These days, the hot advice many business owners are getting from their well-intentioned friends is that they should treat all of their employees as contractors instead of full time employees. As a cost saving strategy, this appears to make sense, because of course, self-employed individuals aren’t entitled to vacation pay, sick days, termination or severance pay, they aren’t added to benefit plans, and they don’t require Workplace Safety & Insurance Board coverage.
Hmmm….sounds great! It’s like money in the bank!
So, why not scrap hiring employees all together?
Let’s start by looking at things from CRA’s (Canada Revenue Agency) standpoint.
When an employer hires somebody, CRA says a contract of service exists (scroll to section titled Appendix A on this link to see what the taxman says). Under this scenario, a worker accepts a position, reports directly to the employer, has little to no control over most aspects of the job, and in exchange for performing their duties, receives wages or salary.
When that wage or salary is paid, your payroll department will withhold the appropriate amounts of income tax, Canada Pension Plan (CPP), and Employment Insurance (EI). These withholding taxes are then remitted to CRA along with the employer portions of CPP & EI.
On the other hand, when an employer hires an independent contractor, CRA says a contract for service (again, scroll to Appendix A) is formed (a business relationship exists). Under these circumstances, contractors tend to control most aspects of the job. They can set their fee or price, accept or refuse jobs, and work for more than one person at a time.
Contractors get paid by submitting an invoice….you pay the invoice….and….you’re done. There’s no income tax, CPP or EI deductions, no T4 slip….and, the best part, there’s no employer portion of CPP & EI for you to pay.
Great deal….where do I sign up!!
Not so fast!!
Here’s the thing….just because you say they’re an independent contractor, doesn’t mean the government will.
If you hire an independent contractor that CRA later deems to be an employee, you’ll be facing penalty and interest charges for failing to deduct and remit the required withholding taxes relating to CPP and EI.
But wait, there’s more….
Not only will you have to pay both the employee & employer portions of CPP & EI, you will also be assessed an additional 10% penalty of the total withholding amount.
Still not done….
You’ll also get to pay interest charges dating back to when the funds should have been remitted.
Don’t worry; you’re not alone! The contractor gets to experience some pain and suffering too.
When a self-employed individual files their tax return they’ll report their revenue (the money you paid them) then they’ll deduct ALL of their operating expenses. Things like vehicle expenses or cell phone charges to name a few. These deductions reduce their taxable income resulting in a lower tax bill.
Once CRA decides they’re an employee and not a contractor, all of these deductions are disallowed leaving them with a potentially hefty tax bill….plus interest….plus penalties.
So, how can you avoid going through all this grief?
You can start by applying the same tests CRA applies when making decisions in this area, they can be found in this guide RC4110 Employee or Self-Employed? on the CRA website.
Here are the tests in a nutshell:
- Test #1 is called the control test. It asks; who’s calling the shots? Who controls the hiring and firing? Amount and method of pay? Time and place where the work gets done? Who decides what work is to be done? Who does the worker report to? If you, as the employer are in the driver’s seat, chances are, your workers are employees.
- Test #2 takes tools and equipment into consideration. Who supply’s the tools and equipment necessary to carry out the work? Who is responsible for the maintenance and repairs of these items? In most situations, employers provide employees with the equipment necessary to perform their duties. They also look after the insurance, repair, and maintenance of these items. On the other hand, an independent contractor will often supply their own tools and equipment and will be responsible for the maintenance and repair of those tools. As a result, an independent contractor bears the risk of loss if their equipment breaks down, which brings us to….
- Test #3; is there a risk of profit or loss to the worker? While employees do have job related expenses (most aren’t deductible) chances are they won’t amount to more than what the employee earns, therefore, an employee is not at risk of losing money. An independent contractor does have the opportunity for profit or loss. They have the ability to work for multiple businesses and are responsible for covering their own operating expenses.
- Test #4 asks if the worker is hired for a specific result or is there an ongoing relationship? Employees are typically hired to perform various duties with no end date in mind, while independent contractors are hired to complete a specific task, upon completion of this task the working relationship comes to an end.
- Test #5 asks if the worker is an integral part of the business; if a continuous employment arrangement exists, this would imply integration of the worker to the business. It suggests the worker is part of a team while a contractor will usually work on their own independently from the team.
No one factor will determine whether an independent contractor or employee/employer relationship exists. If you are unsure of the type of relationship you have, you can request a ruling from CRA; they make their decisions on a case by case basis taking the entire working relationship into account.
Please note, at the time this was written, these are the rules, but you should always refer back to the CRA website for the most current information.
Happy Government = HappyBoss