Independent Contractor vs Employee: Which One Are You?

Independent Contractor vs Employee: How to Tell Which You Are

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Independent contractor vs employee? Which are you? And are you sure?

The difference between the two can have a huge impact on your Canadian income tax if you think you're a contractor and the Canada Revenue Agency (CRA) decides that you're not. This article explains how the CRA determines which is which and how you can protect your status as an independent contractor in Canada.

Employers Love to Hire Independent Contractors

Hiring a contractor means a lot less rigmarole than hiring an employee:

  • Contractors don’t get benefits packages or pensions and pay their own Canada Pension Plan CPP/QPP contributions.
  • As an employer of an independent contractor, you don’t have to do payroll, which involves withholding income tax, pay the employer's share of CPP/QPP, Employment Insurance (EI), etc. Nor do you have to provide pensions, health and life insurance, and other common employee benefits, all of which increase your costs.
  • When you hire a contractor, it is assumed that he/she is proficient at the required task and therefore does not require paid training.
  • Employing contractors rather than full-time employees gives you much more flexibility to match ups and downs in your business activities, which can reduce your overall labor costs and help you better manage your cash flows.

The big tax advantage for the independent contractor, of course, is the potential for tax deductions. Generally, a self-employed person can deduct all reasonable business expenses.

So businesses hiring contractors can be a good deal for both sides. But if a business hires a contractor who is later deemed to be an employee, both parties lose big:

  • The employer will have to remit unpaid taxes and may be subject to penalties and/or interest.
  • CPP and EI premiums will all have to be paid.
  • Business expense deductions claimed by the "contractor" will have to be repaid (this can have catastrophic financial repercussions in cases where a "contractor" has several prior years of deductions disallowed by the CRA).

Because the employee relationship and the business relationship is one of those gray areas that is constantly in flux, it’s important to do what you can to protect your independent contractor in Canada status. In particular, you want to be sure your work as a contractor remains "independent" of your employer by making sure it passes the Four Point Test.

The Four Point Test for Determining Contractor Status

The four-point test is the standard that the Canada Revenue Agency uses to determine which type of relationship exists. Their document Employee or Self-Employed? (RC4110) “sets out a method that should, in most cases, allow payers and workers to determine the nature of their relationship.”

The method is based on four key points; control, ownership of tools, the chance of profit/risk of loss, and integration. Let’s look at each of these from the point of view of the contractor.

1. Independent contractor vs employee: Control

The primary issue here is who’s running the ship. Does the employer have the right to hire or fire, determine the wage or salary to be paid, and decide on the time, place, and manner in which the work is to be done? Then an employer-employee relationship exists. Note that “if the employer does not directly control the worker's activities, but has the right to do so, the notion of control still exists.”

On the other hand, in a business relationship, the worker decides how the work will be performed. As a contractor, then, it’s important that you maintain the right to decide where, when and how the work will be done. If it comes to the test, and you can show that you were the person responsible for planning the work to be done, choosing the hours of work, and/or setting the standards to be met, for example, you’ll have a much better chance of being deemed a contractor rather than an employee.

2. Independent contractor vs employee: Ownership of tools

An obvious point, one would think; a contractor would supply his own tools. However, because it’s customary for employees to supply their own tools in some trades (think of painters and garage mechanics, for example), the cost of using the tools is a much better indication, according to the Canada Revenue Agency. “When workers purchase or rent equipment or large tools that require a major investment and costly maintenance, it usually indicates that they are self-employed individuals, because they may incur losses when replacing or repairing their equipment.”

Another example would be a home-based IT worker - if he is using his own desktop/laptop computer, mobile devices, etc. this would be indicative of self-employment.

3. Independent contractor vs employee: Chance of profit/risk of loss

In this case, whether you’re involved in an employer-employee relationship or a business relationship depends on your financial involvement.

If these three things are true, you’re a contractor, not an employee.

4. Independent contractor vs employee: Integration

This appears to be a further attempt to divine the intention of the parties involved. The Canada Revenue Agency states, “Where the worker integrates the payer's activities to his own commercial activities, a business relationship probably exists... Where the worker integrates his activities to the commercial activities of the payer, an employer-employee relationship probably exists.”

Exactly how to determine such integration is not laid out. The CRA's Employee or Self-Employed? seems to treat this point as a summary category calling for a review of the other three.

One obvious way of “proving” integration to your own commercial activities is to have multiple clientsThe contractor who only has one client makes it too easy for others to perceive his relationship with that client as an employer- employee one.*

*(Note too, that having a single client puts your small business in danger of being declared a personal services corporation by the CRA. See the section Does Being Incorporated Give You Contractor Status? below.)

Also, as a contractor, to protect yourself, you should always enshrine your relationship with each employer in a contract, focusing on the first three points of this four-point test.

“Having a carefully crafted written agreement setting out the intentions of the parties may offer some protection if one of the parties subsequently changes his or her mind and argues that the relationship is not what it was purported to be,” says Anthony Strawson, (CMA, LLB, BComm), in “Employee or Independent Contractor”.

It will also help stave off being recategorized by the Canada Revenue Agency.

In summarizing the case law on the independent contractor vs employee situation, Mr. Strawson points out that the issue is not clear cut, and that while there appears to be a trend towards a more flexible interpretation of the business relationship between a contractor and an employer, the final determination of whether a person is an independent contractor or an employee will always depend on the individual facts and circumstances of the case.

Does Being Incorporated Give You Contractor Status?

Some employers seem to view incorporation as “proof” of independent contractor status – to the point that they will only do business with incorporated contractors. While being incorporated could conceivably be one point of evidence showing an arm’s length relationship between a contractor and employer, it isn’t proof of a business relationship in itself. (See Should You Incorporate Your Small Business? for the advantages and disadvantages of incorporation and How to Incorporate Your Business in Canada if you decide to go this route.)

If you are incorporated but working exclusively for a single employer and performing activities that an employee would normally perform you risk being considered a Personal Service Corporation and losing the ability to claim the Small Business Deduction and other standard business deductions.

Safeguard Your Tax Status

As a contractor, it behooves you to take what measures you can to ensure that your status as an independent contractor in Canada is clearly defined because of the serious effect having the CRA declare you an employee could have on your income taxes. If you have taken measures and are still uncertain about whether you’re actually an employee or an independent contractor, discuss the issue with your accountant and/or contact the Canada Revenue Agency.