One of the most contentious areas of personal tax law involves the distinction between being self-employed and being an employee.

Determining whether you’re one or the other is not simply a matter of deciding how best the relationship plays out financially for each party when it comes to filing taxes.

Accountants and lawyers familiar with court cases and Canada Revenue Agency rulings recommend playing it safe if you are in doubt. They describe a Canadian tax court landscape with hundreds of cases that have forced both employers and employees to refile tax returns retroactively.

Consequences may involve paying Canadian Pension Plan and employment insurance dues, giving back expenses claimed on years’ worth of personal and business tax filings and, potentially, moving into a new income tax bracket that lowers your after-tax pay from years gone by.

“You may think it’s not fair,” says George Smillie, a partner with Deloitte & Touche LLP in Van-couver. “Things may not look so black and white to you. But your tax filing can still be overturned, and it ends up costing you money because it’s overturned.”

Employers are particularly vulnerable. Sometimes a worker may prefer to be treated as a contractor so that he or she can write off various expenses related to being self-employed. But if the worker then applies for employment insurance after his or her “contract” is finished, the CRA is likely to launch an investigation. A worker cannot claim both the tax benefits of being self-employed and employment insurance benefits as an employee.

Entrepreneurs have to be careful if they pay family members. Any salary paid has to be “reasonable” for the work that is carried out. This can be an issue for any advisor with his or her own business.

“Many advisors simply write cheques for $20,000 to their spouses and write it off,” says Jamie Golombek, a chartered accountant and vice president of tax and estate planning at AIM Funds Management Inc. in Toronto.

To determine how any worker/payer relationship would be defined, the CRA’s process and the various factors involved are well described in the RC4110 document, available on the CRA Web site at www.cra-arc.gc.ca/E/pub/tg/rc4110/rc4110-e.html

The CRA applies a detailed three-step test when it examines any worker/payer relationship. If your case is scrutinized, the CRA first asks both the payer and the worker an exhaustive set of questions to establish the business relationship.

The second step aims to answer a central question: “Is the person performing services as a person in business on his or her own account, or as an employee?”

Some of the factors the CRA considers in this step include:

> the level of control the payer has over the worker — control of the hours and whether the worker can take pay from others;

> whether or not the worker provides the tools and equipment;

> whether the worker can subcontract the work or hire assistants;

> the degree of financial risk taken by the worker;

> the degree of responsibility for investment and management held by the worker; and

> the worker’s opportunity for profit.

Third, the CRA considers the intent of the parties involved: how did they mean to define the relationship in the first place?

The relationship is not defined on the basis of any one factor. “Each case has to be looked at individually,” says Smillie.

He describes the case of a carpenter’s assistant who brought his own tools to the job. By agreement, the assistant was able to work for other clients outside normal working hours. But the CRA ruled that the master carpenter was in fact an employer — partly because he was more knowledgeable and because he controlled the majority of his assistant’s normal working hours.

In another case, Smillie says, a small construction business hired a handful of subcontractors to perform certain jobs. The CRA ruled that because the subcontractors had incorporated their businesses and had taken on qualities that allowed them to profit as a separate business, they were self-employed. A single worker, who was performing essentially the same duties, however, was an employee, the CRA ruled.

Incorporation will not insulate a worker from the CRA, however, says Victor Au, a lawyer with Drache LLP in Ottawa. For example, he says, workers performing duties for a single client sometimes incorporate to take advantage of lower corporate tax rates and business write-offs. But the CRA will “look through the corporate structure” to determine if the worker would be an employee if it weren’t for the existence of the corporation, Au says. The same tests will be applied to the worker/payer relationship inside the corporation.

@page_break@Legal experts say the parties involved in ambiguous work relationships should sign contractual agreements to help define their roles and establish documentary evidence that will show what their intentions were.

“A document shows beforehand what your intentions were, and that you contemplated the issue,” Au says. IE