Personal Services Business Rules: The 33% Federal Trap for Incorporated Contractors

A contractor incorporates, invoices one client, works that client’s hours on that client’s systems, and pays himself dividends at the small business rate. It looks like tax planning. If the CRA characterises the corporation as a personal services business, it is the most expensive structure available in Canadian tax.

The corporation loses the small business deduction, loses the general rate reduction, pays an extra 5% federal tax on top, and loses the ability to deduct almost every ordinary business expense. Those four consequences stack.

What a PSB actually is

The CRA’s definition has four conditions, and they must all be met. The corporation is carrying on a personal services business where:

1. An individual performs the services on behalf of the corporation (the incorporated employee)
2. That individual, or a person related to them, is a specified shareholder of the corporation, meaning they own 10% or more of any class of shares
3. The individual would reasonably be regarded as an officer or employee of the payer if the corporation did not exist
4. The corporation does not employ more than five full-time employees throughout the year, and the amounts were not received from an associated corporation

Conditions 1 and 2 describe almost every one-person consulting corporation in the country. Condition 4 is the escape hatch almost nobody fits through: more than five full-time employees means six or more, throughout the whole year, and the incorporated employee is not one of them for this purpose.

So in practice the entire question is condition 3.

Condition 3 is the employee-versus-contractor test

The CRA applies the same analysis it uses for employee versus self-employed status, asking what the relationship between the worker and the payer would look like with the corporation removed from the picture. The factors it weighs are control, ownership of tools, chance of profit and risk of loss, and integration into the payer’s operation.

No single row decides it. The CRA looks at the total relationship, which is why the contractor who says “my contract says I am an independent contractor” is missing the point: the label in the agreement is one fact among many, and it is the weakest one. The full analysis is in employee vs contractor in Canada.

What it costs

Start with the federal rate. The basic rate of Part I tax is 38% of taxable income, reduced to 28% by the 10% federal abatement on income earned in a province. Two reductions normally come off that number, and a PSB gets neither:

• The 13% general rate reduction does not apply to personal services business income
• The small business deduction does not apply either, which is the mechanism explained in the small business deduction

Then a further 5% is added to Part I tax on the corporation’s taxable income from the PSB. That produces a 33% federal rate, before any provincial tax, on income a compliant small corporation would have taxed federally at a fraction of it.

Provincial corporate tax applies on top of the federal figure in both columns, and provincial rates change: check the current combined rates on the CRA’s corporation tax rates page rather than relying on a number in an article.

The deduction restriction is the part people miss

The rate is bad. The expense rule is worse, because it removes the deductions that would otherwise reduce the income the rate applies to.

A corporation carrying on a PSB may deduct only:

• Salary and wages paid to the incorporated employee
• Benefits and allowances provided to the incorporated employee
• Certain expenses of selling property or negotiating contracts, where the corporation was required to pay them under the contract of employment
• Legal expenses incurred in collecting amounts owing to the corporation

That is the whole list. Accounting fees, software subscriptions, home office costs, professional dues, training, insurance, most travel, marketing: all of it becomes non-deductible, even though the same expenses are plainly deductible for an ordinary corporation under the tests in what the CRA allows as a business expense.

The practical consequence is that a PSB has a dominant strategy: pay the entire net revenue out as salary to the incorporated employee. Salary is deductible, so corporate taxable income drops to roughly nil and the 33% never bites. What you have then is an expensive payroll administration exercise that delivers exactly the tax result of being an employee, with none of the deferral that motivated incorporating in the first place, and none of the employment insurance or employment standards protection that goes with a real job.

The catastrophic version is the one that happens by accident: the contractor took dividends rather than salary for three years, on the assumption of the small business rate, and the reassessment arrives with the 33% rate, the disallowed expenses, arrears interest, and a dividend that has already been taxed personally.

The CRA is looking, and it has told you where

The CRA ran a personal services business pilot starting in 2022, contacting corporations and their payers for voluntary review rather than audit. Two findings from the published results are worth acting on.

First, a substantial share of the corporations identified as likely PSBs were claiming the small business deduction they were not entitled to. This is not an obscure technical failure, it is the single most common one.

Second, the participants concentrated in two sectors: transportation and warehousing, and professional, scientific and technical services. If you are an incorporated IT consultant, engineer, project manager or owner-operator driver with one dominant client, you are in the population the CRA has already described publicly.

The normal reassessment period for a CCPC is three years from the notice of assessment, and there is no time limit at all where the CRA establishes misrepresentation attributable to neglect or carelessness. Three years of PSB reassessment is the usual shape of these files.

Reducing the risk, honestly

There is no clause you can add to a contract that fixes this. What changes the answer is changing the facts.

Do you invoice through a corporation for services you perform personally?
│
├── No  ──> PSB rules do not apply.
│
└── Yes
    │
    ├── Do you (or a relative) own 10% or more of a share class?
    │   └── No  ──> Not a specified shareholder, PSB rules do not apply.
    │
    └── Yes
        │
        ├── More than 5 full-time employees all year, or paid by an
        │   associated corporation?
        │   └── Yes ──> Excluded from PSB status.
        │
        └── No
            │
            └── Without the corporation, would you look like the
                payer's employee?
                ├── Clearly no   ──> Ordinary active business income.
                ├── Clearly yes  ──> PSB. Pay salary, not dividends,
                │                    and get advice now.
                └── Arguable     ──> Document the factors contemporaneously
                                     and reassess the structure.

Things that genuinely move the analysis:

• More than one client. A second and third substantial client, concurrently, is the strongest single fact available to you.
• Real investment in tools. Your own equipment, your own software licences, your own workspace, insured and maintained by you.
• Deliverable-based pricing. A fixed fee for a defined outcome creates the chance of profit and risk of loss that hourly billing cannot.
• A right of substitution that is real. Not a clause nobody would ever invoke.
• Distance from the payer’s organisation. No internal email address, no performance reviews, no attendance at staff functions as staff, no vacation approval.
• Your own commercial risk. Liability insurance, warranty obligations, fixing defects at your own cost.

Things that do not help: a clause declaring you an independent contractor, an invoice rather than a timesheet, a business number, or the payer’s preference. The CRA weighs the working relationship, not the paperwork describing it.

If you think you may already be one

1. Stop taking dividends out of the corporation until the position is assessed. Salary is deductible to a PSB; dividends are not.
2. Write down the facts as they are now, factor by factor, and date it. Contemporaneous evidence is worth more than a reconstruction, and it is the same discipline that decides outcomes in a CRA review.
3. Model the alternatives. For a single-client contractor with no employees and no real business risk, the honest comparison is often incorporation against being a sole proprietor or an employee, which is set out in sole proprietorship vs corporation.
4. Fix the relationship, not the wording. Add clients, take on defined deliverables, buy your own tools.
5. Get the prior years reviewed before the CRA raises them. A voluntary correction is a different conversation than a reassessment.

Incorporating is the right answer for a great many Canadian consultants. It is the wrong answer for a person who has one client, works that client’s hours, and would be that client’s employee if the corporation vanished. The structure does not create the independence; it only records it.

If you invoice one dominant client through a corporation and you have never had the PSB question looked at properly, a review of the actual working relationship is worth doing before the next return is filed rather than after a letter arrives. The incorporation decision itself is covered in the Ontario small business incorporation guide.