Payroll is a significant expense for most of our clients and, not surprisingly, they are often looking to reduce the financial burden represented by payroll obligations. One way to do this is to convert employees to self-employed independent contractors (ICs). Care must be taken when doing so, however, as expensive consequences can result from misclassification of employees.
When a business pays an individual for services in Canada, the business has a statutory obligation to assess whether the payee is an employee of the business or an IC. Employees are entitled to protection under provincial Employment Standards legislation and are subject to statutory deductions from their payroll cheques for income taxes, Canada Pension Plan (CPP) and Employment Insurance (EI) premiums.
Employers and employees often have similar interests in wanting to convert from employee to IC. From the employer’s perspective, designating an employee as an IC provides the employer with relief from the administrative burden of payroll deductions compliance, reduces matching CPP and EI costs, and removes employment standards protections such as minimum wages, overtime and holiday pay. From the employee’s perspective designation as an IC results in higher net pay (all other things being equal), avoidance of EI premiums, and more flexible access to tax-deductible expenses.
On the other hand, the Canada Revenue Agency (CRA) tends to favour employee relationships because they result in collection of more CPP and EI premiums under its administration and fewer tax deductions to the employees.
The Importance of Getting it Right (or So What?)
Failure to comply with payroll deduction rules can leave the employer on the hook for both the employee and employer’s portion of CPP and EI premiums. Also, there are significant penalties associated with failing to withhold statutory deductions and failing to prepare annual T4 slips. These can easily amount to tens of thousands of dollars when the error is extended over multiple years and multiple employees.
Employees can find themselves indebted to their employer for thousands of dollars of CPP and EI premiums and be reassessed to disallow tax deductions if they have claimed expenses available to an IC but not to employees.
The designation is also important in determining whether GST applies to transactions (yes for ICs and no for employees) and affects the application of the Personal Services Business (PSB) rules.
Here’s a link to a blog my colleague Chris Brien CPA, CA wrote about PSBs: Personal Services Businesses
Determining the Correct Nature of the Relationship
There is no definition of an employee/employer relationship found in the Income Tax Act. Whether or not an employee/employer relationship exists is a question of fact and over the years a group of factors has been identified by the courts as the common law standard. None of the following factors is definitive; rather, each case is decided by weighing the balance of the factors.
The court will first look at the intention of the parties, the most definitive evidence being a formal written contract between the parties. Absent a formal contract, the courts will look at informal or verbal contracts or testimony of the parties. Intention is of primary importance, but can be negated by the actual relationship between the parties which consists of four factors – control, ownership of tools, chance of profit and loss, and integration.
Control – describes the degree of ability of the employer to direct the activities of the worker. The higher the degree of control, the more likely the worker is an employee. Who schedules and controls the work? Who determines the specific tasks the worker performs from hour to hour? Who has decision making authority over how the work is performed? Is the relationship subordinate or peer-to-peer? Can the worker work for other employers simultaneously?
Ownership of equipment or tools – includes physical equipment, work space and intellectual capital. The more significant the investment by the worker in her own tools and equipment, the more likely she is an IC.
Opportunity for profit/loss – relates to the business risks normally associated with running one’s own business. The higher the opportunity for profit/loss, the more likely the worker is an IC. Can the worker earn a greater profit by using their own initiative or does the worker incur risks of loss? Can the worker accept or reject assigned projects? Schedule their own work? Is the worker paid for hourly attendance or for work outcomes? Can they hire assistants or substitutes to perform their contract? To what degree does the worker bear their own costs? Who controls the timing and amount of payment? Is the worker Included in or excluded from the employer’s benefit plans?
Integration – describes the degree to which the tasks performed by the worker are an integral part of the employee’s revenue earning activities. The higher the degree of integration the more likely the worker is an employee. Are the tasks performed integral or peripheral to the employer’s business?
An example of an employee is the labourer on a construction site. He probably has limited training, He is highly controlled hour to hour by the site foreman, probably doesn’t provide his own tools, and is paid by the hour on a bi-weekly basis. Clearly an employee.
The electrical contractor, on the other hand, has a formal contract in place, works when she want to subject to a completion date, provides her own tools and intellectual capital, is hired to do a complete job under her own professional standards and takes economic risk in the form of a fixed price contract. Clearly an IC.
Of course many real life examples are not so clear cut. And there are lots of things a business can do to mitigate the risks presented by IC relationships. That’s why clients hire us to help
Here’s link to what CRA thinks about this topic: CRA RC4110 – Employee or Self-Employed?
Here’s a link to a recent court case in which the court ruled a roofer was an IC: Roofing Company case
It can prove very expensive to make the wrong decision in employee versus IC matters. The payroll errors accumulate and multiply with years and number of employees. Non-compliance penalties and interest increase the risk.
We can help. Call one of our professional to assist with assessments of existing relationships, advise on how to structure relationships to mitigate risk, seek tax rulings from CRA, and meet with CRA auditors if they are reviewing your IC arrangements.
Doug Johnstone, CPA, CA