Self-employed contractors can claim many more tax deductions than an employee. Therefore Canadian Revenue Agency (CRA) watches for employees who improperly call themselves self-employed.
The distinction carries tax, legal, Employment Insurance (EI), and Canada Pension Plan (CPP) implications for both employer and worker if an employer-employee relationship is found to exist.
CRA uses an "economic reality test" to evaluate whether a work relationship is employer-employee or business-contractor. If your goal is a business-contractor relationship, it's necessary for both sides to act accordingly.
4 Criteria for Defining Business Relationship
If the employer, controls the time, place and manner in which work is done, it is defined as an employer-employee relationship.
If the contract worker decides how and when to perform the required work, it is a business relationship between a company and a contractor.
- Ownership of Tools
If the employer provides the necessary tools, supplies and equipment to do the work, and covers all repair, insurance, rental and operation costs of those items, it is generally defined as an employee-employer relationship. (Note: tradesmen such as mechanics, painters, and carpenters often supply their own tools, even in an employer-employee relationship.)
If the contract worker provides his own tools and equipment, and picks up any costs related to their use, it is typically a business relationship between a company and a contractor.
- Chance of Profit/Risk of Loss
An employee doesn’t assume any financial risk for his employer and is entitled to full compensation regardless of the company's financial health. The employer alone assumes the risk of loss. An employee who does poor work must still be paid.
A contractor has no guarantee of steady income and may either make a profit or incur a loss. His income depends on the value and results of his contracts. If he or she does poor work, he likely won't be paid.
If the services provided are integral to the company, it is generally defined as an employer-employee relationship.
If the services can be viewed as a separate business of the person providing the service, it is typically a business relationship between a company and a contractor.
In an employer-employee relationship, the employer must withhold income tax, CPP contributions and EI premiums on amounts paid to the employee. The employer must then remit these amounts plus the employer's share of CPP and EI to CRA. The employer also must report the employee's income and deductions on the appropriate information return and provide a T4 slip to the employee.
In a business relationship with a contractor, these additional reporting requirements are generally not required. The exception is for a business that is primarily involved in construction activities and is paying subcontractors. In these instances, the construction company files a T5018 Summary and is required to issue slips to the contractors.
If a business believes it has hired a contractor when in fact it is an employee-employer relationship, they’re liable for interest and penalties on unpaid deductions.
Penalties for Unpaid Deductions
- Income Tax - A penalty of at least 10% of the amount that should have been withheld, as well as interest at prescribed rates
- EI Premiums - The full amount for up to 3 years from the end of the year in which they should have been paid, as well as interest and penalties
- CPP Contributions – Up to 4 years from the date contributions should have been paid
- Other employee benefits, such as vacation pay and provincial Workers' Compensation premiums may also have to be paid.
Employee Could Also Face Penalties
If a contractor is determined to have had an employer-employee relationship, the contractor could have to pay 12 months of unremitted EI premiums and CPP contributions. The contractor may also have up to 3 years of tax returns reassessed. This could result in disallowance of business deductions and owing back taxes plus interest. As well, the contractor would have to remit any GST collected in error and be liable for GST plus interest relative to input credits claimed on disallowed business expenses.
As you can see, misrepresentation of a worker's status can prove costly to CRA in terms of lost tax revenue, or to individual workers or employers in terms of unpaid deductions. It's not surprising that a number of cases have ended up in the courts.
The Case of the Hog Farmer
A Manitoba farmer with 20 years experience raising livestock claimed he contracted out his services to a nearby hog-feeder operation. CRA ruled that he was an employee of the business.
While continuing to run his own livestock operation, the farmer worked about 30 hours a week managing a hog barn with sales of 19,000 hogs per year. He received a $1 bonus for each hog he shipped to market. He used his own truck, tractor and other tools to carry out his duties. While visited periodically by feeder personnel, he essentially ran the operation without supervision. He also hired and paid an assistant to help carry out his contracted duties.
The Tax Court ruling agreed with the farmer's position that he was an independent contractor and not an employee since he met the following conditions:
- He was approached by the hog feeder operation because of his considerable experience.
- He ran his own show under his own supervision, and hired and paid his own assistant.
- The feeder operation relied on him to achieve mutually desired results in the marketplace. To accomplish this he used his own vehicles, tools and equipment even though the contract made no specific mention of this requirement.
- Finally, he shouldered part of the risk in that his compensation was tied to a bonus system based on delivering healthy and heavy hogs to market.
The only contract business expenses disallowed by the Tax Court were amounts he deducted for utilities and telephone. These were denied because it was unclear what portion should have been allocated to the home farm versus the hog feeder operation.