The difference between being an independent contractor or an employee can have a huge impact on your Canadian income tax, particularly if you think you're a contractor but the Canada Revenue Agency (CRA) decides that you're not after you've already filed several tax returns.
The CRA uses specific criteria to determine which is which, and you can take steps to protect your status as an independent contractor if you understand them and how to implement them.
Employers Love to Hire Independent Contractors
From a business's perspective, hiring a contractor is much preferred to hiring an employee because means a lot less paperwork and responsibility.
Contractors don’t receive benefits packages or pensions. They must pay their own Canada Pension Plan CPP/QPP contributions. Businesses don't have to provide them with health insurance, life insurance, and other common employee benefits—all of which increase their costs.
A company that uses an independent contractor doesn't have to do payroll, which involves withholding income tax and paying employment insurance (EI).
It's assumed that a contractor is proficient at the service being provided and therefore doesn't require paid training.
Employing contractors rather than full-time employees gives companies much more flexibility to meet the ups and downs of business, reducing their overall labor costs and helping them to better manage cash flows.
When the Contractor Is Actually an Employee
A business hiring a contractor who is later determined to be an employee can lose big financially. The employer will have to remit unpaid taxes, and might even be subject to penalties and interest. All those CPP and EI premiums will have to be paid.
As for the contractor, business expense deductions claimed in previous years will have to be repaid. This can have catastrophic financial repercussions in cases where the individual has claimed deductions through several prior years that were all ultimately disallowed by the CRA. That could be a big tax bill.
The Four-Point Test for Determining Status
The employee relationship and the business relationship are gray areas that's constantly in flux, so it’s important to protect your independent contractor status. You'll want to make sure that your work as a contractor remains independent of your employer by passing the four-point test.
The four-point test is the standard used by the CRA to determine which type of relationship exists. The test is based on four key points: control, ownership of tools, the chance of profit and risk of loss, and integration.
Point No. 1: Control
The primary issue here is who’s running the ship. An employer retains the right to hire or fire an employee, to determine the wage or salary the employee is paid, and to decide on the time, place, and manner in which the work is done. According to the CRA:
"Control is the ability, authority, or right of a payer to exercise control over a worker concerning the manner in which the work is done and what work will be done."
On the other hand, a contractor in a business relationship decides how the work will be performed, so it's important that you maintain the right to decide where, when, and how the work is done if you want to be considered an independent contractor.
You’ll have a much better chance of being deemed a contractor if you can show that you were the individual responsible for planning the work to be done, choosing the hours of work, and deciding the standards to be met.
Point No. 2: Ownership of Tools
It might seem obvious that contractors supply their own tools, but it's also customary for employees to supply them in some trades. Think of painters and garage mechanics.
The cost of using the tools is a much better indication of this test. According to the CRA:
"Self-employed individuals often supply the tools and equipment required for a contract. As a result, the ownership of tools and equipment by a worker is more commonly associated with a business relationship.”
Another example would be a home-based IT worker who uses their own desktop/laptop computer and mobile devices. This would be indicative of self-employment.
Point No. 3: Chance of Profit or Risk of Loss
Your financial involvement also determines whether you’re involved in an employer/employee relationship or a business relationship.
You're a contractor if you have opportunity to make a profit, and run the risk of incurring losses due to bad debts, damage to equipment, materials, or delays. You're not an employee if you cover the operating costs.
Point No. 4: Integration
An employee's job is an integral part of their employer's business. Conversely, tasks performed by a self-employed individual are less likely to be integrated into the payer's business.
Exactly how to determine such integration is not expressly laid out. The CRA's publication seems to treat this point in broad summary terms.
One obvious way of “proving” integration to your own commercial activities is to have multiple clients. The contractor who only has one client makes it too easy for others to perceive his relationship with that client as employer/employee—not to mention that having just a single client puts your small business in danger of being declared a personal services corporation by the CRA.
Will Incorporating Give You Contractor Status?
Some employers seem to view incorporation as “proof” of independent contractor status—to the point where they will only do business with incorporated contractors. Being incorporated could conceivably be one point of evidence showing an arm’s length relationship between a contractor and employer, but it isn’t proof of a business relationship, at least not by itself.
This is particularly the case if you're performing activities that an employee would normally perform.
Safeguard Your Tax Status
Always enshrine your relationship with each employer in a contract, focusing on the first three points of this four-point test.
“Having a carefully-crafted written agreement setting out the intentions of the parties may offer some protection if one of the parties subsequently changes his or her mind and argues that the relationship is not what it was purported to be,” advises Anthony Strawson, CMA, LLB, BComm, in his publication, Employee or Independent Contractor.
Contracts will also help stave off being recategorized by the Canada Revenue Agency.
Mr. Strawson points out that the issue is not entirely clear cut. There appears to be a trend toward a more flexible interpretation of the business relationship between a contractor and an employer, but the final determination of whether an individual is an independent contractor or an employee will always depend on the individual facts and circumstances of each case.