Potentially Adverse Tax Results for Incorporated Employees
Davis LLP Taxation Alert
Thursday, 26 January 2012
On October 31, 2011, the Department of Finance proposed changes to the Income Tax Act that effectively put an end to the potentially advantageous tax planning strategy of having an employee agree to provide their services to their employer through a corporate entity (a “Personal Services Business”). The proposed legislation creates a potential significant tax cost to taxpayers who are currently in this structure.
Up until these proposed changes were announced, Personal Services Businesses that earned service fees which would otherwise have been paid to an individual employee were subject to a 25% corporate tax rate. Compare this with the top marginal rate for individual taxpayers (in BC 43.7%), and one can see the tax deferral opportunity this structure created. In addition to a tax deferral, there was the opportunity for a taxpayer to use the Personal Services Business as a mechanism to income split with low income family members.
The Department of Finance effectively eliminated this tax planning opportunity by increasing the corporate income tax rate on income earned by a Personal Services Business to 38%. This corporate tax rate combined with the personal income taxes payable on the dividend paid by the Personal Services Business to the individual shareholders results in a combined corporate and personal income tax rate of up to 52% in British Columbia. This 52% rate is much higher than would have been the case if the individual services provider had earned the income personally as an employee (as noted above, 43.7% in British Columbia).
Given the proposed changes, employees who provide their services through a Personal Services Business should consider restructuring their affairs. These rules are proposed to be effective for taxation years beginning after October 31, 2011.
Independent contractors providing their services through a corporation are not subject to these rules. The distinction between an independent contractor and an employee is not always clear and it is important that such service providers ensure that they could not be found to be providing services in a manner similar to an employment relationship (so they are not found to be a Personal Services Business).
There are some continuing exceptions to the Personal Services Business rules for incorporated employees, as well as other possible strategies to avoid the application of these punitive rules.
If you wish to discuss the possible application of these rules to your particular situation, please do not hesitate to contact a member of the Davis tax group.
Shane Onufrechuk, CA