What’s New?
On June 26, 2013, the changes to the tax treatment of a “personal service business” (“PSB”) received Royal Assent. Effective for taxation years that begin after October 31, 2011, PSB income will be subject to federal corporate tax at the full unreduced rate of 28% (assuming the availability of the 10% provincial abatement).
What is a PSB?
Generally, a corporation is carrying on a PSB where an individual performs services on behalf of the corporation and that individual would reasonably be considered an employee or officer of the company to which the services are being provided but for the existence of the corporation, subject to certain limited exceptions.
Background
Under the previous rules, the small business deduction and ordinary business expenses were denied to PSB’s resulting in PSB income being subject to the top corporate tax rates.
These rules were intended to prevent employees from terminating their employment contracts and entering into contracts with their previous employer through their own corporation to gain a tax advantage. Until recently, these rules were sufficient to curtail the use of PSB’s.
However, as the corporate income tax rates have decreased significantly over the last several years together with the changes to the dividend tax regime, opportunities for tax deferrals have increased on income earned through a PSB where individuals could afford to leave the income in the corporation. The new rules effectively eliminate this opportunity.
Removal of Tax Advantage
To illustrate the effect of the increased federal tax rate for PSB’s the table below uses an example of an Ontario resident individual paying tax at the top combined federal and provincial marginal tax rate. It is clear that the tax rate increase for PSB’s significantly reduces the tax deferral advantage previously enjoyed from earning income through such a corporation.
| After Tax Rate Increase |
Before Tax Rate Increase |
|
| Income Earned by Individual: | ||
| Employment income earned | 100.00 | 100.00 |
| Individual Tax 1 | (49.53) | (49.53) |
| Net Cash Retained | 50.47 | 50.47 |
| Income Earned by PSB: | ||
| PSB Income | 100.00 | 100.00 |
| Corporate Tax 2 | (39.50) | (26.50) |
| After-Tax Cash in PSB | 60.50 | 73.50 |
| Distribution to Shareholder of PSB: | ||
| Eligible Dividends Paid | 60.50 | 73.50 |
| Individual Tax on Dividend 3 | (20.48) | (24.88) |
| Net Cash Retained by Individual | 40.02 | 48.62 |
Note 1:
Top combined marginal rate on income for 2013 for Ontario (including surtaxes) 49.53%.
Note 2:
| 2013 General Corporate Tax Rate: | |
| Federal | 15.00% |
| Provincial (Ontario) | 11.50% |
| 26.50% |
| 2013 PSB Tax Rate: | |
| Federal | 28.00% |
| Provincial (Ontario) | 11.50% |
| 39.50% |
Note 3:
Top combined marginal rate on eligible dividends for 2013 for Ontario (including surtaxes) 33.85%.
Under the new rules, many PSB’s may now be subject to unintended tax consequences. Taxpayer’s who are earning PSB income through a corporation should review their situation with their Collins Barrow tax advisor to determine the most tax-effective course of action in light of the recent changes.
Gina Pak CPA, CA is a Tax Manager in the Toronto office of Collins Barrow.