In Canada, roughly 2.7 million individuals are self-employed. Generally, an individual is self-employed if they have a business relationship with a payer and also have the right to determine where, when, and how the work is done. These individuals may or may not have an incorporated company. This relationship may sound complicated; however, it is very common, and the implications are often overlooked by the self-employed individual and/or the entity hiring the self-employed person.
In this issue we will focus on matters from the perspective of the self-employed person – critical to ensure proper reporting, administration and organization of the business. Businesses engaging the services of these individuals should also be aware of these matters. In the July 2014 Canadian Tax Planner issue, we will dig into matters facing businesses engaging self-employed persons, as well as issues that may arise if CRA assesses the self-employed individual to be an employee of the payer or a personal service business.
Specifically, we will discuss the following:
PART 1: How are Self-Employed Individuals Taxed?
Self-employed individuals earn income from a variety of sources: a business, a profession, commission, farming or fishing. Business income tends to be the broadest category and can include income earned from any activity carried out with a reasonable expectation of profit. This may include, for example, selling goods online or in a retail store, or providing services such as consulting or landscaping.
Reporting Self-Employed Income
Self-employed income, for unincorporated individuals, is reported on the Statement of Business and Professional Activities, T2125, which is included in an individual’s personal tax return. This is different than corporations which must complete a corporate tax return.
The net profit (income less expenses) is taxed at the individual’s marginal personal tax rate – income over certain thresholds are taxed at higher rates.
If an individual incurs a business loss in the year (quite common in the first few years of operation), the loss can offset other income the individual earns. If the loss exceeds income from other sources, the excess can also be carried-back to offset income earned by the individual in the prior 3 years, or carried forward to offset income earned by the individual for the subsequent 20 years.
Taxpayers must be aware of whether they are carrying on a business or engaging in a hobby or personal activity – losses from a hobby or personal activity are not deductible.
CRA tends to look closely at business losses. In January 2014, the CRA sent targeted letters to a group of taxpayers who previously claimed business losses, reminding them of the possibility of an audit, and encouraging them to correct possible inaccuracies in tax returns filed in prior years.
Accrual or Cash Method?
Most self-employed individuals are required to report business income using the accrual method – that is, they report the income when they earn it (whether or not they receive the cash) and deduct expenses in the fiscal period in which they incur the expense (whether or not they pay the amount). CRA allows certain specific individuals, such as commissioned salespersons to use the cash method to report income and expenses, as long as it accurately shows income for the year. Taxpayers may elect to report farming or fishing income using the cash method.
When does my Business Start?
CRA generally considers a business to have started when it begins some significant activity that is a regular part of the operation, or that is necessary to get the business going. In some cases a business may have started even if there are no revenues yet earned. Each business is looked at on a case-by-case basis. Expenses incurred before a business actually ‘starts’ are not generally deductible.
Tip: Consider maximizing the value of excess losses by applying them against income on which you paid the highest tax rate.
PART 2: Deductible Expenses
As a general rule, a taxpayer can deduct any reasonable expense incurred to earn business income.
Some common deductible expenditures include: advertising, bad debts, business fees, licences or dues, capital cost allowance, insurance, some legal and accounting fees, management and administration fees, office expenses, property taxes, salaries (including some salaries to family members), supplies and travel.
Self-employed individuals can also deduct home office expenses as long as the home office is either,
• the principal place of business; or
• used exclusively to earn income and, on a
regular and continuous basis, is used for meeting customers, clients, or patients.
Home office expenses may include, for example, insurance, utilities, property taxes, repair and maintenance, and mortgage interest. A portion of these amounts, relating to the business, can be deducted. This is most often calculated by determining the portion (i.e. square footage) of the home used in the business.
Some expenditures are not deductible, the most common of which are listed below:
• Capital Expenditures – Amounts paid to acquire a capital property (ex. a building or furniture), which is something that provides an enduring benefit over a period of time, cannot be fully deducted in the year of acquisition. As these properties wear out or become obsolete over time, these costs are deducted over a period of years. This deduction is called Capital Cost Allowance (CCA). For further discussion, see March 2014 Canadian Tax Planner.
• Personal Expenses – These are not deductible, and may include, for example, a personal vacation or a laptop used entirely for personal purposes. In scenarios where there is a personal portion of the expense (ex. home office expenses – insurance for the entire house), the individual can only deduct the business portion of the expense.
• Meals and Entertainment – Only half of the amounts paid for meals and entertainment are generally deductible.
Private Health Service Plan (PHSP)
A PHSP is a type of health spending account which allows employers to pay for certain medical
expenses of employees and their families. Amounts paid are deductible as a business expense. Payments made by an unincorporated business to a PHSP are subject to unique rules and may be deductible in some cases. First, self-employment must be the individual’s primary income source (more than half of the taxpayer’s income in either the current or prior year, unless income from other sources is less than $10,000). Second, with limited exceptions, all employees of the business must receive equivalent coverage.
In cases where fewer than 50% of those insured are unrelated employees, the maximum deduction is based on the sole proprietor and his/her spouse and dependents – $1,500 for each the sole proprietor, spouse, and dependent age 18 or more, and $750 for each dependent under 18. Amounts deducted as a PHSP premium cannot also be claimed as a medical expense.
A payer may sometimes reimburse the sole proprietor. This may include, for example, travel costs to fly to the payer’s locale, or a fixed amount to compensate the individual for using his/her own vehicle. Regardless of the reimbursement, the sole proprietor must include the amount received in income. However, the individual can then deduct associated expenses. In the flight example above, an individual may be reimbursed $1,000 for the flight which cost $1,000 – the $1,000 income and expense must both be reported by the individual. In the automobile case, the individual must report the income and then consider any expense deduction, which is generally the total operating costs prorated for the business use. Likewise, fixed fee payments intended to offset additional costs are treated in the same manner. See PART 6 for a discussion on automobile expenses.
PART 3: Unreported Income
Many taxpayers may be confused about what income they need to report to the CRA. Income from T-slips (such as a T4 for employment) is generally reported correctly; however, taxpayers may be unsure as to other income that should be reported as well. Income earned from, for example, painting a house, taking photographs for a fee, or even selling goods on EBay must be reported. Barter transactions (when two people agree to exchange goods or services without using money) must also be reported: the income inclusion is generally the amount taxpayers would normally charge for their services, or would have sold the goods or property to a stranger.
CRA is targeting unreported income. Whether intentional or not, the consequences of not reporting can be very costly. These can include interest on unpaid taxes, penalties, and in extreme cases, criminal fines or imprisonment.
Most commonly, CRA may levy penalties of up to 50% of the tax evaded, plus interest accrued on the amount in cases when a taxpayer knowingly, or in circumstances amounting to gross negligence, makes a false statement or omits information from a tax return.
If taxpayers voluntarily tell CRA about an amount they failed to report, CRA may waive the penalties under the Voluntary Disclosures Program (VDP).
Recently, the Minister of Finance passed a bill providing for the application of penalties and criminal offence charges relating to Electronic Suppression of Sales (ESS) Software. ESS Software (commonly known as “zapper” software) selectively deletes or modifies sales transactions in point-of-sale systems (ex. electronic cash registers) and business accounting systems, leaving no record of the original transaction.
Tip: The VDP can be complex, and assistance by a tax professional is advisable.
PART 4: Employment Insurance (EI) for Self-Employed
Self-employed individuals can voluntarily choose to pay EI premiums to be eligible to receive EI benefits (maternity, parental, sickness, and compassionate care benefits, and benefits for parents of critically ill children). If a taxpayer is registered in 2013 to participate in this program, premiums for this year will be calculated on their 2013 income tax return and will be payable by April 30, 2014. Going forward, if they pay their income tax by instalments, EI premiums may be included in their instalment payments. EI premiums are payable on self-employment income for the entire year, regardless of the date of registration.
A self-employed individual can opt out of this EI program at the end of a tax year if the individual has never claimed benefits. In cases where an individual has claimed benefits, they must contribute on self-employed earnings for as long as they have self-employed income. This may be an expensive decision for some self-employed and has led many individuals to choose not to opt into the EI program.
EI premiums are payable on self-employed income up to an annual maximum amount of $2,193 for 2014. A regular employee would only pay a maximum EI premium of up to $914 (in 2014), while the employer would pay the remainder. The maximum EI premium level is hit when an individual’s insurable earnings reach $48,600 (in 2014).
PART 5: GST/HST Issues
GST/HST is a tax that applies to the supply of most property and services in Canada. HST applies to the same base of property and services as does GST.
Almost everyone has to pay GST/HST on purchases of taxable supplies of property and services (other than zero-rated goods). A limited number of sales or supplies are exempt from GST/HST. Additional info on this can be found http://www.cra-arc.gc.ca/tx/bsnss/tpcs/gst-tps/gnrl/menu-eng.html but is beyond the scope of this article.
Although the consumer pays the tax, businesses are generally responsible for collecting and remitting it to the government whether incorporated or not.
Do I need a GST/HST Number?
Most sole proprietors that provide taxable supplies (goods or services subject to GST/HST) in Canada must register for a GST/HST number. However, they may be considered a small supplier and be exempt from registering (though may voluntarily register) if their total revenue from taxable supplies (before expenses) from all their businesses is $30,000 or less:
• over the last four consecutive calendar quarters, and,
• in any single calendar quarter.
Caution: Taxi and limousine businesses and non-resident performers selling admissions to seminars and other events must register for the GST/HST, even if they are small suppliers.
Details on GST/HST registration can be found at http://www.cra-arc.gc.ca/tx/bsnss/tpcs/gst-tps/rgstrng/menu-eng.html.
GST/HST Registrants collect the tax on most of their sales and pay the tax on most purchases they make to operate their business. They can claim an input tax credit (ITC) to recover the GST/HST paid on the purchases they use in their business. In other words, the businesses are required to track all of the GST/HST paid and offset this amount against the GST/HST collected on sales. The net amount is either remitted to or refunded from CRA on a regular basis.
Depending on the value of the ITC, various information is required on invoices in order to claim the ITC. Most commonly, invoices with total sales in excess of $150 should include the name of purchaser, invoice date, total amount paid, GST/HST charged, vendor’s name and business number, description of good or service and terms of payments. If an invoice is examined by CRA and is missing one of the above, the ITC may be disallowed.
GST/HST Reporting Periods
When a business registers for a GST/HST number, CRA assigns a reporting period; however, businesses can also choose one of the options in the below
As the above traditional method can be very onerous, many small businesses elect to use the Quick Method to report and remit GST/HST. The Quick Method is substantially simpler, resulting in reduced paperwork and bookkeeping costs. As well, this method may benefit certain businesses with low expenses relative to income, by requiring lower GST/HST payments than would otherwise be remitted.
Tip: A calculation of the savings/cost should be considered before converting to the Quick Method.
GST/HST payable under the Quick Method is a percentage of sales (including GST/HST). The percentage varies depending on:
• whether the business purchases goods for resale or provides services,
• the location of sales and operations, and
• whether the business provides a service, sells goods or is in manufacturing.
Businesses using the Quick Method cannot claim most ITCs, however ITCs remain available on capital asset purchases. An additional 1% credit is also provided on the first $30,000 of annual sales.
Most businesses with annual worldwide taxable sales of up to $400,000 (for reporting periods beginning in 2013) can elect to employ the Quick Method. Some businesses, including accountants, tax consultants, financial consultants and lawyers, cannot use the Quick Method.
Form GST74 is used to elect to use the Quick Method, or to revoke such an election (only available after one full year). The election must be filed by the due date for the return for which the Quick Method is to commence, except for annual GST/HST filers who must elect by the first day of their second fiscal quarter.
PART 6: Administration
Self-employed individuals are required to maintain adequate records that provide sufficient details to determine tax obligations and entitlements. Records must be supported by source documents. These records or source documents can come in the form of account books, sales and purchase invoices, receipts, contracts, bank statements and cancelled cheques.
Generally, taxpayers are required to keep records for six years. Specifically, taxpayers must retain records (other than certain documents for which there are special rules) for six years from:
• the end of the last taxation year to which they relate,
• the end of the year to which they relate for GST/HST and excise duty purposes, and,
• after the goods are imported or exported.
In cases where an individual files their income tax return late, they must keep records and supporting documents for six years from the date that the return was filled.
If an individual is dealing with an objection or appeal, an individual must keep records until the later of,
• the date the matter is resolved and time for filing any further appeal has expired, and
• the above mentioned six year period has expired.
Tip: Failure to retain proper and complete records tend to increase the risk of penalties.
Confusion often arises around the documents required to deduct automobile expenses. CRA expects unincorporated self-employed individuals to maintain a detailed log, identifying each and every business and personal kilometre driven, to establish the percentage of business use. Receipts for driving costs, such as repairs and fuel, must also be maintained. An estimate, such as a fixed amount per kilometer, is typically challenged by CRA.
Some relief, however, is provided in the form of a Simplified Logbook for these self-employed individuals. The rules for this logbook are fairly specific, but generally state that a business must maintain a full logbook for one complete year to establish the base annual business use of a vehicle. After one complete year, individuals can use a three-month sample logbook to project the business use for the year, as long as the usage is within the same range (10%) of the base year.
Tip: CRA expects unincorporated proprietors to keep all automobile receipts and a log. Reduced or denied expenses are common where such support is not maintained.
Internet Business Activities
Commencing in 2013, CRA requires self-employed individuals to provide information on their Internet Business Activities. Such information includes: percentage of gross income generated from webpages and websites, the number of webpages and websites that the business earns income from, and a listing of the main webpages.
PART 7: Important Dates
Certain filing and important dates are as follows:
• March 15 – Due date for personal tax 1st installment
• April 30 – Personal tax payment due date
• June 15 – Filing due date for self-employed individuals or spouses or common-law partners of self-employed individuals. Any taxes owing are due April 30; interest starts accruing at this date.
• June 15 – Due date for personal tax 2nd installment
• Sept 15 – Due date for personal tax 3rd installment
• Dec 15 – Due date for personal tax 4th installment
If any of these dates fall on a Saturday, Sunday or public holiday, the due date is the next business day.
Personal tax installments must be made for 2014 if the individual’s net tax owing is more than $3,000 in both,
• 2014, and,
• either 2013 or 2012.
Issues related to self-employed individuals continue to be questioned by CRA and contested in the Courts. As the costs of errors can be high, attention should be paid to properly reporting this income. Also, very importantly, taxpayers should ensure proper structuring of the relationship at inception and on an ongoing basis.
In the next issue of the Canadian Tax Planner, we will focus on issues facing the business engaging the services of self-employed persons, as well as issues that may arise if CRA assesses the self-employed individual to be an employee of the payer or a personal service business.