Independent Contractor vs Employee in Canada

Jan 25, 2024

Understanding whether you are classified as an independent contractor or an employee is crucial for your Canadian income tax, especially if you believe you are a contractor but the Canada Revenue Agency (CRA) later decides otherwise after you have filed multiple tax returns.

The CRA has distinct criteria to differentiate between the two, and if you familiarize yourself with these guidelines and learn how to apply them, you can better safeguard your status as an independent contractor.

One major tax benefit for an independent contractor is the chance to claim tax deductions that employees typically can’t. Generally, a self-employed individual can deduct all reasonable business expenses

Employers in Canada Love to Hire Independent Contractors

From a business standpoint, hiring a contractor is vastly preferred over bringing on an employee due to significantly less paperwork and fewer responsibilities.

Contractors don’t receive benefits packages or pensions. They have to handle their own Canada Pension Plan (CPP/QPP) contributions. Companies aren’t required to offer them health insurance, life insurance, or other typical employee benefits, all of which would otherwise raise their expenses.

When a company uses an independent contractor, it avoids the need for payroll duties, such as withholding income tax and paying employment insurance (EI).

Contractors are expected to be skilled in their services, which eliminates the need for paid training.

Hiring contractors instead of full-time employees provides businesses with greater flexibility to adapt to the fluctuations in business, thereby lowering overall labor costs and aiding in better cash flow management.

 

When the Contractor Is Actually an Employee

If a business hires a contractor who is later found to be an employee, it can face significant financial losses. The employer will need to pay any unpaid taxes and could be hit with penalties and interest. All CPP and EI premiums will also need to be covered.

For the contractor, any business expense deductions claimed in earlier years will need to be repaid. This can have devastating financial effects, especially if the individual has claimed deductions over several years and these were eventually disallowed by the CRA. This could result in a substantial tax bill.

 

The Four-Point Test for Determining Status

Navigating the boundary between an employee and a business relationship can be tricky as it often changes. To maintain your status as an independent contractor, you need to pass the four-point test.

This test, set by the CRA, helps determine the nature of the relationship. It is based on four crucial factors: control, ownership of tools, the opportunity for profit and risk of loss, and integration.

1. Control

The key question is who is in charge. An employer has the authority to hire or fire employees, set their pay, and decide the specifics of how, when, and where work is done. The CRA defines control as:

“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.”

Conversely, a contractor has the autonomy to determine how to carry out the work. To be considered an independent contractor, it is crucial to retain the right to decide on the time, place, and method of your work.

You are more likely to be recognized as a contractor if you can demonstrate that you were the one setting the work schedule, planning the tasks, and determining the quality standards.

2. Ownership of Tools

While it’s generally expected that contractors provide their own tools, in some trades, employees also bring their own equipment. This is common with painters and garage mechanics.

A more accurate measure of this test is the cost of using the tools. The CRA explains:

“Self-employed individuals often supply the tools and equipment required for a contract. Thus, when a worker owns their tools and equipment, it typically suggests a business relationship.”

For example, a home-based IT worker using their own computer and mobile devices would exemplify self-employment.

 

3. Potential for Profit or Risk of Loss

Your financial stake indicates whether you are in an employer/employee relationship or a business partnership.

You are considered a contractor if you have the potential to earn profits and face the risk of losses from bad debts, equipment damage, material costs, or delays. If you are responsible for covering operational expenses, you are not considered an employee.

4. Integration

An employee’s role is fundamental to their employer’s business, whereas tasks done by a self-employed person are less likely to be embedded in the payer’s operations.

The exact method to assess this integration is not explicitly defined. The CRA’s publication addresses this topic in general terms.

One clear way to demonstrate integration into your own business activities is by having multiple clients. A contractor who works for just one client risks being seen as having an employer-employee relationship. Additionally, relying on a single client can lead to your business being classified as a personal services corporation by the CRA.

 

Will Incorporating Give You Contractor Status?

Some employers seem to consider incorporation as definitive evidence of independent contractor status, to the extent that they prefer to engage only with incorporated contractors. Although being incorporated might serve as one indicator of an arm’s length relationship between a contractor and an employer, it is not sufficient by itself to prove a business relationship.

If you are incorporated but work solely for one employer, you risk being classified as a personal services corporation and might lose the ability to claim the Small Business Deduction and other typical business deductions.

This is especially true if you are carrying out tasks that are typically performed by an employee.

 

Safeguard Your Tax Status

Make sure to always document your relationship with every employer using a contract, focusing on the first three points of this four-part guideline.

Crafting a well-thought-out written agreement that outlines the intentions of both parties can provide some protection if one party later changes their mind and claims that the relationship is different from what was originally intended.

Contracts can also help prevent reclassification by the Canada Revenue Agency.

The issue is not entirely straightforward. There seems to be a trend toward a more flexible interpretation of the business relationship between a contractor and an employer, but ultimately, the determination of whether someone is an independent contractor or an employee will always depend on the specific facts and circumstances of each situation.

 

Summing up

If you have taken steps but are still unsure about whether you are classified as an employee or an independent contractor, consult with your accountant or reach out to the Canada Revenue Agency.

Understanding your worker classification can help you avoid potential legal and financial issues. For further clarification, it may also be beneficial to keep detailed records of your working arrangements and review written contracts carefully.

 

CBES is here to assist you; feel free to contact us for expert guidance.

 

 

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