Correctly distinguishing between an employee and an independent contractor is critical for businesses and workers. Misclassifying someone can trigger serious consequences – retroactive CPP/EI payroll assessments, income tax withholdings, penalties and interest. In short, getting it wrong is costly, so it’s essential to understand the rules and get it right from the start.
Why Worker Classification Matters
- Payroll compliance: Employers must withhold and remit income tax, Canada Pension Plan (CPP) contributions, and Employment Insurance (EI) premiums for employees. If a worker is truly a contractor, no such payroll deductions are required – the contractor handles their own tax filings. Misclassification (treating an employee as a contractor) means the employer could be on the hook for the missed deductions (both the employer’s and employee’s share) plus interest and penalties.
- Entitlement to benefits: Employees are protected by employment standards laws and could be entitled to things like minimum wage, paid vacation and overtime pay. Independent contractors are not covered by these statutory benefits. In other words, a genuine contractor isn’t owed vacation pay, overtime, or termination notice under employment standards legislation.
- Canada Revenue Agency (CRA) enforcement: The CRA can review a work arrangement at any time and issue a binding decision (CPP/EI ruling) on a worker’s status. Either the payer or the worker can proactively request such a ruling. If the CRA finds an employment relationship where a business treated someone as a contractor, CRA could assess the employer for any unremitted CPP contributions and EI premiums (often going back years), along with applicable taxes, penalties, and interest.
The CRA’s Two-Step Test for Employee vs. Contractor
Outside of Quebec (which has its own test), worker status in Canada is determined by common-law principles. The CRA and the courts look at the total relationship between the worker and the payer, using a two-step approach:
Step 1: Intention of the parties. Examine what the worker and the payer intended when they entered into the relationship. Did they intend to create an employment arrangement (“contract of service”) or an independent business arrangement (“contract for services”)? A written agreement can reflect this intention (e.g. labeling the worker an “independent contractor”), but it’s not decisive if the actual work conditions tell a different story. In some cases the intent is clear and mutual; in others, the two sides may disagree or have never explicitly discussed it. The stated intent is only one factor and cannot override the reality of how the work is carried out.
Step 2: Reality of the relationship. Regardless of what the parties call the relationship, the actual working conditions must align with that characterization. The CRA examines several key factors to see if, in practice, the worker is operating their own independent business or functioning as part of the payer’s business. The main factors (outside Quebec) include:
- the degree of control the payer has over the work;
- the worker’s ownership of tools and equipment used;
- whether the worker can subcontract work or hire assistants;
- the worker’s chance of profit and risk of loss in the arrangement;
- the worker’s responsibility for investment and management in the business; and
- any other relevant details (e.g. whether there is an exclusive relationship, how integral the worker’s role is to the payer’s business, etc.).
No single factor is determinative – all factors must be weighed together to decide if the worker is in business for themselves or is effectively an employee. The table below summarizes these factors and how they typically indicate either an employment relationship or an independent contractor relationship:
| Factor | Indicates Employee if… | Indicates Contractor if… |
| Control | The payer has the right to direct how, when, and where the work is done. The worker is expected to follow the payer’s instructions and may need permission to work for others. | The worker is free to organize their work – deciding how, when, and where to do the job. They can generally accept or decline assignments and often work for multiple clients. |
| Tools & Equipment | The payer provides the tools, equipment, and resources needed for the job, or reimburses the worker for such costs. The payer also covers maintenance, insurance, etc. on those tools. | The worker supplies and maintains their own tools, equipment, and workspace at their expense. Any significant capital items (machinery, technology, office space) are purchased or leased by the worker. |
| Subcontracting | The worker must personally perform the services and cannot hire assistants or subcontract the work to others. The relationship is based on the individual doing the work. | The worker has the ability to hire assistants or subcontract parts of the work to others. They cover the cost of any helpers and manage their contributions as part of running their own business. |
| Financial Risk | The worker has little financial risk: they have few (if any) unreimbursed expenses. They typically earn a fixed wage or salary (steady pay) and are not responsible for operating losses. | The worker faces financial risk in the enterprise. They incur ongoing business expenses (equipment, home office, liability insurance, etc.) without guarantee of reimbursement, and they may incur a loss if their costs exceed their revenue. |
| Investment & Management | The worker has no capital investment in the payer’s business and no business presence of their own (no business premises, no employees of their own). They do not actively manage an independent business – they simply perform work as instructed. | The worker has made investments in their own business (such as office space, vehicles or heavy equipment, staff or subcontractors). They manage some or all aspects of delivering the services as a business owner would, exercising decision-making beyond just doing the assigned work. |
| Opportunity for Profit | The worker’s compensation is fixed – often an hourly, weekly, or salaried rate. There is little opportunity for additional profit beyond perhaps a performance bonus or commission. The worker’s income is relatively secure and does not directly depend on managing costs. | The worker has the opportunity to earn profits by working smarter or more efficiently. They can increase their income by taking on additional projects or clients, negotiating higher fees, or reducing expenses. In essence, they can realize a business profit (or loss) based on how they operate. |
In addition to the above, the overall integration of the worker into the payer’s business could also be considered. If a worker is deeply integrated into the company’s operations (indistinguishable from regular employees), that leans toward an employment relationship. If the worker operates distinctly (e.g. under a separate business name, offering services to the market), that leans toward an independent contractor status. All factors must be examined together to get a full picture.
Tax Obligations
Worker classification also affects how taxes are handled:
Employees: When a worker is an employee, the employer is responsible for payroll deductions at source – this means the employer withholds the employee’s income tax, CPP contributions, and EI premiums and remits them to the CRA (along with the employer’s share of CPP/EI).
Independent Contractors: A genuine contractor is considered self-employed for tax purposes. They pay their own taxes – no income tax or EI/CPP is withheld at source by the payer. Instead, the contractor must report business income on their tax return and remit both portions of CPP contributions themselves (the equivalent of both employer and employee CPP) when they file taxes. EI premiums are generally not required for self-employed individuals.
Tax Consequences of Misclassification
If a business incorrectly treats an employee as an independent contractor, the retroactive costs and penalties can be substantial. The employer can be ordered to pay all back CPP and EI contributions that should have been made, for both the employer’s and employee’s portion. The CRA will also assess any overdue income tax that wasn’t withheld.
Penalties can be added – generally 10% of the unremitted amounts, rising to 20% for repeat or gross negligence cases – plus compound daily interest on the entire balance. In essence, the employer might have to pay several years’ worth of CPP/EI premiums and taxes, with interest and hefty penalties, because they failed to remit them when due.
Given these serious repercussions, it’s clear that prevention is far better than cure when it comes to worker classification issues.
Need Help?
Worker classification can be complex. Taxpayer Law – a team of experienced tax lawyers in Canada (with offices in Toronto and Ottawa) can assists payers (businesses) with all aspects of this issue. Contact us for a confidential consultation.
We appreciate the contribution of Gulshakh Gill in the development of this article.
