Many Canadian contractors bill through a corporation because a client asked them to. The Canada Revenue Agency now checks whether that company is genuinely in business. Below is the test it applies, what a failed test costs, and how to lower your tax risks before a letter lands.
Key Takeaways
- The test looks past your contract wording and asks what the working relationship actually looks like.
- A PSB pays 33% federal tax, or 44.5% with Ontario’s 11.5% added, against 11.2% (9% plus 2.2%) at Ontario’s small business rate from July 1, 2026.
- Only four narrow categories of expense survive, and your home office and vehicle are not among them.
- Two exceptions exist: more than five full-time employees, or services billed to an associated corporation.
- Paying everything out as salary neutralizes the rate, which also means the corporation earned you nothing.
What Is a Personal Services Business Under the Income Tax Act?
Subsection 125(7) of the Income Tax Act (ITA) sets out the definition, and the CRA’s guidance splits it into five conditions that must all be met:
- The corporation carries on a business of providing services through an individual who performs services on behalf of the company, called the incorporated employee.
- The incorporated employee, or someone related to them, is a specified shareholder. Under ITA 248(1), that means owning at least 10% of the issued shares of any class of your company or a related corporation, directly or indirectly, at any time in the year. Shares held by people you do not deal with at arm’s length count as yours.
- That person would reasonably be regarded as an officer or employee of the client, were it not for the company sitting between them.
- Your company employs five or fewer full-time employees in the business throughout the year.
- The client paying for the services is not a corporation associated with yours.
The last two conditions are the statutory exceptions, and both are narrow: more than five full-time employees means at least six, all year. The associated corporation test uses the Act’s rules on associated corporations, so a loosely connected client does not qualify. Everything else falls inside the PSB rules.
If you incorporated your business because a client insisted on invoices from a company, these rules were written with you in mind, though most small business owners never hear of them until a letter arrives. Being classified as a personal services business is not a finding of wrongdoing.
Nor does it turn your client into your employer. For tax purposes, the company stays real, files its own T2 return and runs payroll for any salary it pays you. What changes is that you lose the tax advantages you incorporated to get.
How the CRA Decides If You Are Carrying On a PSB
Carrying on a personal services business is a question of fact, decided case by case. Everything turns on the third condition: would you be the client’s employee without your company? You cannot request a CPP/EI ruling on that hypothetical, so the answer comes from the employment tests the courts apply.
The agency’s guide RC4110, Employee or Self-Employed? applies those tests in two steps. First, it asks what you and the client intended. Second, it checks whether the working reality matches, using factors drawn from Wiebe Door Services Ltd. v. MNR (FCA, 1986) and 671122 Ontario Ltd. v. Sagaz Industries Canada Inc. (2001 SCC 59):
| Factor | Points to employment | Points to a real business |
|---|---|---|
| Control | Client sets your hours, location and methods | You decide how and when the work gets done |
| Tools and equipment | Client supplies the laptop, truck or software | You buy and maintain your own |
| Helpers and substitutes | You must do the work personally | You can hire help or send someone else, at your cost |
| Financial risk | Fixed hourly rate, no downside | Fixed-price work, rework at your cost |
| Investment and management | Nothing of your own at stake | You fund and run the operation |
| Opportunity for profit | Pay rises only with hours worked | Pricing and efficiency set your margin |
Intention alone never settles it. In Connor Homes v. Canada (2013 FCA 85), the Federal Court of Appeal held that a contract calling you an independent contractor counts only when the objective facts fit it. Tax Court cases on this question turn on that difference, not on the label in the agreement.
The question we ask first. Could you send a qualified substitute tomorrow without asking permission? A genuine independent business can. An incorporated employee cannot, and in our experience that single fact predicts the outcome of a PSB review more reliably than any clause in the agreement.
What Personal Services Business Examples Look Like in Practice
These examples are illustrations, not rulings. Each turns on who controls the person performing the services, not on the invoice.
| Situation | How the test is likely to read |
|---|---|
| A driver incorporates and hauls only for one carrier, in the carrier’s truck, on its dispatch | Strong signs of employment: one payer, the carrier’s control, little risk |
| An employee resigns, then returns to the same work under a contract with a new corporation | Strong signs of employment, since only the paperwork changed. CRA guidance has the payer issue a T4 slip for the employment and a T4A slip to the company |
| A consultant with three clients, their own equipment and fixed-price projects | Points to a genuine business |
| A contractor whose company employs six full-time staff in the business all year | Outside the definition, whatever the client relationship looks like |
One client is a warning sign, not a verdict. In C.J. McCarty Inc. v. The Queen (2015 TCC 201), a construction manager billed an energy company by the hour, and it was almost his only client. The court still found no PSB: the client could not meaningfully direct his specialist work, hourly billing was normal in construction management, and his company carried its own insurance and a real risk of late payment.
The Personal Services Business Tax Rate and What It Costs
Start from the federal corporate rate of 38%, subtract the 10% federal abatement, and you land at 28%. A normal operating company then claims either the small business deduction or the 13% general tax reduction. A PSB is not eligible for either, and ITA 123.5 adds a further 5%, for 33% federal tax. Budget 2016 deliberately set the tax rate for personal services business income at that level, for 2016 and later taxation years, to match the new 33% top personal rate.
On the T2 return, you report PSB income on line 520 of Schedule 7, which keeps it away from the low rate, and on lines 432 and 555, which remove the general reduction and add the extra 5%.
Corporate Tax Rates by Province
Add your provincial general rate on top. Ontario charges 11.5%, so by our arithmetic the combined corporate tax rate for a PSB reaches 44.5%. The table compares the rates an Ontario company pays in 2026, using Ontario’s published rates.
| Ontario company, 2026 | Federal | Ontario | Combined, by our arithmetic |
|---|---|---|---|
| Income eligible for the small business rate, up to $500,000 | 9% | 3.2% to June 30, then 2.2% | 12.2%, then 11.2% |
| Income taxed at the general rate | 15% | 11.5% | 26.5% |
| Income of a PSB | 33% | 11.5% | 44.5% |
Ontario’s cut to 2.2% came in under the Plan to Protect Ontario Act (Budget Measures), 2026, prorated for a year that straddles July 1, and never reaches a PSB. On the same arithmetic, Alberta’s 8% general rate gives 41% and British Columbia’s 12% gives 45%. Quebec runs its own corporate income tax, so confirm its rate with Revenu Québec.
What the gap looks like. Ravi supplies services through a corporation he owns and kept $150,000 of profit inside it for 2025. Taxed as active business income at that year’s combined small business rate of 12.2% (9% federal plus Ontario’s 3.2%), the bill is $18,300. Taxed as a PSB at 44.5%, the same $150,000 attracts $66,750. By our arithmetic, that is $48,450 more in one year, before interest and denied expenses. Over three reassessed tax years on those figures, the extra tax bill reaches $145,350.
Denied Deductions and the Wider Tax Consequences
The rate of tax is only half the problem, because the tax implications reach your deductions as well. A company found to be a PSB keeps almost none of them. ITA paragraph 18(1)(p) blocks essentially every business expense and leaves four survivors:
- Salary, wages and other remuneration paid to the incorporated employee.
- The cost of benefits or allowances provided to that person.
- Amounts spent selling property or negotiating contracts, but only to the extent an employee could have deducted them.
- Legal fees incurred to collect amounts owing for services rendered.
Notice what is gone. Home office costs, vehicle expenses, accounting fees, phone and internet, insurance and training generally become non-deductible. In November 2025 briefing material for a House of Commons committee, the CRA said reassessed amounts can include a disallowed small business deduction, the additional 5% tax and ineligible expenses. The negative tax consequences compound: a higher tax rate on a larger taxable amount.
There is a counterintuitive escape hatch. If the company pays out all of its earnings as salary to the person doing the work, with the usual payroll source deductions, taxable income drops to roughly nil and the 44.5% never bites. You pay personal tax on that salary and carry on. Surviving the rate that way proves the point, though: incorporating in Ontario bought you nothing except a bookkeeper and an annual T2, and no profit is left for dividends.
Inside the CRA Personal Services Business Pilot
The CRA launched its personal services business compliance project in 2022, published as the PSB pilot. Phase one, from June to December 2022, reviewed the books of about 2,100 hiring companies and found roughly 10%, or 220, were likely using PSBs. Phase two, from October 2023 to June 2024, went to potential PSBs directly: of about 2,100 contacted, 913 agreed to a voluntary review, and 291 were found to be operating as one.
In phase one, 64% of the potential PSBs identified were incorrectly claiming the small business deduction. In phase two, 245 of the 291 confirmed PSBs, or 84%, had claimed a deduction they were not eligible for.
Close to 74% of phase one’s potential PSBs sat in three sectors: transportation and warehousing at 35%, of which 95% were freight trucking, professional, scientific and technical services at 26%, and construction at 13%.
Why the CRA Is Addressing Tax Non-Compliance in the Trucking Industry
Freight carriers popularized a model, often called Driver Inc., where drivers incorporate and invoice instead of collecting a paycheque. Asking contractors to incorporate their services moves employment costs off the carrier and onto the driver, and produces textbook incorporated employees. In March 2025 the CRA and the Labour Program at Employment and Social Development Canada signed an information-sharing arrangement to strengthen compliance in the sector.
The CRA has since lifted its moratorium on penalties for failing to report fees for service transactions in trucking, starting with the 2025 tax year. In December 2025, the Labour Program announced an inspection blitz on driver misclassification in Hamilton and the Greater Toronto Area, and said what it collects will be shared with the CRA.
IT contractors placed by staffing agencies, and consultants who have drifted down to one long-term customer, often supply services to just one buyer too.
In our CRA representation practice, the review rarely opens with financial statements. It opens with a request for your service agreements and a list of who paid you. Your tax returns are then read against that payer list. Auditors are looking for a single payer and a long, unbroken engagement. That pattern sets these reviews apart from the other types of CRA audits you might face.
How to Reduce Your PSB Tax Burden and Risk
You cannot paper over a relationship that is employment in substance. You can, however, change the substance. If you provide services to one payer for most of the year, work through these in order:
- Build a second and third client, even at lower margin, so no single payer defines your year.
- Negotiate a substitution right and be ready to use it.
- Buy and use your own equipment, software and vehicle rather than the client’s.
- Move toward deliverable-based or fixed-price pricing so real profit and loss exist.
- Carry your own liability insurance, WSIB coverage where applicable, and business licences.
- Keep the written agreement aligned with what actually happens day to day.
- Invoice from the company, market under its name, and keep a public web presence.
- Run the numbers honestly on whether the company still earns its keep, and unwind it if it does not.
Contractors who provide services through their own corporation can change these facts faster than they expect. Providing the services to a client under your own brand, with your own tools and insurance, is what the factors reward: a service corporation that looks like a real business usually is one.
If a letter has already arrived, respond with evidence rather than argument. Contracts, invoices to multiple clients, equipment receipts and insurance certificates outweigh any statement that both parties intended a contractor relationship. Bring in your CPA, and a tax lawyer where privilege matters, before you reply. If a reassessment follows, your company has 90 days from the date it is sent to file a notice of objection. Changing how you work today does not change your tax obligations for years already filed, so price any significant tax exposure before you answer. Our CRA audit representation team handles those exchanges, and our corporate taxation advisory group can model whether your structure still makes sense.
Frequently Asked Questions
What is an example of a personal service business?
A software developer incorporates, then works full time for one bank, at its offices, on its laptop, reporting to a bank manager. The corporation exists, but the developer functions as staff. That is the classic case.
How do you avoid being a personal services business?
Serve multiple clients, control your own schedule and methods, supply your own tools, and accept genuine financial risk. Alternatively, employ more than five full-time employees throughout the year, which places you outside the definition entirely.
What expenses are deductible for a personal services business?
Only four categories survive ITA 18(1)(p): remuneration to the person doing the work, benefits and allowances for that person, certain selling and contract-negotiation costs an employee could deduct, and legal fees to collect amounts you already billed.
What is the tax rate for a personal service business?
Federal tax is 33%: the 28% post-abatement rate plus a 5% additional tax in place since 2016. Neither of the reductions an ordinary operating company claims is available. Adding Ontario’s 11.5% general rate produces 44.5%, by our arithmetic.
Does a written independent contractor agreement prevent PSB status?
No. Intent is only the first step; the second is whether the day-to-day facts support it. Where those facts point to employment, the contract label does not change the result, though a contract that matches reality still helps your file.
Can one corporation have both PSB and non-PSB contracts?
It can. The definition tests your relationship with each person or partnership you serve, and the T2 return reports income from a PSB separately. Keep separate records for each engagement so each stream can be supported.
What should you do if you think you are already operating as a PSB?
Gather your contracts, invoices and payer list, and price what the higher rate would cost in each open year. To fix past returns, the CRA’s guidance points to the Voluntary Disclosures Program or a request to reassess your T2 return. Then change the arrangement itself.
Does billing through a staffing agency prevent PSB status?
Not automatically. The definition looks at the person or partnership the services were provided to, so the contracting chain matters. Auditors still examine who directs the work, and an agency that only passes payments through rarely changes what your day looks like.
How far back can the CRA reassess a PSB year?
The normal reassessment period runs three years from the original notice of assessment for a Canadian-controlled private corporation, and four years for other corporations. That limit falls away where misrepresentation attributable to neglect, carelessness or wilful default, or fraud, is established, and gross negligence penalties can follow in the worst cases.
The Bottom Line
Incorporation is a tool, not a shield. When one client controls the work and the company exists mainly to change how you get paid, the tax system treats it accordingly.
- Check whether any single payer accounts for most of your billings.
- Compare your day-to-day reality against control, tools, helpers, risk and profit.
- Price the exposure at 44.5% in Ontario plus denied deductions, not at your current filing position.
- Fix the substance of the relationship, then make the paperwork match it.
The difference between a defensible file and an expensive one is usually decided long before an auditor calls. Book a review with our team if you bill a single client through a corporation and want to know where you stand.
