Two Systems of Tax Obligations in Canada

15-Two-Systems-Tax-Obligations-Canada-Article-Featured-777Taxes-Accountant-Toronto-VaughanCanada operates with two distinct systems of tax obligations—one for average employees and another for small business owners or the self-employed. Navigating the intricate tax landscape of Canada involves understanding the divergent systems for employees and small business owners or the self-employed. Employees witness deductions for taxes, pension contributions, and other levies, significantly impacting their take-home pay. On the other hand, small business owners and the self-employed enjoy the advantage of legally deducting business-related expenses from their income, ultimately reducing their taxable “net” profit.

TAXATION OF eMPLOYEES:

In essence, the state deducts money from employees through taxes as soon as they earn income. Employees have the opportunity to allocate money for their daily needs only after all deductions, including taxes, pension contributions, and other levies (up to a maximum of approximately 46% in Ontario).

Taxation of Small Businesses and Self-Employed Individuals:

In contrast, small business owners or those who are self-employed can legally deduct almost all business-related expenses from their total income. They then pay taxes on the resulting “net” profit.

The aforementioned highlights the importance of establishing a business structure to legally minimize tax obligations in Canada (and the US).

It might seem straightforward to declare oneself as “self-employed” and deduct all business expenses —an approach that appears logical and attractive. However, this method is illegal. The Canadian Revenue Service (CRA) prefers individuals to remain employed, ensuring budget contributions from both the individual and the employer.

Key Characteristics of an Employee:

According to the CRA, an individual is classified as an employee if:

The employer controls their time and work processes, restricting them from earning additional income elsewhere.

  1. All business risks are assumed by the employer.
  2. The individual is a key figure in the organization.
  3. The work is performed using the employer’s production facilities/tools.

The CRA broadly interprets the concept of “tools,” covering not just equipment and production space but also certain company employees like secretaries. If a specialist receives an annual salary, the CRA is likely to consider them an employee. A recommended approach is to establish a contract specifying the final amount without indicating a time frame or stipulating hourly payment without guaranteeing specific weekly, monthly, or contract duration hours.

Individuals uncertain about their employment status can request a ruling from the CRA to determine whether they fall under the employee or self-employed category.

Practical Experience:

In practice, courts typically favor the CRA only when meeting all specified criteria for employee status. The CRA rarely takes legal action against Canadian citizens, as lawsuits tarnish the tax service’s reputation, prove costly for the treasury, and potentially reveal ways for savvy citizens to evade taxes.

Rules for Drafting a Contract with a Contractor (Self-Employed):

  • The contractor is independently responsible for tax payments.
  • The contract should be project-specific in duration and/or scope.
  • The contractor must issue an “invoice” to the company for completed work.
  • The contractor retains the right to enter contracts with other companies/employers.
  • The contractor is not bound by the internal rules of the company.
  • The contractor is responsible for their own expenses and, if feasible, can work outside the company’s premises.
  • Self-employed individuals are not entitled to company perks (cafeteria, gym, etc.) or health/pension benefits.
  • The contractor can hire subcontractors.

Establishing a sound business structure is crucial for legally minimizing tax obligations in Canada. Despite the apparent allure of declaring oneself as “self-employed” to exploit deductions, adherence to legal frameworks is essential. The Canadian Revenue Service (CRA) emphasizes the significance of proper categorization to ensure fair contributions and discourage unlawful practices.

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