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Determining a Worker's Status.

Many factors should be considered by both employers and employees when establishing a work arrangement

In today's fast-paced business environment, a worker's status as an independent contractor or employee continues to be important to both the individual concerned and the entity to which those services are provided. There are many professionals, executives, trades people and others taking the position that they are independent contractors for tax purposes.

This trend is most pronounced today among information systems and computer professionals, many of whom are leaving full time employment and assuming contract positions with their former employers. Although this may be a legitimate contractual agreement with the previous employer, the Canada Customs and Revenue Agency (CCRA) may still consider the individual to have continued the employment relationship for tax purposes. There are certain issues that both employer and employee should take into consideration when establishing an independent contractor type work arrangement.

From an employee's perspective, the benefits of being considered an independent contractor, as opposed to an employee, include the possibility of reducing his or her tax liability by being able to deduct expenses, and arranging flexible work terms suitable to his or her needs. Although many individuals identify tax reduction as the primary motive in such work arrangements, not all such arrangements are tax-driven. Quite often, individuals also overlook the possibility of not being eligible to receive Employment Insurance (El) benefits if the work contract is terminated.

From an employer's perspective, this arrangement reduces or eliminates the employer's reporting requirements, withholding and remittance of taxes and other amounts, employer borne payroll taxes, and minimizes labour law issues, workers' compensation issues and other legal issues that arise in the context of employment. However, there can be risks associated with establishing an independent contractor relationship. Employers should be giving adequate consideration to an employee's work status since they may be subject to penalties for failing to withhold income tax from the employee and making other required remittances. There are no legislative criteria available to assess an individual's employment status, and since it is subject to interpretation based on a case-by-case basis, tax authorities find this among the most abused area by taxpayers.

Many factors must be taken into consideration in establishing whether an individual is an employee or is self-employed. The question to be decided is whether the contract between the parties is a contract of service that exists between an employer and an employee, or is a contract for services, that is, the engagement of a self-employed individual. A contract of service generally exists if the person for whom the services are performed has the right to control the amount, the nature, and the management of the work to be done and the manner of doing it. A contract for services exists when a person is engaged to achieve a defined objective and is given freedom required to attain the desired result. For example, there is an indication that a contract for services may exist where an individual has a chance of profit or risk of loss, deals (directly or through an agent) with different persons (clients) during the course of a year, provides the tools and equipment required in carrying out the services or can hire helpers, fix their salary, direct them or dismiss them.

When dealing with persons of particular skills and expertise, supervision and control of the manner in which the work is done may not be a critical and decisive factor. However, no single factor is conclusive in all circumstances. The determination of whether an individual is under a contract of service or a contract for services is a question of fact, and will depend on the nature and the terms of the contract or arrangement (written or oral), its duration, and all the elements that constitute the relationship between the parties.

There is no single test to determine whether an individual is an employee or an independent contractor. However, three specific tests have evolved in the courts to establish the distinction between employee and independent contractor.

Economic reality or entrepreneur test. This test examines several economic factors and draws from them conclusions as to the nature of the relationship. In particular, four dimensions are looked at involving control, ownership of the tools, chance of profit and risk of loss.

The control test determines whether the individual is directed by someone who is in a position to order or require not only what is to be done, but also how it is to be done. Where such control is exercised over the individual, an employer-employee relationship exists.

In cases where the individual doing the work supplies neither funds nor required equipment needed to do the work, takes no financial risk and has no liability, the courts have applied the economic reality test and determine that the individual is an employee. On the other hand, the major tool necessary for some work is the knowledge expertise or skill of the person doing the work, as in the case of a professional consultant. In that case, the "ownership of the tools" test may not be conclusive.

Integration or organization test: The more dependent the individual is on the organization, the more he or she will appear to be an employee. This test examines whether the tasks performed by an individual formed an integral part of the business. Where these services were determined to be critical to the business, as opposed to being merely an accessory, an employer-employee relationship exists. The proportion of the individual's income derived from the organization and the availability of benefits to the individual is also considered.

The specific results test: An employer-employee relationship usually contemplates the employee putting his or her personal services at the disposal of his or her employer during a given period of time without reference to a specified result and, generally, envisages the accomplishment of work on an ongoing basis. On the other hand, where a party agrees that certain specified work will be done for the other, it may be inferred that an independent contractor relationship exists.

Assuming the individual meets all the requirements described above and qualifies as an independent contractor/self-employed person, he or she would be eligible to deduct business expenses with certain limits and exceptions. However, in certain circumstances, based on an employee's work contract, it is also possible to deduct a limited amount of employment expenses against employment income. Employers generally would provide the employee eligible for these deductions with form T2200, which describes the terms of employment and the nature of the expenses eligible as a deduction.

Many self-employed individuals also consider the option of incorporating their business. Regardless of whether a business is incorporated or not, assuming an independent contractor relationship exists, it is still possible to deduct certain expenses. The benefits of incorporating include the potentially significant deferral of income tax and, in many cases, creditor proofing.

One of the major tax benefits of incorporating is the ability to utilize the small business deduction to reduce the current corporate tax liability. It should be noted that although there are immediate tax savings in the corporation, when the after tax income is ultimately paid to the shareholders as dividends, these dividends will be subject to tax in the shareholders hands. In other words, there will be little deferral of tax, if any, when income is received in the corporation and is paid out to the shareholders as a dividend in the same year. As such, incorporation for the purposes of tax deferral should be considered only if the corporation can retain the after tax income from the business for a period of time. Also, one must consider the administrative requirements of incorporating, which includes filing annual corporate tax returns and financial statements.

When considering incorporation one should also consider a provision in the Tax Act that may classify a corporation as a "personal service business (PSB) or in very general terms, an incorporated employee. A corporation that operates a business in this manner or meets the definition of a PSB is not eligible for the small business deduction and is only eligible for limited expense deductions.

The issues identified provide a general framework with respect to a worker's status and professional advice should be obtained in making any conclusive decisions. In any case of doubt as to the status of an individual worker, professional advice could be obtained from your legal or tax advisor. It may also be possible to obtain a ruling from the CCRA with respect to Canada Pension Plan (CPP) and EI withholding requirements, which may complement the position with respect to the independent contractor issue. There are also bulletins published by the CCRA to assist in establishing a framework of criteria that they use to determine the work status of an employee.

Noel Perera (, CMA, is a tax manager at Deloitte & Touche LLP Reviewed by Heather Evans, partner at Deloitte & Touche LIP
COPYRIGHT 2001 Society of Management Accountants of Canada
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Copyright 2001 Gale, Cengage Learning. All rights reserved.

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Author:Perera, Noel
Publication:CMA Management
Geographic Code:1CANA
Date:Apr 1, 2001
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