March 11, 2013
If you provide your services through a corporation, are you carrying on a personal services business? If so, you will lose the tax deferral advantage that this structure previously offered because a tax rate increase on personal services business income will soon be law.
This change is already generally effective for taxation years ending on November 30, 2012 and later. You will need to evaluate the impact of this tax rate increase on your personal services business and decide what to do with your existing corporation.
|Tax rate increase to become law soon|
These changes for personal services businesses are included in Bill C 48, a large bill of outstanding technical tax amendments. This bill received first reading in the House of Commons on November 21, 2012 and is currently working its way through the Parliamentary process. We expect the bill to be passed into law soon.
Tax advantages drastically reduced
Previously, carrying on a personal services business meant the loss of certain deductions and a higher tax rate but there was still a tax deferral advantage to having a personal services business compared to earning the income personally. That deferral will be severely curtailed or nearly eliminated as the tax rate increase to personal service business income becomes law.
Not only has the deferral been significantly reduced, but you will now generally pay much higher total tax when income from a personal services business is withdrawn personally.
Personal services business income is subject to a federal tax rate of 28% (up from 15% for 2012) plus the applicable provincial tax rate, effective for taxation years that begin after October 31, 2011. If you have a December 31 taxation year-end, for example, this tax hike applies to your taxation year that ends on December 31, 2012.
|Background — What is a personal services business?|
Your corporation may be considered a personal services business if you provide services on behalf of your corporation to another company and you would reasonably be considered an employee or officer of the company to which you provide services but for the existence of your corporation.
If your corporation employs more than five full-time employees or it provides services to an associated corporation, it will generally not be considered a personal services business.
A personal services business is not eligible for the small business deduction and the expenses it can deduct for tax purposes are severely restricted. In general, a personal services business’ deductible expenses are restricted to salary and wages paid to an incorporated employee. No deduction is available for costs such as training employees, transportation and advertising.
These rules were introduced to prevent employees from terminating their employment agreements and entering into contracts with their previous employer through their own corporation to obtain tax advantages.
Effect of having a personal services business corporation
Under the previous rules, differences between tax rates caused money earned by a personal services business corporation to be taxed at a lower rate than it would have been if the individual corporation owner had received it directly.
As such, there was a tax deferral advantage to earning income through a corporation as long as after-tax income was invested rather than spent because the corporation had more after-tax income to invest than the individual would have had if he or she earned the income directly.
To illustrate, the table below uses an example of an Alberta resident individual paying tax at the top combined federal and provincial marginal rate. The table shows that the tax rate increase for personal services businesses significantly reduces the tax deferral advantage from earning income through a corporation.
|Personal Services Business Income Tax Deferral Advantage|
Tax Rate Increase
Tax Rate Increase
As a result of the federal tax rate increase, your corporation will have $620 in after-tax income for every $1,000 it receives (down from $750 under the previous tax rate). On the other hand, if you earn $1,000 in salary income personally and pay tax in Alberta at the top marginal rate of 39%, you will have $610 in after-tax income. As such, the tax deferral available by having the corporation earn the income has been reduced to $10 per $1,000 of income (from $140 per $1,000 of income).
Along with losing most of the tax deferral advantage, you will pay an absolute tax cost for flowing the income through the corporation, as illustrated below using the same example of an Alberta resident individual as above.
After the personal services business tax increase, when the corporation pays its after-tax income of $620 to you as an eligible dividend taxed at Alberta’s top marginal rate of 19.3%, you will have $500 in after-tax income from the $1,000 the corporation received. If you had received the $1,000 directly as salary income instead, you would have $610 in after-tax income.
As such, the individual pays an absolute tax cost of $110 per $1,000 of income (or 11%) as a result of flowing income through the personal services business corporation. As illustrated, before the corporate tax rate increase, there was still an absolute tax cost of flowing income through the corporation but it was only $5 per $1,000 of income, or 0.5%. As a result, the effective tax rate for an Alberta resident on income earned in a personal services business will now be 50%, compared to roughly 39% previously, which represents a significant tax cost that can’t be ignored.
|Personal Service Business Income Absolute Tax Cost of Flow-Through Corporation |
Tax Rate Increase
Tax Rate Increase
in corporation (see above)
|Net retained by individual after tax (C)
|Net retained if $1,000 income earned directly by individual (D)
|Net cost of flow-through corporation per $1,000 (D-C)
You will first need to assess whether your corporation is carrying on a personal services business. If it is, you’ll need to determine the effects of the tax rate increase on your personal services business corporation and decide what steps you should take. For example, you may want to “bonus out” all corporate income as salary or wind up or restructure the corporation. Depending on your province, you may still get a modest tax deferral using a personal services business corporation, so you may want to evaluate whether using the corporation still makes sense, taking all your specific circumstances into account.
If the investments in your corporation have built up significant value, you may want to keep the corporation in existence so you can continue to defer tax on the existing retained earnings until you withdraw them from the corporation in the future.
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We can help
Your KPMG Enterprise adviser can help you evaluate whether you have a personal services business and if so, how the tax rate increase will affect you. We can also help you determine the most tax-effective course of action for you. For details, please contact your KPMG Enterprise adviser.
Information is current to March 11, 2013. The information contained in this TaxNewsFlash-Canada is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act upon such information without appropriate professional advice after a thorough examination of the particular situation. For more information, contact KPMG’s National Tax Centre at 416.777.8500.
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