Legislative History
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The US legislative history of the tax rules that deal with our procedure to eliminate income tax liability is much older than the corresponding Canadian legislative history. This is because tax changes usually occur first in the United States, and then are copied to varying degrees in Canada -- decades later. So, this section will deal only with the relatively recent legislative developments in Canada. The status of the relevant law in the United States can be seen by clicking the "USA" tab in the left column of this web page. (It is the same as it is in Canada.)
Canadian Legislative History of our Procedure to Eliminate Income Tax Liability
Our twenty-five-year-old time-tested method started in 1984. At that time, Revenue Canada had already attacked many cases where personal services were provided by a corporation. Such attacks were generally made on the ground that the corporation was a sham or that the income was really that of the employee and not of the corporation.
In Canadian legislation, a "leased employee" is called an "incorporated employee," and throughout this discussion about legislation the term "incorporated employee" will be used.
However, the courts have ruled that the personal services business (incorporated employee) is a valid business arrangement: in the Federal Court of Appeal decision in The Queen v. Parsons, [1984] 2 F.C. 909, 84 DTC 6345, the Court held that to ignore the corporate structure would be to ignore the legal realities of the situation and further held that the corporation was not "sham" even though the sole purpose of the corporation was the reduction of tax.
This ruling cleared the way for employees to become incorporated employees so that they could deduct their business expenses just like an ordinary business could.
Then Section 18(1)(p) of the Income Tax Act was enacted to curtail these deductions, so that an incorporated employee could deduct only those expenses that any other employee could deduct. And Section 125(7) was enacted to prevent the personal service business from using the small business deduction for corporations.
But later, the practice developed of using the personal service business to avoid all income tax by turning a salary into a loan. Thereupon Section 80.4(1) of the Income Tax Act was enacted and "deemed interest" was imposed in perpetuity on the incorporated employee when his salary was received as a tax-free loan rather than as taxable salary.
However, Section 80.4(3) prevented the imposition of deemed interest if a fair rate of interest were charged on the loan, even if the interest were never paid, and the loan were never repaid. Moreover, the amount owing to the employee for services rendered to the personal services business is always the same as the amount owing on the loan. Consequently, there is no incentive for either the personal services business to pay the salary owing to the incorporated employee or the incorporated employee to repay the loan. So both can be left outstanding forever.
The use of this approach by a non-resident licensor of intellectual property rights is even better than it is for employees or other service providers. This is because it is not subject to the restrictions imposed by Section 80.4(1) of the Income Tax Act. (That section imposes deemed interest if the interest rate on the loan is not at least as much as a fair rate (as determined by market conditions) for that type of loan.) So, the personal-services-business concept works even better for non-resident licensors of intellectual property than it does for providers of personal services.
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