Income Deferral for Employees An Overview of Non- Registered Plans Eva M. Krasa and Maria A. Scullion Presented at the Ontario Bar Association 2002 Institute of Continuing Legal Education “Compensation Planning for Valued Employees: Tax Highlights and Hazards”, January 24, 2002 INTRODUCTION This paper provides a general overview of the income tax considerations relevant to various "non-registered" income deferral plans. The deferral of employment income is of interest to many highly paid employees. Under a properly structured income deferral plan, the employee’s liability for tax is deferred until the income is actually received by him or her. Tax deferral can ultimately result in tax savings. For example, because income levels tend to drop upon retirement, taxpayers often pay tax at a lower effective rate during their retirement years than during their employment years. From a tax viewpoint it is, therefore, desirable to defer income recognition to retirement or to a time when a taxpayer expects to have a lower effective tax rate. Not surprisingly, the Income Tax Act (Canada) 1 severely limits opportunities for tax deferral, and generally imposes strict limitations and/or 1 R.S.C. 1985, c. 1 (5 th Supplement), as amended, hereinafter referred to as the "Tax Act." All statutory references are to the Tax Act unless otherwise indicated. Borden Ladner Gervais LLP Lawyers • Patent & Trade-mark Agents www.blgcanada.com
23
Embed
Income Deferral for Employees An Overview of Non ... Estate_Planning/Income deferal... · Income Deferral for Employees An Overview of Non-Registered Plans Eva M. Krasa and Maria
This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Transcript
Income Deferral for Employees An Overview oRegistered Plans Eva M. Krasa and Maria A. Scullion Presented at the Ontario Bar Association 2002 Institute of CoLegal Education “Compensation Planning for Valued EmpTax Highlights and Hazards”, January 24, 2002
INTRODUCTION
This paper provides a general overview of the income tax cons
relevant to various "non-registered" income deferral plans. The d
employment income is of interest to many highly paid employees.
properly structured income deferral plan, the employee’s liability f
deferred until the income is actually received by him or her. Tax de
ultimately result in tax savings. For example, because income levels ten
upon retirement, taxpayers often pay tax at a lower effective rate du
retirement years than during their employment years. From a tax viewp
therefore, desirable to defer income recognition to retirement or to a tim
taxpayer expects to have a lower effective tax rate.
Not surprisingly, the Income Tax Act (Canada)1 severe
opportunities for tax deferral, and generally imposes strict limitation
1 R.S.C. 1985, c. 1 (5th Supplement), as amended, hereinafter referred to as the "Tax Act.
references are to the Tax Act unless otherwise indicated.
Lawyers •
Borden Ladner Gervais LLP
Patent & Trade-mark Agentswww.blgcanada.com
f Non-
ntinuing loyees:
iderations
eferral of
Under a
or tax is
ferral can
d to drop
ring their
oint it is,
e when a
ly limits
s and/or
" All statutory
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
• A plan with multiple purposes may be an SDA even if only one of
those purposes is tax deferral.
• An SDA may exist even where the right to receive the amount is
conditional only. As a result, a provision in the arrangement that
would require the employee to forfeit the amount unless certain
conditions are satisfied will not be sufficient to avoid the SDA rules
unless there is a substantial risk that the conditions will not be
satisfied, i.e. if there is a substantial risk of forfeiture.2
• The SDA rules do not apply to awards made with respect to
services to be rendered in a future year or in future years.
• A number of express exceptions are listed in the SDA definition
(some of which are discussed below in Part III of the paper).
Where an arrangement falls within the SDA definition, the income tax
consequences to the employee are onerous. The deferred amount is subject to
tax in the year that the right to receive the amount arises rather than in the year
that the amount is actually received.3 Furthermore, any interest or other
additional amount which accrued in the year on the deferred amount is itself
2 The Department of Finance’s Technical Notes to the Notice of Ways and Means Motion of October 31, 1986
provide some guidance as to what would constitute a substantial risk that a condition of receiving a deferred amount will not be satisfied. The Department explained the general rule as follows:
…a substantial risk of forfeiture would arise if the condition imposes a significant limitation or duty which requires a meaningful effort on the part of the employee to fulfil and creates a definite and substantial risk that forfeiture may occur.
3 See: Subsection 6(11) and paragraph 6(1)(a).
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
deemed to be a deferred amount which the person had a right to receive and is,
therefore, required to be included in the taxpayer’s income for the year.4 A
deduction is available to the taxpayer where a deferred amount that has been
included in the taxpayer’s income is later forfeited. The deduction occurs in the
taxation year in which the forfeiture occurs.5
From the employer’s perspective, an immediate deduction is permitted for
any deferred amount included in the income of the employee. Where in a
subsequent year the employee claims a deduction for a forfeited amount that has
been previously taxed, that amount is required to be added back to the
employer’s income for the year.6
Constructive Receipt
Employees are taxed, under sections 5 and 6 of the Tax Act, on income
from an office or employment. Income from an office or employment includes
“salary, wages and other remuneration, including gratuities, received by the
taxpayer in the year.” While there is little basis in Canadian case law for its
position, Canada Customs and Revenue Agency (“CCRA”) has always taken the
view that an employee has “received” an amount, for the purposes of sections 5
and 6, in the earliest taxation year in which the employee receives it or has
4 See: Subsection 6(12). An exception is provided for an SDA which is a trust since any income of the trust
would be taxable under the normal taxation rules that apply to inter vivos trusts, i.e. the income would be subject to tax in the trust unless it is payable in the year to the beneficiary, in which case the beneficiary would be subject to tax thereon.
5 See: Paragraph 8(1)(o). 6 See: Paragraphs 20(1)(oo) and 12(1)(n.2).
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
“constructively received” it because absolute enjoyment or use vests in the
employee. CCRA has summarized its views on constructive receipt as follows:
The Department considers an amount to have been received by an employee upon the earlier of the date upon which payment is made and the date upon which the employee has constructively received a payment. Constructive receipt is considered to occur in situations where an amount is credited to an employee’s debt or account, set apart for the employee, or otherwise available to the employee without being subject to any restriction concerning its use. The situation is the same following termination of employment, retirement, or death. An election to receive payment in instalments must be made before the amounts become available to the employee.7
This statement predates the introduction into the Tax Act of the SDA rules.
To some extent, the doctrine of constructive receipt has now been codified in the
SDA rules but it nevertheless remains a relevant consideration when designing
income deferral plans.8 Constructive receipt may still be invoked by CCRA in
circumstances where an arrangement falls outside the SDA definition but the
plan or arrangement allows the employee to choose whether or not to call for
payment in a particular year. However, CCRA does not generally apply the
7 See: “Revenue Canada Roundtable,” in Report of Proceedings of the Thirty-sixth Tax Conference, 1984
Conference Report (Toronto: Canadian Tax Foundation, 1985), Question 13 at 794-95. See also: Paragraph 5 of Interpretation Bulletin IT-196R2; Paragraphs 10 and 11 of Interpretation Bulletin IT-502; Technical Interpretation 1999-0007315 dated May 24, 2000; and Technical Interpretation 9821425 dated October 19, 1998.
8 CCRA has commented on the interaction of the doctrine of constructive receipt and the SDA rules as follows:
…there is an overlap in intent, that is, to currently tax amounts which the employee has earned and should have received. Although the SDA rules provide a statutory basis for this end and are broad in application,…there will be cases where constructive receipt would apply and the SDA rules could not; for example where the main reason (or reasons) for the deferral is other than to postpone taxation…(See Technical Interpretation 1999-0007315, ibid.)
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
doctrine of constructive receipt where an employee elects to defer employment
income before becoming legally entitled to the amount being deferred.9
PART II
Supplementary Pension Plans
Supplementary pension plans or, as they are commonly called,
supplementary employee retirement plans (“SERPs”) are unregistered
arrangements which provide pension benefits over and above what may be
provided under the Tax Act under a registered plan.10 Traditionally, SERPs were
established for executives only, but now are common for rank and file
employees. This increased popularity of SERPs has its genesis in the relatively
low level of benefits permitted under the Tax Act in respect of RPPs. The
maximum pension benefit permitted under a defined benefit RPP ($1,722.22 per
year of service) has been virtually unchanged for 25 years. As a result, many
more employees now have incomes which exceed the tax-assisted limits than
was previously the case.
SERPs may take a variety of forms. Accordingly, there are numerous
issues to consider when designing a SERP, including the following:
9 See: Supra note 7. 10 For a detailed discussion of various SERP related issues see the materials presented at The Canadian Institute
Conference held on May 10 and 11, 2001 entitled “Supplemental Employee Retirement Plans.” See also: The paper presented by Lyle S. Teichman entitled “The Outer Limits: Supplementary Pension Plans for Canadian Executives” presented at the Ontario Bar Association Conference From Top Hat Pensions to Stock Options held on October 29, 2001.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
From an income tax perspective, CCRA has stated that a bona fide
supplementary pension plan is not subject to the SDA rules.11 In the case of an
unfunded (pay-as-you-go) SERP, the income tax treatment is generally
straightforward. No tax is payable until such time as benefits are paid to the
employee.12 Where the SERP is funded (or secured) the income tax implications
are more complex. The remainder of this Part of the paper considers SERPs of
this nature.
The RCA Rules
The primary method of providing funding or security for the benefit
promised under a SERP is through the use of a retirement compensation
arrangement. “Retirement compensation arrangement” (“RCA”) is defined in
subsection 248(1) of the Tax Act and, in general terms, means a plan or
arrangement under which contributions are made by an employer or former
employer of a taxpayer to another person (referred to as the “custodian”) in
connection with benefits that are to be or may be received by any person on,
after or in contemplation of any substantial change in the services rendered by
the taxpayer, the retirement of the taxpayer or the loss of employment of the
taxpayer.13 Certain enumerated types of plans which are specifically provided for
11 See for example: Documents 2001-0086113 and 2001-0095493 both published on November 21, 2001; and
Technical Interpretation 1999-0007315, supra note 7. 12 See for example: Document 2001-0095493, ibid. 13 For a detailed discussion of the RCA rules see supra note 10. For a discussion of the practical issues in
administering RCAs see Marilyn Lurz, “A Practical Guide to Administering a Retirement Compensation Arrangement” (November 1996) 8 Taxation of Executive Compensation and Retirement 211.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
• Contributions made by the employee are deductible provided that
the amounts contributed by the employee do not exceed the total
contributions made by the employer in the same year.
Unlike in the case of a registered plan, the Tax Act does not impose any
investment restrictions on an RCA. Given the 50% refundable tax on all earnings
of an RCA, it is advantageous, from a purely tax viewpoint, for the RCA to hold
investments that produce little annual income or dividends but rather provide
capital growth, such as growth stocks, so that if held for a reasonably long period
of time the effects of the refundable tax are minimized.15
Letter of Credit
The 50% refundable tax payable on contributions to, and earnings of, an
RCA is a significant drawback of cash funded RCAs. As noted above, no interest
is payable by CCRA in respect of the refundable tax. An alternative to the cash
funded RCA is the secured RCA under which a letter of credit (“LOC”) is used to
secure the SERP promise. From an income tax viewpoint, the main advantage
of the secured RCA is the greatly reduced refundable tax obligation. The key
elements of a secured RCA are, in very general terms, as follows:
15 While there are no specific rules prohibiting the RCA trust from investing its after-tax funds in shares or debt of
the employer, caution should be exercised in regards to such arrangements. Depending on all of the circumstances, such arrangements may cause CCRA to question the validity of the RCA.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
• The employer pre-arranges with its bank for a LOC to be issued to
the RCA in the desired amount (based on the actuarial present
value of the benefits accrued to date under the SERP).
• The employer pays twice the amount of the issuing bank’s LOC fee
as a contribution to the RCA. One-half of this contribution is
withheld by the employer and remitted by it to CCRA on account of
the 50% RCA refundable tax.
• The trustee pays the net proceeds of the contribution to the bank
and acquires the LOC.16
• In the normal course, SERP benefits are paid directly by the
employer as they fall due, as would be the case if there were no
RCA-LOC in place. However, when an event of default occurs
(e.g., failure to renew the LOC on a timely basis; the bankruptcy or
insolvency of the employer; or failure on the part of the employer to
pay benefits) the trustee of the RCA is entitled to draw down on the
LOC and to use the net proceeds to pay the benefits. CCRA takes
the position that any payment made by the bank under the LOC
16 It is important that the trustee acquire the LOC using the net proceeds of the employer’s contribution as
opposed to the employer making a contribution in kind of the LOC to the RCA. This is because in the latter case the amount of the contribution to the RCA would be equal to the “fair market value” of the LOC. CCRA has suggested that such fair market value could be equal to the face amount of the LOC, which would result in a much higher liability for the 50% RCA refundable tax.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
constitutes a contribution to the RCA and accordingly is subject to
the 50% RCA refundable tax.17
Care should be taken as regards the granting by the employer of any
security to the issuing bank in respect of the LOC. CCRA has stated that where,
in order to secure the LOC, assets are pledged by the employer so that they are
no longer available to the general creditors of the employer, such granting of
security constitutes a further contribution to the RCA to which the 50%
refundable tax applies.18 However, where the security is in the nature of a
general floating charge only no additional contribution to the RCA is considered
to be made.19
Use of Insurance
An initial reading of the RCA definition might lead one to conclude that the
RCA rules do not apply to payments made to acquire an interest in a life
insurance policy. This is because the definition of RCA specifically excludes an
insurance policy.20 Special deeming rules apply, however, to an arrangement
involving life insurance where an employer has an obligation to provide
retirement benefits and the employer acquires an interest in a life insurance
policy that may reasonably be considered to be acquired to fund, in whole or in
17 See: Document 9418895 dated September 14, 1994, Technical Interpretation 9705065 dated April 1, 1997 and
Ruling 9718073 dated 1997. 18 See: Document 9322985 dated September 13, 1993 and Document 9322485 dated September 14, 1993. 19 See: Ruling 9706673 dated 1997. 20 See: Paragraph (m) of the RCA definition as well as the opening language of the definition.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
It is not uncommon for an employee who earns a large bonus in a year to
seek to defer receipt of all or a portion of the bonus to a subsequent year. An
explicit exception to the SDA rules allows “a bonus or similar payment” not to be
taxed until paid to an employee provided the amount is paid within three years
following the end of the year in which it is earned.23 On payment, the bonus will
be included in the employee's employment income and will be deductible to the
employer.
As a result of this exception to the SDA rules, an employee may defer the
income inclusion of a bonus or similar payment for up to three years after the
year in which the employee's services were rendered.24 Thus, the maximum
deferral period can, in effect, be up to four years from the beginning of the period
of service for which the bonus is payable. It should be noted that it is the year in
which the services are rendered by the employee and not the year in which the
bonus is awarded that is relevant in determining the permitted deferral period.
23 See: Paragraph (k) in the definition of salary deferral arrangement in subsection 248(1). 24 Some employee incentive plans base a “bonus or similar payment” on certain criteria such as the appreciation
in the employer’s stock value or the increase in sales where the bonus is based on the results of such criteria over a number of years. CCRA has been asked whether the payment may be deferred for an additional three years and still meet the criteria for the three year bonus deferral exception. CCRA has responded that the payment can not be deferred up to an additional three years and still meet the exception as the bonus relates to
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
A phantom stock plan which meets the requirements of Regulation
6801(d) to the Tax Act is an express exception to the SDA definition. By way of
background, a phantom stock plan is, in essence, a deferred bonus arrangement
under which units which correspond to the value of the employer corporation’s
shares are allocated to employees and the amount of the bonus ultimately paid
to the employee is dependant on the number of units held and the value of the
underlying shares at that time. The SDA rules must be considered in connection
with the establishment of any phantom stock plan.29 In this regard, CCRA
distinguishes between “full value” phantom stock plans where the payment is
based on the full value of the underlying shares and phantom stock plans where
the employee is entitled to receive only the increase in value of the underlying
shares (also known as stock appreciation rights plans). CCRA accepts that the
latter type of plan is not an SDA. This is because where the amount paid to the
employee is based on the increase in the value of the underlying shares the
phantom units are considered to be granted in respect of the employee’s future
services only. With respect to full value phantom stock plans, however, it is
29 Where the bonus will be paid within three years, the taxpayer may rely on the three-year bonus deferral
exception described above; however, if the payment date extends beyond three years, this exception will not apply and the potential for the application of the SDA rules must be addressed.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
• the employee is not entitled to receive, immediately or in the future,
absolutely or contingently, any amount or benefit for the purpose of
reducing the impact of any reduction in the fair market value of the
shares (i.e. there can be no “downside protection”).31
Where the plan satisfies the requirements of Regulation 6801(d), the SDA
rules will not apply with the result that there will be no income inclusion to the
employee in respect of the allocation of notional units or in respect of any
increase in the value of those units during his or her employment. Payments
received under the plan by the employee following the termination of his or her
employment will be included in income for the year in which the payments are
received as employment income. The employer will not be entitled to any
deduction until the year in which the cash amount is paid to the employee.
DSU plans have proven to be a popular compensation arrangement for
both senior executives and corporate directors. It is beyond the scope of this
paper to discuss any other type of stock based compensation arrangement
(employee stock based compensation is the subject of another paper being
delivered at this conference). However, one significant disadvantage of the DSU
plan as compared to traditional employee stock option plans should be noted. In
the case of stock option plans which meet certain conditions only one-half of the
31 For some recent examples of phantom stock plans where CCRA has ruled favourably with respect to the plan’s
qualification as a DSU plan under Regulation 6801(d) see: Rulings 9900433 and 9831833 both dated 1999 and Ruling 9821383 dated 1998. For more detailed commentary on some of the issues relating to DSU plans, see: Christina H. Medland and Ronit Florence, “Pricing of Deferred Share Units – Part I” (July/August 2000) 12 Taxation of Executive Compensation and Retirement 303 and Diana Woodhead, “Recent Rulings on Deferred Stock Unit Plans” (November 1999) 11 Taxation of Executive Compensation and Retirement 203.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion
• it is reasonable to conclude that the arrangement is established for
the purpose of funding a true leave of absence and not for the
purpose of funding retirement benefits; and
• the deferred amount, once deducted from the employee’s salary, is
either held (i) under an employee benefit plan trust34or (ii) by or for
the account of any other person35.
In addition to the provisions of Regulation 6801(a), CCRA imposes certain
administrative requirements with respect to leave of absence plans and the
documentation relating thereto. For example, CCRA requires that the employee,
once enrolled, be prohibited from withdrawing from the plan in any circumstances
except in the case of financial or other hardship.36
CONCLUSION
This paper has reviewed in general terms the income tax considerations
relevant to the deferral of employment income and has described certain of the
34 In very general terms, an employee benefit plan is an arrangement whereby an employer makes contributions
to a custodian to or for the benefit of employees. An employee benefit plan is defined in subsection 248(1). (The definition is subject to a number of exclusions. See: Interpretation Bulletin IT-502.) Under an employee benefit plan, the employer’s deduction is limited to its contributions to the plan that have been included in the income of the employee. (See: Section 32.1.) The deferral amount, therefore, is not deductible to the employer until it is paid out to the employee during the leave of absence. An amount that may reasonably be considered to be the income of the trust for a taxation year that has been earned by it for the benefit of the employee must be paid in the year to the employee.
35 To meet this requirement, the employer may simply establish a separate account as part of the general assets
of the corporation. This alternative may not provide the same security to the employee as a trust. Interest and other additional amounts that may reasonably be considered to have accrued to or for the benefit of the employee to the end of a taxation year must be paid in the year to the employee.
36 For a more detailed discussion of the requirements for qualification of an arrangement as a Regulation 6801(a) leave of absence plan, see: Elizabeth M. Brown, “Executive Sabbaticals and the Deferred Salary Leave Program” (September 1997) 9 Taxation of Executive Compensation and Retirement 24; and Lea M. Koiv, “Achieving Tax Savings Through a Deferred Salary Leave Plan,” (May 1996) 7 Taxation of Executive Compensation and Retirement 131.
Income Deferral for Employees by E.M. Krasa and M.A. Scullion