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Here Is What CRA and The Tax Courts Have to Say- And What your Clients- the employers- can do to protect themselves
So we have a colorful group of character's here:
An Employee,
Independent Contractor
the Dependent Contractor.
The dependent contractor is a non-employment relationship that the Courts consider to be an intermediate relationship between employee and the independent contractor. In trial case McKee (Ontario Court of Appeal), the Court notes that the dependent contractor is analogous to someone who is not an employee but is not really a complete separate business because of the economic dependency (which are services contracted to a single supplier).
This means that if terminated (wrongfully or with just cause), under employment law they maybe owed reasonable notice and severance or other financial benefits, as if they were acting in the capacity of an employee (which is beyond the scope of this article). However this relationship can easily be a recategorized as an employee if not careful. Some consequences are that they maybe owed reasonable notice and other financial benefits, as if they were acting in the capacity of an employee (which is beyond the scope of this article).
Over the years practicing accounting and (my time with CRA audits), I have encountered many businesses that if not careful are on the brink of a huge potential liability. This article will also provide some insight on how you can protect your clients by wording contracts for services carefully.
How does one decide the nature of the relationship. The Tax Court and Federal Court of Appeal have heard many cases that have garnered a variety of tests and are backed by CRA policies.
The main determining factors are organized into a two stage test. Courts are first required to determine the intentions of the two contracting parties. Did they intend to arrange their affairs as independent (self employed) contractors or considered themselves as employees. This is backed by the Sagaz case and known as the Sagaz test. If the courts find that the intention was that of an employee it ends their with that determination.
If the first test determined that both parties viewed this contract as one of self employment, then the courts must determine if the relationship is one of independent or dependent. The latter being most applicable when determining benefits usually reserved for employees such as severance pay and issues of vicarious liability among others.
The first test is in my opinion is not very conclusive if the facts of the relationship reveals a different scenario. As an employer it may be to my benefit financially not to have to pay CPP, EI and vacation pay on wages earned, and not have to deal with the administration burden of being an employer.
For the worker, it appears favorable in the fact that now I am entitled to deductions that I would never have been afforded as an employee, thus reducing my tax liability and granting me more disposable income. So what is not too like, right?
Well there are some hazards for the worker if the facts say otherwise. The main one being that should CRA determine that they have been misclassified as a contractor, then they will have those deductions beyond those reserved for an employee disallowed and tax will now be owing on the additional income generated including interest and penalties assessed. This can add up especially when more than one year is assessed. For the employer they will be responsible for the employers CPP, EI deductions that should have been paid, and vacation pay payable to their new found employee.
So lets continue, we have now determined the risk of misclassification and the intention of the two parties to be one of a contractor type relationship, so what other hurdles now need to be cleared.
The second test is more determinant and is based on the factual representation of the relationship. Such as:
the level of control the payer has over the worker's activities
whether the worker or payer provides the tools and equipment
whether the worker can subcontract the work or hire assistants
the degree of financial risk the worker takes
the degree of responsibility for investment and management the worker holds
the worker's opportunity for profit
any other relevant factors, such as written contracts
Note: for a more detailed discussion of the above topics and the questions that will be asked in an interview with CRA (from there website) in making that determination, See the end of the article.
The central question is whether the person who has been engaged to perform the services is performing them as a person in business on his own account. In making this determination, the level of control the employer has over the worker’s activities will always be a factor. However, other factors to consider include whether the worker provides his or her own equipment, whether the worker hires his or her own helpers, the degree of financial risk taken by the worker, the degree of responsibility for investment and management held by the worker, and the worker’s opportunity for profit in the performance of his or her tasks.
So we have quite a list (in which CRA's Website has gone into quite detail) to help make that determination.
What I have found being in practice for many years, that a lot of my clients are making the determination incorrectly. Or believe they can state it any which way they choose and they have the final determination. Here is what happened with an actual client:
Jim (not his real name) owned a business. As the business became more successful, he needed help quickly to fulfil contractual obligations. So he ran an ad and hired his first worker. As his business grew, more workers were needed and thus hired. Everything was going smoothly. The workers (who were hired as independent contractors) loved the fact that no taxes were being withheld and really loved the extra income (yes they did not consider their tax obligation at end of year). Now, some were responsible and set aside a small amount to cover this liability. However many did not. In fact many had not even filed for years. Some more than a decade outstanding.
Now CRA started sending out request letters to these individuals. And when some were interviewed, my clients name was identified as the business that they were engaged under. This alerted the suspicion for a particular CRA auditor, who then believed these individuals should have been employees. To add further problems, CRA knows that the tax liability of many of the workers, especially those owing several years in back taxes would make the amount owing almost impossible to collect, as most were considered "hard targets" ( meaning they did not own real assets to put a lien on). Some were owing in excess of a $100,000 which included back taxes, CPP liability on self employed earnings among others.
One thing to be sure of, is CRA loves employees. Since employers are required to withhold income tax and other employee deductions (CPP, EI) they can be certain of avoiding collection procedures, which is time consuming and costly, and usually can end up being futile. Now to make a long story short, my client felt he was doing well and even discussed he finally saved enough up to buy a new car. He was dreaming of the new set of wheels in fact for many weeks. Then one day he got that letter that everyone dreads "You are being audited". It was like life just punched him in the solar plexus's.
You see it is often like a drug dealer who is going along his merry way, and banking lots of money, but completely unaware that the police are gathering their information, and have compiled a lengthy investigation that is about to drop the hammer. The "drug dealer" is oblivious to the repercussions that are about to collapse his world. Many clients are like that too. They are making plans, banking lots of money and totally unaware of what is happening in some distant office at CRA that is about to change their world.
The client reached out to me in a panic. I could feel the sweat coming of his brow. By the end of the "investigation" conducted by CRA, all the workers were reclassified as employees. After the rubble cleared, the employees had their deductions re adjusted and many had to go bankrupt. CRA in this case lost a lot of money and when interest and penalties were assessed to the client his dreams of a new car vanished. In fact the dream was dead for many years to come.
The point of this real life story, is to make practitioners aware of potential hidden liabilities that can ruin sometimes a business owners dream. The client ended up into a payment arrangements that crippled his family for many years in the future. So clients are really unaware of hidden liabilities that could ruin them, and as a great tax practitioner that you are, should at least be aware and ensure your client is also aware of situations that can have dire consequences.
So how can we help our clients. We can review the nature of the relationships with contractors that are employed and ensure a proper agreement is drawn up. This will include:
Ensure the contractors are registered for GST and have their own business number with CRA.
Invoices for services are not on a regular schedule that mimics that of an employee. Employees are paid on a set bi weekly or semi monthly pay period. Your contractor can bill in irregular cycles. Maybe for a whole month one time. Or 3 week period another time. Or 18 days and so on. I have seen them issue invoices on a continuous 2 week period, that indicates how employees are usually paid.
Include in the contract some tools that are needed to be supplied by the contractor that are not reimbursed by the business. This can take care of the "who supplies the tools to get jobs done" requirement.
Include in the contract that the contractor, may have some kind of risk of loss of profit if there is some form of penalty based on performance issues.
Include a clause that a replacement worker (if possible) may be designated to get the job done. Perhaps they can decide to subcontract at their discretion if possible. Whether or not it is ever exercised is beyond the point. Just have it that the job needs to be completed and how it is completed is at the discretion of the contractor, so long as it is done.
Have the contract state, if possible, that the job is to be completed by a certain date, and as long as it is completed by that date the worker is free to set there own hours. And if not completed by that date, will incur a penalty that may interfere with the contractors profit and could cause a loss.
Allow the worker the right to refuse certain work and they have the discretion to choose what they can engage in or supply labor for. May be hard to word, but nevertheless may allow in certain situations.
Ensure that there is no continuity guaranteed that the contract may be cancelled at any time.
This list is not exhaustive, but may provide a necessary buffer if ever contested.
CRA questions asked when making a determination:
Factors to consider
To help you understand the process, we explain each factor below and show some indicators that the worker may be an employee or a self-employed individual.
Control
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.
Degree of control or independence
Consider the degree of control held by the payer or the degree of independence held by the worker.
The actual degree of control will vary with the type of work and the skills of the worker.
Deciding the degree of control can be difficult when examining the employment of professionals such as engineers, doctors, and IT consultants. Because of their expertise and specialized training, they may need little or no specific direction in their daily activities. When examining the factor of control, it is necessary to focus on both the payer's control over the worker's daily activities and the payer's influence over the worker.
Payer's right to exercise control
It is the right of the payer to exercise control that is relevant, not whether the payer actually exercises this right.
It is the control of a payer over a worker that is relevant and not the control of a payer over the end result of a product or service purchased.
Indicators showing that the worker is an employee
The relationship is one of subordination. The payer will often direct, scrutinize, and effectively control many elements of how and when the work is carried out.
The payer controls the worker with respect to both the results of the work and the method used to do the work.
The payer chooses and controls the method and amount of pay. Salary negotiations may still take place in an employer-employee relationship.
The payer decides what jobs the worker will do.
The payer chooses to listen to the worker's suggestions but has the final word.
The worker requires permission to work for other payers while working for this payer.
Where the schedule is irregular, priority on the worker's time is an indication of control over the worker.
The worker receives training or direction from the payer on how to do the work. The overall work environment between the worker and the payer is one of subordination.
Indicators showing that the worker is a self-employed individual
A self-employed individual usually works independently.
The worker does not have anyone overseeing their activities.
The worker is usually free to work when and for whom they choose and may provide their services to different payers at the same time.
The worker can accept or refuse work from the payer.
The working relationship between the payer and the worker does not present a degree of continuity, loyalty, security, subordination, or integration, all of which are generally associated with an employer-employee relationship.
Tools and equipment
Consider if the worker owns and provides tools and equipment to accomplish the work. Contractual control of, and responsibility for, an asset in a rental or lease situation is also considered under this factor.
What is relevant is the significant investment in the tools and equipment along with the cost of replacement, repair, and insurance. A worker who has made a significant investment is likely to retain a right over the use of these assets, diminishing the payer's control over how the work is carried out. In addition, such a significant investment may place the worker at a risk of a financial loss.
Note
Tools and equipment can vary widely in terms of value and can include everything from wrenches and hammers, to specialized clothing, appliances, stethoscopes, musical instruments, computers, and vehicles such as trucks and tractors.
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.
However, employees sometimes also have to provide their own tools. The courts have acknowledged that because a worker is required to provide tools of the trade, this does not in itself mean that the worker is a self-employed individual. For example, many skilled tradespeople such as auto mechanics have to supply their own tools, even if they are full-time employees.
Indicators showing that the worker is an employee
The payer supplies most of the tools and equipment the worker needs. In addition, the payer is responsible for repair, maintenance, and insurance costs.
The payer retains the right of use over the tools and equipment provided to the worker.
The worker supplies the tools and equipment and the payer reimburses the worker for their use.
Indicators showing that the worker is a self-employed individual
The worker provides the tools and equipment needed for the work. In addition, the worker is responsible for the costs of repairs, insurance, and maintenance to the tools and equipment.
The worker has made a significant investment in the tools and equipment and the worker retains the right over the use of these assets.
The worker supplies their own workspace, is responsible for the costs to maintain it, and does substantial work from that site.
Subcontracting work or hiring assistants
Consider if the worker can subcontract work or hire assistants. This factor can help decide a worker's business presence because subcontracting work or hiring assistants can affect their chance of profit and risk of loss.
Indicators showing that the worker is an employee
The worker cannot hire helpers or assistants.
The worker does not have the ability to hire and send replacements. The worker has to do the work personally.
Indicators showing that the worker is a self-employed individual
The worker does not have to carry out the services personally. They can hire another party to either do the work or help do the work, and pay the costs for doing so.
The payer has no say in whom the worker hires.
Financial risk
Consider the degree of financial risk taken by the worker. Consider if there are any fixed ongoing costs incurred by the worker or any expenses that are not reimbursed.
Usually, employees will not have any financial risk as any expenses will be reimbursed, and they will not have fixed ongoing costs.
Self-employed individuals, on the other hand, can have financial risk and incur losses because they usually pay fixed monthly costs even if work is not currently being done.
Employees and self-employed individuals may be reimbursed for business or travel expenses. Therefore, focus on the expenses that are not reimbursed by the payer.
Indicators showing that the worker is an employee
The worker is not usually responsible for any operating expenses.
Generally, the working relationship between the worker and the payer is continuous.
The worker is not financially liable if they do not fulfil the obligations of the contract.
The payer chooses and controls the method and amount of pay.
Indicators showing that the worker is a self-employed individual
The worker hires helpers to assist in the work. The worker pays the hired helpers.
The worker does a substantial amount of work from their own workspace and incurs expenses relating to the operation of that workspace.
The worker is hired for a specific job rather than an ongoing relationship.
The worker is financially liable if they do not fulfil the obligations of the contract.
The worker does not receive any protection or benefits from the payer.
The worker advertises and actively markets their services.
Responsibility for investment and management
Consider the degree of responsibility for investment and management held by the worker.
Is the worker required to make any investment in order to provide the services?
A significant investment is evidence that a business relationship may exist. You should also consider if the worker is free to make business decisions that affect their profit or loss.
Indicators showing that the worker is an employee
The worker has no capital investment in the payer's business.
The worker does not have a business presence.
Indicators showing that the worker is a self-employed individual
The worker has capital investment.
The worker manages their staff.
The worker hires and pays individuals to help do the work.
The worker has established a business presence.
Opportunity for profit
Consider whether the worker can realize a profit or incur a loss, as this indicates that a worker controls the business aspects of services rendered and that a business relationship likely exists. To have a chance of a profit and a risk of a loss, a worker has to have potential proceeds and expenses, and one could exceed the other.
This factor has to be considered from the worker's perspective, not the payer's. It is for the most part an assessment of the degree to which the worker can control their proceeds and expenses.
Employees normally do not have the chance of a profit and risk of a loss even though their remuneration can vary depending on the terms of their employment contracts. For example, employees working on a commission or piece-rate basis, or employees with a productivity bonus clause in their contract can increase their earnings based on their productivity. This increase in income is not normally viewed as a profit, as it is not the excess of proceeds over expenses.
Employees may have expenses directly related to their employment, such as automobile expenses, and board and lodging costs. Normally, expenses would not place employees at risk of incurring a loss because it is unlikely that the expenses would be greater than their remuneration.
Self-employed individuals normally have the chance of profit or risk of loss, because they have the ability to pursue and accept contracts as they see fit. They can negotiate the price (or unilaterally set their prices) for their services and have the right to offer those services to more than one payer. Self-employed individuals will normally incur expenses to carry out the terms and conditions of their contracts, and to manage those expenses to maximize net earnings. Self-employed individuals can increase their proceeds and/or decrease their expenses in an effort to increase profit.
Employees generally do not share in profits or suffer losses incurred by the payer's business.
The method of payment may help to decide if the worker has the opportunity to make a profit or incur a loss. In an employer-employee relationship, the worker is normally guaranteed a return for the work done and is usually paid on an hourly, daily, weekly, or similar basis.
Similarly, some self-employed individuals are paid on an hourly basis. However, when a worker is paid a flat rate for the work done, it generally indicates a business relationship, especially if the worker incurs expenses in doing the work.
Indicators showing that the worker is an employee
The worker is not normally in a position to realize a business profit or loss.
The worker is entitled to benefit plans that are normally offered only to employees. These include registered pension plans, and group accident, health, and dental insurance plans.
Indicators showing that the worker is a self-employed individual
The worker can hire a substitute and the worker pays the substitute.
The worker is compensated by a flat fee and incurs expenses in carrying out the services.