A Personal Services Business (PSB) is a special classification under Income Tax Act (Canada) (ITA) that can have significant tax consequences for corporations. In essence, a PSB is often referred to as an “incorporated employee”– where an individual provides services through their own corporation but, if that corporation didn’t exist, the individual would likely be considered an employee of the client company. This framework was designed to prevent the conversion of what is effectively employment income into corporate income taxed at lower rates.
Understanding the legal definition, criteria, and tax implications of PSBs is crucial for small business owners and accountants, especially given the Canada Revenue Agency’s (CRA) recent scrutiny of these arrangements. Below, we break down the PSB concept, how the CRA identifies a PSB, the tax impact of being deemed a PSB, recent CRA enforcement trends, and the rights of taxpayers facing a PSB reassessment.
Legal Definition and Framework of a PSB
Under the ITA, a corporation is carrying on a personal services business if it meets all the conditions that generally mirror an employer-employee relationship between the corporation’s worker and the client. A PSB generally exists when a specified shareholder (generally someone owning 10% or more of the corporation) provides services to a client through their corporation, and that worker would reasonably be considered an employee of the client if the corporation did not exist.
Two important exceptions are built into the PSB definition. Even if the worker would otherwise be an “employee” of the client, a corporation will not be a PSB if (a) the corporation employs more than five full-time employees throughout the year, or (b) the services are provided to an associated corporation (essentially a business under common ownership or control). These exceptions recognize that a larger or affiliated business is likely carrying on a genuine enterprise rather than serving as a disguised employment vehicle. In summary, the PSB rules generally catch small one-person service corporations where the owner is working for a single arm’s-length client in circumstances akin to employment.
CRA’s Criteria for Identifying a Personal Services Business
The CRA uses a set of specific criteria to determine whether a corporation qualifies as a PSB. All of the following conditions must be met for a corporation’s service income to be classified as a personal services business:
- Incorporated Worker: The worker provides their services through a corporation (i.e. they have incorporated a company that contracts with clients).
- Specified Shareholder: The worker (or a person related to the worker) is a specified shareholder of that corporation, generally meaning they own at least 10% of the corporation’s shares (directly or indirectly).
- Small Employee Base: The corporation employs five or fewer full-time employees in the business throughout the year. (Having six or more full-time employees would exempt the corporation from PSB status, as noted above.)
- Unrelated Clients: The income earned by the corporation for its services in the year is not paid by a corporation that is associated with it. In other words, the client is arm’s length and not part of the same corporate group as the service provider.
- Employee-Like Relationship: Crucially, if the corporation did not exist, the worker would reasonably be considered an employee of the payer (client) to whom the services are provided. This is the fundamental test – essentially asking whether the working arrangement is effectively employment in all but name.
All five conditions must be satisfied for the CRA to classify the corporation’s activities as a personal services business. The last condition (the employee-like relationship) is often the most contested. To evaluate it, the CRA and courts look at the same factors used in distinguishing an employee vs. independent contractor, such as the level of control the client has over the worker’s activities, whether the worker provides their own tools/equipment, the worker’s opportunity for profit or risk of loss, and the degree of integration or exclusivity in the client’s business. This analysis is fact-specific – each case is unique and requires a thorough review of the actual working conditions and contracts in place. In practice, if a worker through a corporation has one main client, works under that client’s direction, and isn’t carrying on a diversified business of their own, the CRA will be inclined to view the arrangement as a PSB.
Tax Implications of PSB Status
Being classified as a personal services business triggers punitive tax consequences designed to negate the benefits of incorporating for tax reasons. The ITA essentially treats PSB income as if it were personal employment income by denying the usual corporate tax perks. Key tax implications of PSB designation include:
- Denial of the Small Business Deduction: A PSB is not eligible for the small business deduction (SBD). Ordinarily, a Canadian-controlled private corporation can apply the SBD to its active business income up to a certain limit, reducing the federal tax rate (to 9% federally, plus reduced provincial rates). PSB income, however, is expressly excluded from the definition of “active business income,” so none of it qualifies for the lower small-business tax rate.
- Higher Corporate Tax Rates (Full Rate + Surtax): Income from a PSB is taxed at the full federal and provincial corporate tax rates, with no access to the general rate reduction either. Federally, the base corporate rate is 38%, which after a 10% federal abatement (for provincial tax room) leaves 28% federal tax. Provinces then levy their corporate tax (for example, 11.5% in Ontario). On top of this, since 2016 the federal government imposes an additional 5% surtax on PSB income. Combined, these taxes are much higher than for other corporations. For instance, a PSB in Ontario faces about a 44.5% corporate tax rate on its income (28% federal + 11.5% Ontario + 5% PSB surtax). This approaches or even exceeds the effective tax rate an individual would pay on high employment income, thereby removing the incentive to funnel personal earnings through a corporation.
- Restricted Expense Deductions: Perhaps most painful for PSBs is the severe limitation on deductible business expenses. Personal services businesses cannot deduct most normal operating expenses that other companies can. The ITA (paragraph 18(1)(p)) restricts PSBs to only a few allowable deductions:
- Salaries or Wages paid to the incorporated employee (and other employees, if any) for the services rendered. In practice, this means the corporation can deduct the salary it pays to the owner-worker (which then gets taxed in the owner’s hands personally).
- Benefits or allowances provided to that employee (for example, if the corporation provides a taxable car allowance or health benefits to the worker, those costs can be deducted).
- Certain sales-related expenses that would be deductible if the worker were an employee. This covers specific expenses associated with selling property or negotiating contracts, analogous to what a commissioned employee might deduct. These are narrowly interpreted.
- Legal expenses for collecting unpaid fees for the services. If the corporation has to incur legal costs to collect amounts owing for its work (for instance, suing a client for unpaid invoices), those legal fees are deductible by the PSB.
Apart from the above items, a PSB cannot write off other usual business expenses – no deductions for advertising, rent, travel, training, capital cost allowances on equipment, etc. This mirrors the restriction on employees, who also cannot deduct most employment-related expenses on their personal tax returns. The intent is that a PSB should not get more tax write-offs than an individual employee would in performing the same work. The practical outcome is that many costs incurred to earn income (which would normally be deductible in a business) provide no tax relief to a PSB, making the effective tax burden even heavier.
In addition, a corporation carrying on a PSB still has the usual compliance obligations of any employer. It must register for payroll, withhold and remit income tax, CPP, and EI on any salary it pays to the incorporated employee, and issue T4 slips for that salary just like any other employer would. The PSB must also file annual corporate tax returns (T2) and applicable GST/HST returns if it is a registrant. These obligations recognize that, for tax purposes, the PSB is essentially functioning as an employer paying wages to its owner.
Recent CRA Enforcement Patterns and Audit Trends
In recent years, the CRA has sharpened its focus on personal services businesses, concerned that many small corporations may be misclassified or non-compliant. A clear sign of this focus was the CRA’s PSB Pilot Project (2022 – 2024) – a two-phase initiative aimed at identifying PSBs and educating both the companies and their clients about tax obligations. Rather than immediately launching audits, the CRA invited participants to a voluntary review, giving them a chance to correct filings without penalty in the pilot’s cooperative framework. The findings from this pilot shed light on enforcement trends and areas of risk:
- Prevalence in Certain Industries: The pilot confirmed that PSBs are especially common in specific sectors. Nearly 74% of the potential PSBs identified were in just three sectors: transportation and warehousing (about 35%), professional, scientific and technical services (26%), and construction (13%). For example, many truck drivers, IT consultants, engineers, and construction contractors operate through personal corporations, often at the behest of those hiring them. The CRA knows to pay particular attention to service corporations in these fields.
- Misuse of the Small Business Deduction: A striking finding was the high rate of incorrect tax filing among PSBs. In Phase 1 of the pilot, about 64% of the potential PSBs were improperly claiming the small business deduction which they are not entitled to. Similarly in Phase 2, more than three-quarters (over 80%) of confirmed PSBs had claimed the SBD on their corporate returns and failed to include the additional 5% PSB tax, indicating widespread non-compliance. This suggests that many PSB owners or their advisors did not realize the corporation’s income should have been taxed at the higher PSB rate. The CRA is likely to view such patterns as a compliance concern warranting audits or reassessments.
- Forced Incorporation and Misconceptions: The pilot also revealed that a majority of individuals operating PSBs felt they had to incorporate to get work. About 63% of the PSBs surveyed said they only incorporated because they were required or pressured by the hiring company. In fact, 29% were explicitly told to incorporate by the client, and many of those were misinformed – some were wrongly advised that they would still qualify for the small business deduction or could claim various business expenses through the corporation. These findings highlight a knowledge gap: both the PSB owners and the companies engaging them often misunderstand the tax restrictions on PSBs. The CRA’s response to this is likely twofold: continued educational outreach and targeted audits. We can expect the CRA to increase audits on service corporations that fit the PSB profile, especially now that an educational pilot has been completed. Audit risk is certainly elevated for one-person corporations in the known high-risk industries, or any situation where a worker’s T4 income was replaced by invoices from a corporation.
- Voluntary Compliance vs. Reassessment: During the pilot, the CRA gave participants a chance to self-correct without immediate reassessment. Going forward, however, taxpayers should anticipate a less lenient approach. The CRA has amassed data from the pilot to refine its compliance strategies. Businesses identified as potential PSBs may receive educational letters or be selected for audit if they haven’t corrected their filing position. Reassessments can be issued for past tax years where a corporation wrongly claimed the small business deduction or inappropriately deducted expenses as a PSB. This can result in substantial retroactive taxes, penalties and interest. The pilot’s key takeaway for the CRA was the need for greater awareness. Now that outreach has been done, one can expect less leniency on the premise of ignorance. In short, the CRA’s enforcement trend is moving from education to enforcement, meaning that taxpayers who continue to operate in a PSB-like manner without compliance should be prepared for possible audits and reassessments.
Legal Defensibility and Taxpayer Rights in PSB Disputes
Facing a CRA determination that your corporation is a personal services business can have serious financial consequences, but taxpayers are not without recourse. If you are reassessed as a PSB (for example, denied the small business deduction and hit with higher taxes), it’s important to know your rights and options:
- Right to Challenge the CRA’s Decision: A PSB classification often hinges on the nuanced question of whether the worker is effectively an employee of the client. This is a question of fact. Taxpayers (through their corporations) have the right to file a Notice of Objection to any reassessment within 90 days, initiating a formal appeal within the CRA’s Appeals Division. If the issue isn’t resolved there, you can further appeal to the Tax Court of Canada for an independent review of the facts. The Tax Court has dealt with numerous PSB cases, and it will consider the substance of the working relationship rather than just the form. In court, factors such as who controls the work, how the worker is paid, and whether the worker had multiple clients will be weighed to decide if the arrangement truly resembled employment or independent business. The burden is on the taxpayer to show that the CRA’s classification is wrong, but with strong evidence, it may be possible to overturn a PSB determination.
- Reliance on Legal Criteria: The legal defensibility of your position will rest on the established tests for employment vs. independent contractor status. The CRA’s view is not final – the courts will apply common law criteria (control, ownership of tools, chance of profit/risk of loss, integration, etc.) in an objective manner. If you can demonstrate, for instance, that you retained significant control over your work, used your own tools, bore financial risk, and operated more like a contractor than an employee, you stand a better chance of defeating a PSB reassessment. It’s not enough that a contract calls you an “independent contractor” – what matters is the actual conduct of the parties.
- Consequences of Losing or Settling: It’s important to approach a potential PSB dispute realistically. If the facts clearly show an employee-like relationship (single client, working full-time under supervision, etc.), the chances of overturning the designation may be slim. In such scenarios, a taxpayer might consider negotiating the scope of reassessment (for example, limiting it to certain years or arguing against gross negligence penalties if the filing position was taken in good faith). On the other hand, if your situation is borderline, pushing back may yield a settlement or a favorable judgment.
In all cases, maintain a litigation-aware approach: document your working arrangements thoroughly, keep records of advice received, and respond to CRA queries carefully. Even during an audit, how you explain your business model can influence the outcome. If classified (or at risk of being classified) as a PSB, consult a qualified tax advisor or tax lawyer early – proactive legal guidance can sometimes reframe the narrative before a reassessment is issued.
Conclusion
Recent trends show the CRA is actively hunting for PSBs – especially in industries where “incorporate to get work” has become common – and is tightening the compliance screws on those caught. Small business owners and accountants should be alert to these rules: if you or your client has a service corporation with characteristics of an incorporated employee, recognize the risk and ensure you are filing correctly (or be prepared to defend the position that it’s a genuine independent business).
While the PSB designation is onerous, it is not always a foregone conclusion. The nature of a working relationship can be complex, and there is room to argue the facts. Taxpayers facing a PSB audit or reassessment should remember that they have rights to challenge the CRA’s view. With a professional, litigation-aware approach – grounded in the actual facts of how the business operates – it is possible to fight a reclassification. Consider seeking legal advice if the CRA approaches you about a possible personal services business.
