Recent Proposed Changes to Rules Applicable to Personal Services Business

April 17, 2013 | Bryant D. Frydberg

Back in the 1970s, while the Montreal Canadiens were dominating the NHL, Ken Dryden backstopped the Canadiens to win six Stanley Cups. While much can be said about Ken Dryden’s heroics in winning the Stanley Cup, this is, after all, a tax article. During Ken Dryden’s time with the Montreal Canadiens, he decided to form a corporation and have his corporation provide goal-tending services to the Montreal Canadiens. At the time, in the Province of Québec, significant income tax deferral could be realized by rendering such services through a corporation. A corporation paid tax at a combined Canadian federal and provincial corporate tax rate of approximately 17% (at least while the income remained in the corporation) compared to a combined Canadian federal and provincial personal tax rate in excess of 50%. The Canadian tax authorities challenged Ken Dryden’s arrangement and the matter was settled out of court.

Existing Personal Services Business (“PSB”) Regime

Similar planning was becoming more prevalent and legislative amendments were introduced in the early 1980s to curtail this perceived abuse. Under the existing PSB regime, a corporation that carries on a PSB in a taxation year is not entitled to claim the small business deduction. In addition, such a corporation is only entitled to claim certain expenses expressly listed in paragraph 18(1)(p) of the Income Tax Act (Canada) (the “Act”) in computing its income.

A corporation is generally considered to be carrying on a PSB (as defined in subsection 125(7) of the Act) if its business consists of providing services in the circumstances where an individual who performs the services on behalf of the corporation (an “incorporated employee”) or a person related to the incorporated employee is a specified shareholder of the corporation, and the incorporated employee would reasonably be regarded as an officer or employee of the person or partnership to whom or to which the services were provided but for the existence of the corporation. However, a corporation that employs in its business throughout the year more than five full-time employees will not be considered to be carrying on a PSB even if all of the conditions discussed herein are met.

A “specified shareholder” is defined in subsection 248(1) of the Act and generally refers to a shareholder who owns, directly or indirectly, at any time in a year, alone or together with non-arm’s length persons, 10% or more of the issued shares of any class of the corporation or any other corporation that is related to such corporation. The determination of whether an employment relationship exists involves the review of all relevant facts and circumstances and is not a bright line test. A discussion of the tests that are applicable in making such a determination is beyond the scope of this article.

Proposed PSB Regime

For a while, the Canadian tax authorities appeared to be satisfied that the existing PSB regime was adequate in curtailing the perceived abuse and eliminating the tax advantages related to PSBs. However, as a result of decreasing combined Canadian federal and provincial corporate tax rates over the years and the introduction of reduced combined Canadian and federal provincial personal tax rates applicable to “eligible dividends” (as defined in subsection 89(1) of the Act), significant tax savings could be achieved by having employees incorporate. Furthermore, where a low income earning spouse was a shareholder of a corporation that was carrying on a PSB, further income tax splitting objectives could be enjoyed.

In light of these unintended tax advantages, the Minister of Finance (Canada) introduced on October 31, 2011 certain technical income tax amendments (now included in Bill C-48 introduced on October 24, 2012) to amend the definition of a corporation’s “full rate taxable income” (in subsection 123.4(1) of the Act) to exclude income earned by a corporation from a PSB. The effect of this proposed amendment is rather severe since income earned by a corporation from a PSB would no longer be eligible for the general Canadian federal corporate tax rate reduction pursuant to 123.4(2) of the Act.

In other words, the income earned by a corporation from a PSB for taxation years that begin after October 31, 2011 will be taxed at the basic Canadian federal corporate tax rate of 28% (assuming the provincial abatement is available such that the basic Canadian federal corporate tax rate is reduced from 38% to 28%) and will no longer be entitled to the 13% general Canadian federal corporate tax reduction.

It is important for those corporate taxpayers that are, or may be considered to be, carrying on a PSB to obtain legal and tax advice to determine whether the proposed changes could apply in their particular circumstances and what steps could be undertaken to address any tax issues related thereto.


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