Many IT contractors incorporate expecting to access the small business deduction and a broader range of business expense claims. A personal services business determination by CRA eliminates both.
This article explains what a personal services business is, how CRA determines whether one exists, and what the financial consequences look like in practice.
What a Personal Services Business Is
A personal services business is defined in the Income Tax Act as a corporation that provides services where the individual performing those services would reasonably be regarded as an employee of the client if the corporation did not exist.
The definition is straightforward. The application is not.
CRA does not rely on what the contract says. A contract that describes the relationship as independent does not prevent a PSB determination. The assessment is based on the actual working arrangement.
How CRA Determines PSB Status
CRA applies the same four-factor test used to distinguish employees from independent contractors.
Control. Does the client direct how and when the work is done? A contractor who works set hours established by the client, follows internal processes, and reports through a management structure looks more like an employee than an independent business.
Tools and equipment. Who supplies the equipment? A contractor using the client’s hardware, software licenses, and office infrastructure has less independence than one who supplies their own.
Chance of profit and risk of loss. Does the contractor have real financial exposure? A fixed hourly rate with no expenses at risk and no possibility of loss is an employment-style arrangement. A contractor who bears the cost of errors, provides their own insurance, and accepts financial risk for project outcomes has a stronger independent business case.
Integration. Is the work integral to the client’s core business operations? A contractor performing functions that would otherwise be handled by an employee is more likely to be seen as integrated into the client’s business than one providing a specialized service at arm’s length.
No single factor is determinative. CRA looks at the full picture, and the weight given to each factor depends on the circumstances.
Risk Factors in Practice
Certain arrangements draw more scrutiny than others. Situations that increase PSB risk:
- One primary client generating most or all of the corporation’s revenue
- Work performed at the client’s location using the client’s equipment
- Hours and scheduling set by the client rather than negotiated by project
- No ability to subcontract work or send a replacement
- Contract language limiting the contractor to one client or one project at a time
- Extended engagement with a single client with no break or competitive bid
None of these factors alone creates a PSB determination, but combinations of them produce the working profile CRA is looking for.
What a PSB Determination Costs
The financial consequences operate on two levels: the corporate tax rate and the deductible expenses.
Corporate tax rate. A qualifying Canadian-Controlled Private Corporation generally accesses the small business deduction, which in Ontario produces a combined corporate rate of approximately 12.2% on the first CAD $500,000 of active business income. A PSB does not qualify for the small business deduction. The income is taxed at the general corporate rate, which in Ontario is approximately 26.5%. The rate difference is roughly 14 percentage points.
Deductible expenses. A PSB is restricted in what it can deduct. Allowable deductions are limited to salary and wages paid to the incorporated employee, contributions to certain employee benefit plans, and expenses that would have been deductible if the individual had been an employee directly.
In practice, this means most common business expense claims are disallowed: management fees, home office expenses, vehicle expenses, and professional development costs. These deductions are routine for incorporated contractors under normal circumstances. They are not available to a PSB.
A retroactive determination compounds the impact. CRA can reassess past years, which means the rate difference and disallowed expenses apply not just to the current filing but to prior years still within the reassessment window.
What Does Not Resolve the Risk
Two things that often appear in contractor files but do not, on their own, reduce PSB risk.
A contract that uses independent contractor language. The terms of the agreement matter, but they are not controlling. CRA assesses the actual working arrangement, not the document that describes it. A contract can say “independent contractor” while the day-to-day relationship looks like employment.
Incorporation itself. Incorporating does not establish independence. The PSB rules exist specifically because the corporate form was being used to create tax advantages in arrangements that CRA determined were fundamentally employment relationships.
The Point at Which This Becomes Relevant
The PSB question should be analyzed before incorporating, not after. The decision to incorporate and the structure of the engagement with a primary client are connected. If the working arrangement would not survive a PSB analysis, the tax advantage of the corporate structure may not materialize.
For contractors already incorporated with one primary client, reviewing the arrangement and assessing the risk is the first step. Some risk factors are within the contractor’s control: expanding the client base, supplying their own tools and equipment, and structuring engagements around deliverables rather than hourly commitments. Others depend on the client’s practices.
The goal is not to pass a CRA review on the basis of contract language. The goal is an arrangement that is genuinely independent.