The rules changed effective October 31, 2011.
What makes a corporation a Personal Services Business and what are the ramifications?
Your corporation’s business will generally be considered a Personal Services Business (PSB) if you meet the following criteria:
- The shareholder performing the service (or someone related to the person) owns 10% or more of any class of shares of the corporation providing the service.
- Without the corporation, the individual would reasonably be considered an employee of the party to whom the services are being performed.
- The said individual is then considered to be an incorporated employee.
There is an exception for corporations having more than 5 full time employees, and for services provided to an associated company. Associated companies share one small business deduction limit between them.
The Canadian tax system allows for two corporate tax rates. For profits under $500,000, corporations in BC are taxed at 13.5%. For profits in excess of $500,000 tax is 26.5%. Every Canadian Controlled Private Corporation has this $500,000 limit, referred to as the Small Business Deduction Limit.
At one point in time, executives recognized that if they set up a new corporation that just employed themselves and then charged the corporation that they actually did work for, they could double the amount of profit subject to the small rate of tax. CRA identified this loophole and legislated against it.
CRA has changed the rules retroactively to October 31, 2011. Effective as of that date the dividends paid out of the PSB are not considered eligible dividends (eligible dividends are a special low tax rate dividend). The result is that you will pay 26.5% corporate tax followed by regular dividend tax rates of up to 34%. The additional of the two tax rates will result in total tax of over 50%. When you consider the top personal tax rate is 43.7% it makes no economic sense to use a PSB.
For more information on Personal Services Businesses (PSB) and how to avoid the pitfalls that could cost you taxes, please contact us.Download a copy of this issue