For self-employed individuals or freelancers that don’t meet the requirements of either wage subsidy program, the Canada Emergency Response Benefit may provide relief.
CANADA EMERGENCY WAGE SUBSIDY (75%)
The government is proposing a 75% wage subsidy, up to a maximum of $847 per week for each eligible employee. The subsidy would be available for qualifying businesses who have suffered a decline of 30% in monthly revenue for a period of 3 months (March 2020 through May 2020).[embeddoc url=”https://digitaljam.files.wordpress.com/2020/05/d7818-the-canada-emergency-wage-subsidy-canada.ca_.pdf” download=”all”]
For businesses that don’t qualify for the 75% subsidy, there is an alternative 10% subsidy for businesses (a person – including a CCPC – or a partnership) with CRA Payroll Account (Business Number with an RP0001 extension) that existed as at March 18, 2020.
The Temporary Wage Subsidy for Employers is a three-month measure that will allow eligible employers to reduce the amount of payroll deductions required to be remitted to the Canada Revenue Agency (CRA) by 10%, to a maximum of $1,375 per employee.
The Federal Government has announced emergency support for individuals and families:
- Increases to the Child Tax Benefit will be automatically be adjusted for families receiving the benefit.
- A one-time special payment for recipients of the GST credit will be sent automatically
In addition, the filing deadline for personal tax returns has been extended from April 30th to June 1st.
More details can be found online:
These days tax jurisdictions are struggling to deal with online transactions. In British Columbia we are subject to both Federal GST and BC PST. If the jurisdictions themselves are struggling, that means that small businesses may find that they are caught up in a dizzying array of complex rules for multiple jurisdictions. By and large it is likely that most small CCPCs (Canadian-controlled private corporations) are flying blind.
While government tax authorities can be saddled with complex tax laws to administer, they often aren’t adequately resourced to ensure compliance. In the case of the Federal government and the Goods & Services Tax, they hire people straight out of school with no accounting training or experience. Even the supervisors typically learn on the job without the benefit of the discipline that comes from having to justify their time to clients and actually collect fees in a competitive environment.
For their part smaller CPA firms focus on basic compliance for both PST and GST. Unlike the tax authorities, CPAs in practice do work in a competitive environment.
Their clients won’t thank them for doing a “deep dive’ into PST and / or GST issues and uncovering additional tax liabilities. Particularly when they charge more than competing firms that don’t bother.
PLACE OF SUPPLY RULES for GST
While I’m not a sales tax (aka “indirect tax”) specialist, I had to bring in a specialist when one of my clients had a bit of a home run in the first month of a new product launch. The issue surrounded the “place of supply rules” for GST. While the issue is too complex to discuss here, we needed to establish where their online customers resided and whether or not they were GST registrants.
If we were unable to document that, the tax authority would have been in a position to assess 15% GST on all online sales. This, in spite of the fact that 95% or more of the customers were non-residents and shouldn’t have been subject to GST. Luckily the specialist was able to keep us out of that minefield.
SELF-ASSESSING PST for ONLINE PURCHASES
For startups (and anyone else for that matter) purchasing online services from other jurisdictions, there is a requirement to self-assess PST on the taxable portion of those services. Most of us simply pay for online services as billed. We don’t question whether the vendor properly excluded BC PST from the invoice.
However consider that most SAAS (software as a service) companies are located in other jurisdictions and know even less about BC PST regulations than we do here. If the service is taxable – and some are – our local startup would be required to self-assess and remit tax on the purchase.
Currently GOOGLE is billing me $12.50 a month for 3 users of email services. I must confess that I am not convinced that these services aren’t subject to PST. However I’m not being charged and haven’t done a deep dive into local PST legislation to determine whether I should self-assess. Since the PST for a year would only be about $10.50, I felt that it didn’t warrant the research time.
If the exposure is fairly small, it may be practical to simply wait for the Ministry to assess. In its wisdom the government’s new PST legislation doesn’t allow for the taxation of transactions that occur more than four years before they were eventually identified by the director (Section 200 of the Provincial Sales Tax Act).
Unless of course the omission was significant and intentional.
SELF-ASSESSING PST on FOREIGN LEGAL FEES
There is also some risk that legal fees in the US relating to investments by a venture capital firm may actually be subject to BC PST. Since we’re not in that position yet, we haven’t looked too closely at the legislation.
TAX ISSUES IN SELLING TO FOREIGN JURISDICTIONS
While I’m not a US or cross-border tax specialist, I have been told that companies selling into California for instance, may be exposed to income taxes in the State of California, at some level of penetration. While Canada has tax treaties with most countries that Canadians export to, it should be noted that these typically cover federal income tax only. States and provinces may have other filing and tax requirements.
Clearly companies that deal routinely across borders should seek advice from CPAs with relevant experience.
Technology companies – in fact most small businesses – often have difficulty taking advantage of the recently enriched lifetime capital gains deduction. When first introduced the capital gains deduction was targeted the first $500,000 of capital gains on family farms and qualified small business corporation shares (“QSBCs”). Since then the lifetime capital gains limit has been increased to $806,800 for QSBCs and $1 million for family farms.
However it is always difficult for sellers to sell shares. Buyers prefer to buy assets for 2 reasons:
- The cost of shares is not deductible by the buyer against income – while most assets are at least partially deductible
- Shares of small business corporations are much more complex beasts to acquire and may include undisclosed liabilities or other “surprises” that buyers are understandably nervous about acquiring
Buyers and their legal representatives will typically discount the purchase price if the vendor insists on selling shares. In some cases buyers simply won’t consider acquiring shares.
Many small, private corporations have at least a few skeletons in their closets. Closely-held companies often operate a little too close to the line and sophisticated buyers will often engage professionals to uncover at least some of these.
As a former senior manager with PwC LLP in Vancouver I was seconded to a due diligence team looking at the potential acquisition of a technology company. As it happened, the target company was one of a number of companies owned by the same entrepreneur. The entrepreneur had separate accounting firms handling each of his companies.
The problem was that he never informed his accountants of the existence of the other companies. Each year he filed for refundable SR&ED tax credits with one of his companies. Presumably his accountants were unaware of the existence of these other companies, since they were not disclosed on the tax returns as “associated” corporations.
Because of the amount of taxable income of the associated group, the corporation would not have been entitled to high-rate refundable tax credits. Thus any purchaser could be on the hook for undisclosed tax liabilities – and penalties – in the millions of dollars.
Of course it isn’t only undisclosed tax liabilities that could surface after an acquisition. There could be problems with employees, former employees, customers or suppliers. With small corporations eligible for the lifetime capital gains exemption, financial statements are often merely compiled with little or no assurance from the public accountants drafting the statements.
For that reason most accounting and legal professionals will advise buyers of QSBCs to purchase assets – or to discount the purchase price and conduct significant due diligence before determining that price.
CAPITAL DIVIDENDS AS AN ALTERNATIVE STRATEGY
Technology entrepreneurs looking to sell their companies should understand that the value of their companies is most often determined by the value of their IP.
Selling intellectual property developed by a technology company now results in a capital gain. With capital gains, only 1/2 of the gain is taxable. The remaining un-taxed half can be distributed tax-free to shareholders via an amount paid out of the capital dividend account (“CDA”).
So rather than selling shares – typically at a discount – the entrepreneur keeps the company and sells the IP within the company. So the sale price is higher, the sale is only partially taxable and may even be shielded by non-capital losses, SR&ED ITCs or SR&ED expenditure pools within the company. When the proceeds are distributed, the company can elect to pay dividends from the CDA account.
While this works well for technology companies that have IP, it can also work for any corporation selling goodwill as well. Usually buyers will attempt to structure their purchase so that proceeds are allocated more to tangible assets which can be depreciated more quickly. This may result in fully taxable “recaptured” depreciation.
For entrepreneurs that have done this before, be aware that the rules around gains on the sale of what used to be “eligible capital property” have changed in the last few years. Clearly each company’s particular circumstances will be unique. So it pays to get advice from a tax professional that you trust.
British Columbia’s Small Business Venture Capital Act provides a 30% tax credit to eligible investors in corporations involved in a “prescribed business activity” within BC. For individuals the tax credit is fully refundable and isn’t considered taxable under paragraph 12(1)(x) of the Income Tax Act:
SUBSECTION 12)(1) – INCOME INCLUSIONS
(x) Inducement, reimbursement, etc. — any particular
amount (other than a prescribed amount) received by the tax –
payer in the year, in the course of earning in come from a busi –
ness or property, from
(i) a person or partnership (in this paragraph referred to as the
“payer”) who pays the particular amount
(A) in the course of earning in come from a business or prop –
(B) in order to achieve a benefit or advantage for the payer or
for persons with whom the payer does not deal at arm’s
(C) in circumstances where it is reasonable to conclude that
the payer would not have paid the amount but for the receipt
by the payer of amounts from a payer, government, munici –
pality or public authority described in this sub paragraph or
in sub paragraph (ii), or
(ii) a government, municipality or other public authority,
where the particular amount can reasonably be considered to
have been received
(iii) as an inducement, whether as a grant, subsidy, forgivable
loan, deduction from tax, allowance or any other form of in –
(iv) as a refund, reimbursement, contribution or allowance or
as assistance, whether as a grant, subsidy, forgivable loan, de –
duction from tax, allowance or any other form of assistance, in
(A) an amount included in, or deducted as, the cost of prop –
(B) an outlay or expense,
to the extent that the particular amount
(v) was not otherwise included in computing the taxpayer’s in –
come, or deducted in computing, for the purposes of this Act,
any balance of undeducted outlays, expenses or other
amounts, for the year or a preceding taxation year,
(v.1) is not an amount received by the tax payer in respect of a
restrictive covenant, as de fined by sub sec tion 56.4(1), that was
in cluded, under subsection 56.4(2), in computing the income
of a person related to the taxpayer,
(vi) except as provided by subsection 127(11.1), (11.5) or
(11.6), does not reduce, for the purpose of an assessment made
or that may be made under this Act, the cost or capital cost of
the property or the amount of the outlay or expense, as the case
(vii) does not reduce, under subsection (2.2) or 13(7.4) or
paragraph 53(2)(s), the cost or capital cost of the property or
the amount of the outlay or expense, as the case may be, and
(viii) may not reasonably be considered to be a payment made
in respect of the acquisition by the payer or the public author –
ity of an interest in the taxpayer, an interest in, or for civil law a
right in, the taxpayer’s business or an interest in, or for civil
law a real right in, the taxpayer’s property;
The key wording here is:
(other than a prescribed amount)
VCC tax credits are prescribed by Regulation 7300 of the Income Tax Act to be “prescribed amounts” for the purposes of paragraph 12(1)(x). Not only do recipients not have to include the tax credit in income, they don’t have to reduce the Adjusted Cost Base of the underlying shares after receiving the tax credit (Regulation 6700)
This is a good deal for investors – to extent that investments in such companies can ever be considered “good” for investors. It also means that friends and family can invest in eligible shares and obtain a full deduction for the share when transferring to a self-directed RRSP.
Whether you are an individual looking for a broader range of tax deductions than employees are ordinarily entitled to, or an employer looking for a more flexible working arrangement with your “employees”, you need to understand the rules around employment.
The employer-employee relationships is dealt with by a number of different legislative regimes. These include:
- The Income Tax Act (Canada)
- The Canada Pension Plan
- The Employment Insurance Act
- The BC Employment Standards Act
It is important to understand that simply wanting to qualify for enhanced tax deductions as an independent contractor isn’t enough. Similarly employers can’t avoid the obligations of an employer merely by stating that a person providing services is self-employed.
Tax authorities – as well as other regulators – will look to the specifics of the relationship itself and make their own determination. This is true whether or not both parties intended to avoid the characterization of the relationship as an employment contract.
If you wish to establish a relationship that isn’t an employer-employee relationship, you should understand the position of the CRA with respect to this issue.
The CRA publication:
Employee or Self-Employed?
explains how this issue is perceived by both the CRA and the courts.
It is possible for the employer and the employee/contractor to contract out of the employee relationship, but it must be done thoughtfully and should be in writing. Regardless of whether or not the contract is in writing, the terms must clearly avoid the appearance of a “master-servant relationship”, or the courts (and the CRA) will look through the contract and assess accordingly.
If an employer pressures an employee to agree to a position as an independent contractor, the government may side with the employee if the self-employed contractor seeks employment insurance and severance when he or she is dismissed.
In a situation like this the employer could be required to pay severance and be subject to an assessment for a shortfall in CPP and EI withholdings.
The website TaxTips.ca has a decent explanation of many of the issues: TaxTips.ca
If an “employee” forms a corporation to provide services to his or her employer, the corporation may be considered as a Personal Services Business – which would have significant implications. These are potentially more onerous than what an individual would face if he is deemed to be an employee without the complication of a corporation.
The case of Walter Pielasa and his wife, Susan (758997 Alberta Ltd. v. The Queen – 2004 TCC 755) illustrates some of the problems that an “incorporated employee” can face if his corporation is found to be a personal services business.
IMPLICATIONS TO A CORPORATION OF CLASSIFICATION AS A ‘PERSONAL SERVICES BUSINESS’
LIMITS TO ALLOWABLE DEDUCTIONS
Paragraph 18(1)(p) of the Income Tax Act restricts the deduction of expenses of a personal services business of a corporation to the following allowable deductions:
The above amounts are only deductible by a personal services business if they would be deductible by a business other than a personal services business.
LOSS OF THE SMALL BUSINESS DEDUCTION
While these outcomes would significant for any incorporated employee and could be devastating to employers, there are other potentially significant disadvantages in those cases where the employer is successful in structuring contracts to meet the definition of ‘independent contractor’. I’ll discuss these in a future post.
With the return to the old regime in British Columbia, businesses are now forced to comply with the complexity of 2 separate consumption taxes (i.e. PST and GST). What prompted this discussion were the challenges faced by one of our clients – a software developer – in complying with the new regime.
To begin with small businesses must understand that accounting software isn’t expert software. Too often there is an expectation that commercial accounting software will provide professional expertise and guide inexperienced users into automatically recording transactions – including sales taxes – correctly.
In fact, from a marketing perspective Canadian customers are not a terribly important source of revenue to an international firm like Xero Limited. Xero is more focused on Australia, New Zealand (local markets), the UK, India and the US (large markets). As a result the software provides adequate generic tools to support various tax jurisdictions, but little or no ‘localization’ for secondary markets like Canada.
No matter how well accounting software has been localized to handle the mechanics of sales tax calculations for a particular jurisdiction, it simply isn’t realistic to expect the software to provide any expertise with respect to understanding what transactions are taxable or at what rates taxes need to be calculated. In fact such determinations are difficult for tax professionals, who invariably need a great deal of context before making decisions.
Handling GST in Xero
The Goods and Services Tax in Canada is a ‘value-added’ tax (aka “VAT”). That means businesses only pay tax on the value they add in taking products and services to the ultimate consumer. It is the ultimate consumer – at the end of the process – who pays the full amount of tax on the good. In the simple case of a consumer good – like a pair of shoes. The end user buys the shoes and pays GST on the full cost of the shoes.
The manufacturer buys raw materials and pays tax on the materials. It then ‘adds value’ by putting the raw materials through a manufacturing process and sells the shoes – usually to a retailer. The manufacturer charges GST on the sale price to the retailer. The difference between the GST collected on the sale price and the GST paid on the cost of the raw materials is remitted to the Canada Revenue Agency (the “CRA”).
Similarly the retailer collects GST from the consumer and gets a rebate from the CRA of the GST paid to the manufacturer. In the end, the final consumer pays the full amount of GST.
This type of value-added tax is commonplace in many countries (other than the US). Xero is familiar with handling value-added taxes and does a good job of handling Canada’s GST. All of the GST collected on sales and paid on purchases is collected in the Sales Tax Payable account.
Handling PST in Xero
Companies that charge PST to customers must remit the PST collected to the their provincial tax authority. However they don’t get any credit for PST paid on purchases. Instead PST paid is treated simply as a part of the cost of the good or service that was purchased.
This approach to sales taxes results in business paying tax on certain of their inputs. Typically raw materials and goods for resale are exempted from PST. However companies must still pay PST on overheads like telephone bills, tools and utilities. The PST paid is generally expected to form a part of the cost of any taxable good or service. Instead of being claimed as reduction or offset of PST collected, the PST ends up on the income statement as an expense.
Unfortunately Xero doesn’t handle this very elegantly.
This means that when entering PST on expenses, it should actually be entered as a second expense line (i.e. currently 7% of the taxable purchase) and should be allocated to the same account as the purchased item:
Supplies expense $100
Supplies expense …..7
Sales tax payable ……5
So we have 2 supplies expense lines. The first is subject to GST (input tax credits) at the current rate. The 2nd line represents the PST paid on the supply.
In this way the GST reports correctly as an input tax credit. The PST reports as an expense. Unfortunately the balance in the Sales Tax Payable account combines both GST and PST. So PST should NOT be set up as a sales tax.
Ideally there would be 2 separate Sales Tax Payable accounts (i.e. GST and PST), however it can be made to work as shown above. Of course other workarounds are possible – but they are workarounds, and could easily be misunderstood by bookkeeping staff.
Depending on where your business is located, GST rates can vary from 5% to 13% of all taxable supplies that your company purchases. For startups that expect to be in a loss position for a year or 2 after incorporation, that can mean a significant amount of cash donated to the federal government as a kind of ‘voluntary tax’ .
The problem is that registration isn’t automatic when you incorporate a company. In fact, until you’ve earned $30,00 in revenue you’re not required to register.
For many early stage companies they may spend 2 or 3 years burning through their equity to build a new product or service. If they don’t explicitly register for GST, they won’t be able to recover the 5% (or more) of expenditures paid to contractors and to purchase other services and supplies. In fact we recently completed 3 years of filings for a BC-based company that spent some $300K in developing new technology. Because they weren’t registered – at least not until we became involved – they lost almost $25K in recoverable GST.
An article by Leena Rao – a senior editor at TechCrunch.com – suggests that while convertible debt may be getting popular with early stage investors, it can cause a lot of problems. This is especially true where Series A funding doesn’t come along before the notes become due – putting start ups in default.
This is an interesting read – Convertible Debt or Equity – but I’ll let you read it for yourself.
In BC there is a different problem for which convertible equity may also be a solution. With this province’s VCC incentives, angels are in certain circumstances (EBC investments) encouraged to hang on for 5 years in exchange for an immediate 30% return to investors. While this lowers the risk, it may also extend the amount of time that the money is at risk. Regardless of which investment model is used, it is often difficult for investors to achieve an exit.
As I mentioned in an earlier post – convertible equity may be used by VCC or EBC investors as a means of ‘encouraging’ a management buyout, thereby securing an exit, where funds may be stranded in a ‘lifestyle business’.