Enjoy the Benefits of Operating as Personal Service Corporation
In Canada, utilizing a corporation to operate your business through provides substantial tax benefits over operating as a sole proprietorship. These benefits include legitimate tax minimization, income splitting, and limited asset protection from creditors.
However, there are limitations to using the personal service corporation structure – one cannot just set up a corporation to provide his/her services to another person, which for purposes of the Income Tax Act (I.T.A) includes a corporation or partnership.
Many individuals recognize the benefits of establishing a corporation, and then contract their services to other corporations through it. Subsection 125(7) of the I.T.A will, however, cast such a corporation as a Personal Services Business, and as a result impose punitive penalties in the form of excessive tax on it.
Specifically, where an individual provides services to a person (ie: corporation) or a partnership through a corporation of which he or she is a shareholder, and he/she would reasonably be regarded as an officer or employee of that person or partnership but for the existence of the corporation through which the services are provided, the Canada Revenue Agency (CRA) will consider the corporation as a Personal Services Business. That individual is considered to be an “incorporated employee”.
As of October 31, 2011, if cast as Personal Services Businesses, these corporations would not only have to pay tax at the general corporate rate (38%), but would also be ineligible for the 13% general tax rate reduction enjoyed by other Canadian corporations, resulting in an ending tax rate of 51%, – far above (depending on your personal tax situation) the personal tax rate you would otherwise pay were the business operated as a sole proprietorship.
It must be noted that only the net income remaining in the personal service corporation is subject to these tax rates; however, expensing out all of the net income to the individual defeats the tax minimization purpose of creating the corporation in the first place.
Many business owners – and employees –have set up this type of corporate structure designed to minimize tax and split income with their spouses. Such a structure, however, if exposed to the CRA will result in the above tax rates. In addition, the only expenses that can be deducted in a Personal Services Business are those that are specific to the incorporated employee (ie: no salaries paid to the spouse can be deducted from the net income of the corporation).
The reality is that a lot of business people have set up a structure with exactly this type of corporation in place – to extract management fees from the operating entity and simultaneously enjoy the benefits of tax deferral planning.
However, there is room within the Income Tax Act (ITA) to maintain the benefits of tax deferral using a corporate structure while circumventing the Personal Services Business Rules. This is effectively done by inserting a Partnership into the corporate structure.
The practice of structuring asset profiles utilizing partnerships has existed for a long time, essentially because the partners are not considered to be providing services to the partnership, but rather hold and participate in an income and equity interest in it. The structure is as follows:
Under the old structure, a management services agreement is in place between Holdco and Opco which enables Holdco to invoice Opco for management services. Opco is normally either wholly owned by Holdco or jointly with a spouse, although such a scenario can apply with some minority ownerships.
In this structure, the Personal Services Business Rules under subsection 125(7) would apply because the shareholders of Holdco providing the services to Opco via Holdco would be considered employees or directors of Opco but for the insertion of Holdco in the structure.
One way to circumvent these rules, as diagrammed above, is to roll the operations contained within Opco to ABC Partnership. Such a rollover is provided at the adjusted cost base of the shares of Opco under section 97of the ITA, thereby avoiding any tax consequences on the transfer. Newco is a newly formed corporation and owns a partnership interest in ABC partnership, while the ownership of Newco by Holdco is transferred via resolutions. The value in Opco previously held by Holdco is frozen, giving Holdco access to a commensurate portion of the value of ABC Partnership via the provisions under section 97.
To avoid attacks by the CRA, yearly profits from ABC Partnership should be transferred to Newco and taxed appropriately there; any residual funds remaining in Newco after tax can be transferred up to Holdco via “reasonable” management fees (accompanied by a management services agreement) and dividends. The fact that Newco is taxed on its partnership earnings strengthens the argument that there is a bona fide reason for Newco’s existence within the structure. This is important because, absent a legitimate purpose, Newco could be cast as merely a conduit of funds to Holdco, and if Newco is dismissed, the relationship between Holdco and ABC Partnership becomes that of a Personal Services Business.
A key to the partnership plan is to make sure that Holdco and Newco are Associated as defined in section 248 of the ITA (ie: Holdco owns at least 25% of the voting shares in Newco). Subsection 125(7) exempts associated corporations from the Personal Services Rules.
Practical benefits to the plan
1. Access to the Small Business Deduction Limit
By re-structuring in this way, both Holdco and Newco have access to the Small Business Deduction limit and pay tax at the low corporate rate.
2. Multiplication of the Small Business Deduction Limit among non-related groups
Other corporate groups taking partnership interests in ABC Partnership, and set up similarly to the Newco-Holdco structure above (assuming they are non-related to Newco and Holdco) may have a separate entitlement to the Small Business Deduction (SBD) limit, thereby facilitating multiplication of the SBD for ABD partnership profits. New rules initiated in 2018, however may limit the ability to multiply the SBD.
3. Safety from the PSB rules
The main reason for undertaking this restructuring, of course, is to avoid the Personal Services Business Rules, allow for the low corporate rates and, ultimately, the deferral of tax. Any dividends travelling from Newco to Holdco will be considered inter-corporate under section 112 of the ITA and exempt from part IV tax (ie: the dividends would be taxed only when distributed to shareholders).
One note: Section 67 of the ITA requires that any management services agreement established between Holdco and Newco be reasonable. Determining what constitutes a reasonable management fee here usually requires investigating what other people in the market are paying for similar management services.
If you think you may in this type of situation, give our office a call to discuss your options re: how to re-structure your corporate interests to avoid the Personal Services Tax Rates.
Nicholas Kilpatrick is a partner with the accounting firm of Burgess Kilpatrick and specializes in tax structuring and business development for his small and medium business sized clients. Please visit our website at www.burgesskilpatrick.com or on Facebook at www.facebok.com/Burgess Kilpatrick for more information on our firm.
