In 2004, I provided a technical review of employees profit sharing plans ("EPSPs") as part of a paper that I wrote for the Canadian Tax Foundation. The 2012 Federal Budget significantly changed the game. Accordingly, I thought it might be time to update my 2004 analysis.
The use of EPSP in Canadian owner-manager remuneration planning has become very common over the recent past. Accordingly, the purpose of this blog is to comment on certain issues that must be reviewed to ensure technical integrity when utilizing EPSPs in owner-manager remuneration planning, and discuss 2012 recent Budget changes.
B. Definition of EPSP
An EPSP is defined in the Income Tax Act (the "Act") to be an arrangement under which payments computed by reference to an employer's profits from the employer's business (or a corporation that does not deal at arm's length with the employer) are required to be made by the employer to a trustee under the arrangement for the benefit of employees of the employer or of a corporation with which the employer does not deal at arm's length. The definition of an EPSP also requires that the trustee of the EPSP annually allocates to the beneficiaries all amounts (i.e. before December 31 of each calendar year) received by the EPSP from the employer, or from a corporation with which the employer does not deal at arm's length, any profits from property realized by the trust, and any capital gains or losses of the trust.. The employee beneficiary of the EPSP includes the amounts in his/her income that are contingently, or absolutely, allocated to the employee by the trustee of the EPSP at any time in the year.
An EPSP trust is an inter vivos trust. Normally, any income realized by an inter vivos trust would be subject to the highest rate of tax on such income. However, no tax is payable by a trust on the taxable income of the trust for a taxation year throughout which the trust is governed by an EPSP.
One key component that must be met with respect to the definition of EPSPs is that the payments which are required to be made by the employer to the trustee must be computed by reference to an employer's profits from the employer's business. In the absence of certain relieving provisions, one could speculate as to what the phrase "profits" means. For example, does "profits" mean profits as outlined in section 9 of the Act? Must profit be calculated using generally accepted accounting principles? Alternatively, must the principles as outlined in recent Supreme Court of Canada cases dictate the computation of profit? One can therefore expect that it would become a question of fact as to whether or not a particular payment from an employer to an EPSP would be considered to be by reference to the employer's profits.
Subsection 144(10) of the Act is a provision that will deem an arrangement under which an employer makes payments to a trustee whereby the arrangement specifically provides for payments to be made "out of profit" to have met the requirement that payments are computed by reference to the employer's profits to the extent that the employer elects in prescribed manner. Such a deeming provision can provide considerable flexibility and a relieving opportunity where the trustee of the EPSP does not want to be constrained by an otherwise rigid formula. The election will allow a plan to qualify as an EPSP even though the payments are not computed by reference to profits if the payments are limited by the level of profits.
C. Deductibility Of Employer Contributions To An EPSP
An amount paid by an employer to a trustee under an EPSP is deductible by the employer if the payment is made during the year, or is made within 120 days after the taxation year to the extent that it was not deductible in computing income for a previous taxation year. As compared to a bonus that would otherwise be paid to the individual shareholder, the bonus payable must be paid within 179 days of the employer corporation's taxation year end in order to be deductible.
A common issue that must be considered whenever an employer corporation makes contributions to an EPSP, is whether or not the contribution is subject to the reasonableness provisions of section 67 of the Act. Whether or not an employer contribution to an EPSP is subject to the limitation provisions of section 67 but granted relief under the CRA's administrative policy has been the subject of debate over the years. The CRA has commented in numerous Technical Interpretations that their belief is that an employer contribution to an EPSP is subject to the reasonableness provisions of section 67. Many tax authors are also of the view that contributions to an EPSP by an employer are also subject to a reasonableness test as outlined in section 67.
D. Allocations To Employee Beneficiaries
As outlined in the definition of EPSP, the employee beneficiaries must be allocated, either contingently or absolutely, amounts no later than the end of the taxation year in which the contributions to the EPSP were made. To the extent that a beneficiary meets the definition of an employee, the trustee will allocate amounts to the beneficiary using its discretion. Are amounts allocated by the trustee subject to the reasonableness provisions of section 67? Again, this issue has been the subject of debate over the years. However, a careful review of section 67 reveals a technical argument that section 67 should not apply to the allocation by the trustee to the employee beneficiaries. At face value, this would appear to open the door to income splitting opportunities with other family employee beneficiaries of the EPSP. To the extent that the family employee beneficiaries of the EPSP are at lower marginal income tax rates than that of the principals, income tax savings could occur, prior to the 2012 Federal Budget, to the extent that amounts were allocated out to such lower income employee beneficiaries. However, caution should always have been the norm with this type of planning.
E. Source Withholdings
Subsection 153(1) of the Act requires the withholding of income tax for certain amounts paid by payors. A review of subsection 153(1) reveals that amounts paid by an employer to an EPSP, and allocations made by an EPSP to employee beneficiaries, are not captured by the withholding requirements.
The requirement to withhold CPP is created under the CPP Act. Under subsection 21(1) of the CPP Act, every employer paying remuneration to an employee employed by the employer in pensionable employment must deduct and remit the employee's CPP contribution for the year. The CRA has taken the position that allocations to a beneficiary from an EPSP are not subject to CPP withholding.
The obligation to withhold EI premiums is created in the EI Act. Pursuant to subsection 82(1) of the EI Act, every employer paying remuneration to a person they employ in insurable employment must deduct and remit the employee's EI premium. Using the CRA's logic, there should be no EI withholdings on allocations to an employee from an EPSP, given that an allocation is not a "payment."
Hence, prior to the 2012 Federal Budget, some practitioners designed owner-manager remuneration so that the owner-manager is remunerated wholly through employer contributions to an EPSP so as to avoid withholding requirements such as income tax, CPP and EI. For plans designed to avoid CPP and EI withholdings entirely, all of the owner-manager's remuneration would have to be directed through an EPSP. This leads to an obvious question as to whether or not such a position would be challenged by the CRA. The CRA has opined in some Technical Interpretations that whether or not the payment of an employee's total remuneration through an EPSP is acceptable is a question of fact.
Some practitioners have also suggested that an EPSP be established for the benefit of the sole shareholder of the owner-manager corporation. Although the EPSP definition does not exclude this possibility, the CRA has called into question the legitimacy of such an approach. Accordingly, caution should also be exercised with this type of planning.
F. Income Tax Deferral Opportunities
Given the above framework, it should now be apparent that, prior to the 2012 Federal Budget, income tax deferral opportunities could arise with careful planning. The use of an EPSP could result in a greater deferral of taxes for the employee or owner-manager of a CCPC than would have otherwise been possible with the declaration of a bonus. An EPSP could potentially provide a tax deferral of one year beyond which would have been achieved through the accrual of a bonus. The deferral of federal and provincial income tax, and the non-withholding of CPP, and EI premiums, would result in more funds in the employee's hands for a longer period of time, thus allowing greater investment returns on such retained funds.
Consider the situation of Mr. Apple and Opco. Mr. Apple is the sole shareholder of Opco. Opco wishes to obtain a deduction for its taxation year ending December 31, 2011 and, accordingly, accrues a bonus at this year-end date. Opco will therefore obtain a deduction for the year ending December 31, 2011 assuming that the bonus is paid within 179 days of the corporation's year-end. Accordingly, Federal and Provincial income taxes in addition to CPP and EI will have to be remitted by the corporation on the accrued bonus within approximately six months of December 31, 2011.
If, on the other hand, Opco makes a similar payment to an EPSP, the amount of money allocated to the respective employee(s) would be taxable in the 2012 calendar year (to the extent that the payment was made to the EPSP in the 2012 calendar year and no later than 120 days after December 31, 2011), but the taxes need only be remitted by the employee when the employee files his/her 2012 personal income tax return due by April 30, 2013 – a considerable deferral and advantage for the employee. However, the employee may be required to make personal tax installments into the future.
G. 2012 Federal Budget Changes
As discussed in our 2012 Federal Budget blog, Budget 2012 targets "excess EPSP amounts" paid to a specified employee (defined as an employee who owns 10% of the shares of the employer or a related person). An "excess EPSP amount", computed by reference to new Part XI.4, will be the subject of a new tax computed under that Part. Generally, the new Part XI.4 tax will be computed by reference to the highest rate of Federal and provincial tax (with the exception of Quebec). An employee in receipt of an excess EPSP amount will be entitled to a deduction under section 8 of the Act. This mechanism appears intended to ensure that an excess EPSP amount is not taxed under Part I of the Act but rather new Part XI.4. Excess EPSP amounts are amounts allocated from an EPSP to the specified employee that exceed 20% of the specified employee's salary from the corporation in the year.
For example, consider the example again of Mr. Apple and Opco. Mr. Apple would be considered a "specified employee" of Opco. If Mr. Apple's yearly salary from Opco is $100,000, any EPSP amounts in excess of $20,000 received by Mr. Apple would be subject to the new Part XI.4 tax.
As mentioned above, owners could often avoid paying CPP and EI by paying themselves a salary of a nominal amount from their corporation and receive the balance of their compensation by having the corporation contribute to an EPSP and receive allocations from it. The 2012 Budget proposal should deter an owner of a business from doing this in the future (assuming they have a significant equity interest in the business) since the excess EPSP amounts of the allocation from the EPSP would be subject to the special tax at the highest marginal tax rate.
Bottom line, it would appear that much of the mischief involving EPSPs and owner-manager remuneration planning (income splitting with minor children or other non-arm's length persons and CPP/EI avoidance) will end and many EPSPs will now likely need to be wound down.
H. Cross-border Issues
For US citizens who are residents of Canada, EPSPs can provide significant complications. While beyond the scope of this blog, a careful review of the terms of the EPSP and the distributions to the US citizen resident in Canada would need to be completed in order to determine any adverse tax and reporting requirements.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.