David asked:

I have a corporation M with a friend, we do IT consulting. I have another full-time job. TO avoid high tax, I incorporated another company A with my wife. And income from M goes to A. My wife only got a full-time job one year ago, before that, she had some part-time job and basically she was a full-time student since the company A was incorporated.

I gave my wife $15,000 to $20,000 in the past years from company A, treated her as a contractor. Recently CRA contacted me and says they need their ruling department to decide if my wife should be a employee or a contractor to company A.

Now I am worried and confused, did I do something wrong? Can't my wife be a contractor in this case? What is best way to handle the income? Should I try dividend?

James Rhodes answered:

I reading what you have written I am thinking you should consult a tax professional like an accountant to review your corporate structures. One of my worries is that you are trying to multiple your use of the small business deduction between different corporations. The small business deduction must be allocated between associated corporations. This is always a very touchy structuring affair which you should ensure is correct under the Income Tax Act ("ITA").

Regarding your wife, the issue is whether she performed services for A under a contract of service (which is an employment situation) or a contract for service (which is an independent contractor situation). This is a legal test. Drawing up a contract for your wife to be paid as an independent contractor does not make her an independent contractor. The courts look at many tests in the determination, and what the parties have described the situation as (i.e. calling your wife an independent contractor to A) is only ONE of the many tests looked at. If the majority of the tests indicate she was an employee, the court is free to disregard what you have described the situation as, and find that she was an employee.

I would recommend you review what is on the Canada Revenue Agency's ("CRA") website, under Canada Pension Plan ("CPP") and Employment Insurance ("EI") rulings. It will give you background information on what the ruling is about, what does it determine, and how does it affect both A's and your wife's income tax filings. Specifically, look at RC4110 "Employee or Self-Employed" [ http://www.cra-arc.gc.ca/E/pub/tg/rc4110/README.html]. It will be a good starting point for you.

Under the legal test for whether your wife was an employee or independent contractor, there are three main tests: control, ownership of tools and equipment, and opportunity for loss or profit. What the parties have termed the arrangement, i.e. contract for service, is important but does not overrule the outcome from the three main tests.

Based on what you have described there might be two other problems. Simply because A paid your wife money and called it for contracting services does not make it deductible to it for income tax purposes. In order for it to be deductible the payment has to have been incurred for the purpose of gaining or producing income [paragraph 18(1)(a) of the ITA]. If your wife performed no services to A, there is a good possibility that if the CRA determines this, they will disallow the deduction entirely. The worse part is that they might not reassess your wife to remove the amount from her taxable income. In other words, no tax deduction to the corporation, and a tax inclusion to your wife. The other problem is that if the CRA believes your wife did some services to the corporation, either as an employee or an independent contractor, they might believe she was paid too much. If that is the case, they might disallow the deduction for the overpayment under section 67 of the Act on the basis that the payment was unreasonable in the circumstances.

If your wife is not going to be doing any services to A, you should really consider paying her as a shareholder. Shareholders are paid as of the right of holding the shares, and not for having to done work for the corporation. Payments to your wife for salary or services as an independent contractor require her to perform work for A.

Another problem I commonly see in this circumstances is that if your wife was paid as an independent contractor, was she required to charge A for GST. If she passed the small supplier threshold, she was required to charge and collect GST on the services she bills for. While A might get an input tax credit for GST paid, this still means your wife might have had to collect and pay GST. And if she didn't there is a huge interest and penalty issue.

I would recommend that you speak to a tax professional about the CRA ruling. You will be required to answer questions with regard to the main tests. The control test will be the main focus. They will ask questions like did she have set work hours, was she able to subcontract the job to others to perform, does she have a set workstation, was she free to come and go, etc.

To make some further comments, there is no specific rule that a spouse/partner cannot be an independent contractor to a family corporation. While the situation will be looked at more closely, as the question will come up whether that spouse looks for work from other non-related companies or just works for the family corporation. An independent contractor by nature works for anyone they can get a job from. So in the times the person is not doing work for the family corporation, the CRA will ask for evidence of what was done to get work from other businesses, i.e. did she have business cards, a company telephone number, were ads taken out or flyers distributed, etc.

If your wife is found to be an employee, the following reassessments might occur. She will be reassessed to make the payments as employment income. Assuming she had no other source of income the CRA will disallow any deductions she has taken from the income unless she qualifies for the deductions under the employee rules (see section 6 of ITA). The corporation will be reassessed for her CPP contributions (as an employee) and possibly EI contributions (she might be exempt depending on the exact facts). Further, it might be hit for a penalty as it did not make the required source deductions on her pay. And both A and your wife might be reassessed for interest owing on extra tax, and penalties depending on the specific facts.

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