and foremost, act like a consultant and not an employee. Here are some common ways to achieve this:

• print business cards,
• develop a website,
• have more than one client,
• do not accept employment perks such as group medical plans and holiday pay,
• set your own hours,
• do not accept an office space at the client’s premise.

These are just some of the more obvious criteria that the CRA use to differentiate a consultant from an employee.

Failure to establish yourself as a true incorporated consultant has dire tax consequences.

First of all, personal services businesses are only allowed to deduct wages paid to the person performing the services and other employment related expenses (which are very limited). Secondly, the corporate income retained by a corporation is taxed at 39%, which is way higher than the favorable 13.5%!

What are the tax planning options if you are an incorporated consultant?

Many large corporations with ongoing projects often hire consultants on a full-time basis for a predetermined period and, for various reasons, these organizations often require the consultant to be incorporated. If the service provider does not meet the self-employed test, the best tax planning option is to reduce the annual corporate taxable income to zero by paying the service provider a salary and whatever travel expenses incurred to earn the salary. In this situation, there is no risk of reassessment if a CRA audit occurs.

For corporations that used the small business deduction but are subsequently regarded as a personal services business during a CRA audit, the tax costs are high. First of all, all expenses deducted (except for the salary paid to the service provider and travel costs as discussed in the above paragraph) will be added back to the corporate taxable income and taxed at 39%. Second of all, any other draws from the corporation other than for the salary and travel expenses above will be taxed personally to the shareholder. In effect, the taxpayer is paying tax twice on the same funds drawn from the corporation. And of course, there would be interest and possible penalties to manage on top of everything else.

The Bottom Line

The bottom line: If you want to take advantage of the small business deduction and the current low corporate tax rate, structure your business affairs properly.