Understanding Canada'a Personal Services Business (PSB) For Tax Purposes
In Canada, the concept of a Personal Services Business (PSB) under subsection 125(1) of the Income Tax Act, R.S.C., 1985, c. 1 (5th Supp.) (“ITA”) is a critical tax classification that affects incorporated individuals who provide services to clients. While incorporating can offer tax advantages in many situations, being classified as a PSB can significantly reduce those benefits and increase your tax burden. Understanding how PSBs work—and how to avoid being classified as one—is essential for contractors, consultants, and freelancers.
What Is a Personal Services Business?
A Personal Services Business is a corporation that essentially acts as an incorporated employee. The Canada Revenue Agency (CRA) may classify your corporation as a PSB if:
- You (the incorporated individual) perform services on behalf of the corporation, and
- You would reasonably be considered an employee of the client if the corporation did not exist.
In this context, you are often referred to as an “incorporated employee.” Therefore, you will not receive the benefits of incorporation such as a reduced tax burden and the ability to claim business expenses. If CRA assumes you are a PSB they will reassess, deny expenses, increase income along with shareholder benefits. You will have to appeal the auditor’s assumption to correct the reclassification.
Key Factors the CRA Considers
The CRA doesn’t rely on a single rule but evaluates the overall relationship between the worker and the client. Some of the main factors include:
- Control: Does the client control how, when, and where the work is done? If yes, this resembles employment.
- Ownership of Tools: Do you provide your own equipment and tools, or does the client supply them?
- Chance of Profit and Risk of Loss: Can your business earn more by being efficient, or lose money due to expenses? Employees typically don’t face financial risk.
- Integration: Are you integrated into the client’s business (e.g., using their email, appearing as staff)?
- Exclusivity: Do you work primarily or exclusively for one client over a long period?
If most of these factors point toward an employment-like relationship, the CRA may classify your corporation as a PSB.
Tax Implications of being classified as a PSB
Being classified as a PSB comes with significant tax disadvantages:
- Higher Corporate Tax Rate: PSBs are taxed at a much higher rate than regular small businesses because they are not eligible for the small business deduction.
- Limited Expense Deductions: Unlike typical corporations, PSBs can only deduct a narrow range of expenses, such as:
- Salary and wages paid to the incorporated employee
- Certain employment-related expenses
- Professional fees
Many common business deductions (like home office, travel, or equipment) may be denied
3. No Access to Small Business Benefits: You lose access to tax deferral strategies and lower tax rates available to active business income.
Example Scenario
As an example, a software developer who incorporates and works full-time for one company. They work regular hours, use company equipment, and report to a manager. Even though they invoice through a corporation, the CRA may determine this is effectively employment—triggering PSB classification.
How to Avoid PSB Classification
If you want to maintain the benefits of incorporation, your business should demonstrate:
- Work with multiple clients instead of relying on one primary source of income
- Use your own tools and equipment
- Set your own hours and work methods
- Take on financial risk, such as fixed-price contracts
- Operate under a business identity, including branding and marketing
- Hire employees or subcontractors if possible
No single step guarantees safety, but the overall picture should reflect a genuine business.
SpenceDrake Tax Law – Tax Lawyers
Disclaimer
Each article/blog post is only meant to provide general information. It is posted on a specific date. Laws and rules change. Please know that it may be out of date. It is not meant to provide legal advice, and it does not provide legal advice. It cannot be relied on. Every tax situation is unique, and that may mean situations differ from this article/blog. If you have legal questions, please consult a lawyer.