Introduction - Salary Deferral Arrangements
Employers have come up with many different ways of compensating their employees to better achieve a tax effective method of compensating employees and ensuring their loyalty. Typical objectives include tax efficiency, rewarding employee performance, improving retention of employees, and compensating employees based on the employer's financial or share value performance. One major legal constraint on the design of employment compensation arrangement is that if any arrangement meets the Income Tax Act's definition of a salary deferral arrangement then it can unexpectedly change the timing of when the employee includes the compensation in their taxable income and the employer's payroll compliance obligations.
Timing of Employment Income and Deductions - Salary Deferral Arrangements
Most forms of employment compensation are included as income in the year in which they are paid to the employee. There are several exceptions to this general rule, one of which is related to salary deferral agreements as described below, which requires employees to include compensation amounts in their income before those amounts are paid. Another major exception is for stock options granted to an employee.
One general principle guiding when a business expense is deductible is that an expense is normally deductible in the year in which the business acquires an unconditional legal liability to pay that expense, even if the date the business is required to make the payment falls in a later year. This general principle applies to the expense associated with compensating employees but is subject to an anti-avoidance rule.
Another general principle the influences the timing of business expenses are that businesses are required to use an accounting system, including accounting for expenses, that produces an accurate picture of their annual profit for each tax year through the application of well-accepted business principles. The annual profit for a business is a "net" concept that involves setting the revenues associated with that year against the expenses associated with that year. Accounting standards and principles can supply well-accepted business principles that may aid in producing an accurate picture of profit, but are they do not hold the status of rules of law or legal principles. The Income Tax Act also contains many specific expense timing rules that taxpayers must follow even if they are contrary to well-accepted business principles.
For example, there is a principle of accounting that a business should report specific a expense on its income statement for the period in which revenue associated with that specific expense is reported. This matching principle would suggest that a sales commission expense should be reported on the same income statement as the revenue from the sale that gave rise to the commission. This principle is commonly used by taxpayers in computing their annual profit for Canadian taxation purposes. In the tax context the principle suggests that an expense (or appropriate portion of an expense) should be claimed as a deduction in the same tax year that related revenue is recognized. As described above, this matching principle is not a legal rule and is only one well-accepted principle of business practice among many that are taken into consideration when evaluating whether a taxpayer's accounting method produces an accurate picture of profit. Notably, in Canderel Ltd. v. Canada the Canada Revenue Agency's attempt to attack the taxpayer's decision to deduct its full tenant inducement expense when incurred instead of amortizing the expense was ultimately unsuccessful.
For salaries, wages, bonuses and most other types of employment compensation, if an employer has not paid an employment expense incurred in a tax year within 180 days after the end of that tax year, then the expense will instead be deemed to have incurred in the tax year in which the employment amount is paid. This means that it is possible for the employee to defer the tax payable from some types of employment income up to one year after the employer is able to reduce its tax payable for incurring its corresponding employment expense.
As the timing of an employment income and expense can have a significant impact on the tax positions of both employees and employers, it is important to consult an experienced Canadian tax lawyer to avoid tax traps.
Income Tax Act Statutory Definition - Salary Deferral Arrangements
A salary deferral arrangement is any plan or arrangement, subject to specific exceptions, under which a person has a right in a particular year to receive an amount after the particular year where:
- It is reasonable to consider that one of the main purposes for the creation of existence of the right is to postpone income tax payable to a taxpayer in respect of an amount that is or is a substitute for salary or wages for services rendered in the particular year or a preceding year by the taxpayer; and
- The right is not subject to a condition or conditions where there is a substantial risk that at least one condition will be satisfied.
There are specific exceptions to this statutory definition which include the following:
- a registered pension plan,
- a pooled registered pension plan,
- a disability or income maintenance insurance plan under a policy with an insurance corporation,
- a deferred profit sharing plan,
- an employees profit sharing plan,
- an employee trust,
- an employee life and health trust,
- a group sickness or accident insurance plan,
- a supplementary unemployment benefit plan,
- a vacation pay trusts which meet certain requirements,
- a plan or arrangement the sole purpose of which is to provide education or training for employees of an employer to improve their work or work-related skills and abilities,
- a plan or arrangement established for the purpose of deferring the salary or wages of a professional athlete for the services of the athlete as such with a team that participates in a league having regularly scheduled games,
- a plan or arrangement under which a taxpayer has a right to receive a bonus or similar payment in respect of services rendered by the taxpayer in a taxation year to be paid within 3 years following the end of the year, or
- a plan or arrangement specifically exempted from the definition of "salary deferral arrangement" in the Income Tax Regulations.
Many of the above specific exceptions require that the plan or arrangement meet other specific legislative requirements for the exception to apply. For example, an employee profit sharing plan is a technical term in Canadian income tax law and there are specific requirements that must be met for a plan that involves sharing profits with employees to qualify as an employee profit sharing plan.
As of July 2020, the Income Tax Regulations contain explicit exceptions to the salary deferral arrangement rules for:
- sabbatical arrangements,
- deferred salary arrangements for certain on-ice officials of the National Hockey League, and
- deferred share unit plans.
When designing a compensation arrangement or plan, it is essential to consult with an expert Toronto tax lawyer to ensure that your plan does not qualify as a salary deferral arrangement.
Tax Consequences - Salary Deferral Arrangements
Employees who are entitled to a payment in a future year under a salary deferral agreement in a future year are required to include the full amount of the future payment in their income in the tax year in which they received the right to the future payment. In addition, to the extent interest or similar accrues with respect to the future payment, then the employee entitled to that payment must included the interest in his or her income in the year the interest accrues. This means that the employees must pay income tax on payments under the salary deferral arrangement years ahead of when the employees actually receive the payments. Employees who do not realize the consequences of being entitled to compensation under a salary deferral agreement are at risk of underreporting their income and being subject to significant tax penalties and unexpected tax liability and related interest as a result.
Employers administering a salary deferral agreement are entitled to a deduction for any "deferred amount" under a salary deferral arrangement in the tax year of the employer in which the tax year of the employee ends where the amount is included in the relevant employee's income. This means that the employee's income inclusion and employer's deduction are matched as closely as possible and correspond to when the employee gets the right to the future payment and not to when the future payment is made. Employers must also take care to include deferred compensation amounts in employee's income for the purposes of filing T4 information returns or they may be subject to penalties. Significant care must also be taken by employers when determining the correct amount to withhold from payments to employees when a salary deferral arrangement is in play.
Pro Tax Tips - Salary Deferral Arrangements
Compensation plans are subject to complex legal rules and requirements imposed by Canadian tax law. Employers should always consult with a top Canadian tax lawyer when designing or implementing new compensation plans. Compensation plans should almost always be designed so as not to be salary deferral arrangements and ensuring that hurdle is avoided requires significant care and expertise.
In the event that a compensation plan that was not intended to be a salary deferral arrangement turns out to be one, taxpayers should consult with an expert Toronto tax lawyer as to whether a voluntary disclosure application is appropriate to attempt to reduce interest and penalties associated with the error and to whether it is possible to apply to a court to rectify the compensation plan.
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.