A look at the tax implications of offering employees flexible benefits
Properly designed, a flexible benefits plan offers the dual advantage of delivering employee benefits with maximum flexibility and tax effectiveness. However, if the plan design runs afoul of the Income Tax Act, employees and employers may suffer adverse tax consequences.
Granting flex credits to employees will not confer a taxable benefit, provided certain criteria are met. When an employee uses flex credits to select options under the plan, she may receive a taxable benefit, depending on the option chosen.
Flex benefits are just like benefits provided under a traditional benefits plan in terms of taxability (see "Related articles" below for information on benefits and taxes).
Plan design should ensure that nothing triggers a taxable benefit at the time the credits are conferred, and that employees understand which benefits are taxable.
Maintaining flex status
Timing of benefit selections: The Canada Customs and Revenue Agency (CCRA) is opposed to selections that have retroactive effect. Make sure benefit choices are made in advance of the plan year to which they relate, or they will be recognized as taxable income.
Irrevocability of selections: Benefit choices must be irrevocable by the employee for the duration of the plan year. There are two exceptions: the occurrence of a “life event” and a change in employment status. A life event will be defined in the plan, but it generally includes the birth or death of a dependant, a change in marital status or the loss of insurance coverage under a spouse’s employer’s plan.
A change in status would include, for example, moving from part-time employment to full time, in which case an employee may be eligible for additional flex credits. The employee may modify a benefits selection, provided that the change only applies to the future.
Characterization as another arrangement: Features of a flexible benefit plan may inadvertently fall within the definition of other arrangements defined under the Income Tax Act. The end result could be tax consequences to the plan sponsor, as well as employees, even though the benefits payable will be tax exempt.
Check the definitions of the following arrangements/plans in the Income Tax Act to ensure they don’t apply to your flexible benefits plan: salary deferral arrangement, retirement compensation arrangement, employee benefit plan, employee trust.
Health care spending accounts
Most flex plans include a health care spending account (HCSA). (Ninety per cent of respondents to Hewitt Associates’ 2002 survey Flex-ability: Employer Attitudes toward Flexible Benefits offered an HCSA as part of a flexible benefits program.
The HCSA is used for the payment of medical, dental or vision benefits not covered under an employer’s basic medical plan. An HCSA must qualify as a “private health services plan.” It can only be used to pay “medical expenses” as defined in the Income Tax Act, and a one-year carry-forward of unused credits or unclaimed expenses is allowed, but not both.
If the HCSA does not qualify as a private health services plan, benefits received will be taxable.
Salary reduction
Whenever a flex plan incorporates a salary reduction element, it’s sure to attract attention from the CCRA. Suppose employees have the choice to voluntarily receive 98 per cent of pay and the remaining two per cent as (additional) flex credits.
The two per cent will be taxable because it is a cash entitlement which the employee has decided to direct to the flex plan. If, on the other hand, an employer unilaterally (no employee choice) reduces employees’ pay by two per cent and the two per cent is used to provide flex credits, this may constitute a change to the employment contract and not be subject to tax. (The same arrangement may be used with bonuses or future salary increases.) This is a tricky area, however. Bulletin IT 529 contains CCRA’s policy statement on this issue. (See "Related articles" below for a copy of the bulletin.)
Vacation trading
Vacation buying is a more prevalent option in flex plans than vacation selling. (The Flex-ability survey found 31 per cent of respondents offer vacation buying, while only 20 per cent offer vacation selling.) One reason is likely the CCRA position on vacation selling. If employees sell vacation in exchange for flex credits, the amount credited to the plan is a taxable benefit immediately, even though the flex credits have not been used.
On the other hand, if an employee uses flex credits to purchase additional vacation time, there is no taxable benefit. The only caveat is that the extra vacation time must be used in the year in which it is acquired.
Taxation of individual benefits
Employees should understand that certain benefits are taxable and, if they choose these options, they will receive a taxable benefit. The following points summarize the taxability of some common options under flex plans:
•premiums paid by an employer to an insurance company to provide medical benefits to employees are not taxable to employees;
•medical benefits are non-taxable, as long as they are “medical expenses” under the Income Tax Act and the plan is characterized as a private health services plan — dental and vision care benefits are included in the definition of medical benefits, provided the procedures are incurred for medical reasons;
•medical benefits are taxable in Quebec;
•employer-paid premiums for life insurance are taxable benefits;
•life insurance benefits paid on death are not taxable to the beneficiary;
•neither premiums paid for accidental death and dismemberment coverage nor benefits paid out are taxable to employees; and
•long-term disability benefits are taxable if paid from an employer-funded plan, but not if paid from an employee-funded plan.
Payments to registered plans
When an employee chooses, prior to the beginning of the plan year, to receive a portion of her flex credits in cash or deposited to an RRSP, that amount is included in the employee’s income as soon as it is received or deposited. The employee is entitled to a deduction in accordance with the rules governing RRSPs, however.
Because flex credits are considered employer dollars, they may be deposited into a deferred profit sharing plan or money purchase pension plan. In this case, they would be treated as an employer contribution to the plan.
Retiree benefits
The Flex-ability study indicated that, while most organizations today do not offer flex to retirees, 19 per cent of respondents plan to extend flex to retirees. It’s important for retirees to realize that the benefits they will receive will be subject to the same income tax treatment as those received by employees. For example, life insurance coverage is taxable for retirees. Medical insurance coverage is not taxable, except in Quebec.
Tax effectiveness can be achieved in any flexible benefits plan, provided care is taken in plan design and the implications are communicated successfully to employees.
Christopher Newton is a lawyer and the head of Hewitt Canada’s legal group. He may be contacted at (416) 225-5001 or [email protected].
Granting flex credits to employees will not confer a taxable benefit, provided certain criteria are met. When an employee uses flex credits to select options under the plan, she may receive a taxable benefit, depending on the option chosen.
Flex benefits are just like benefits provided under a traditional benefits plan in terms of taxability (see "Related articles" below for information on benefits and taxes).
Plan design should ensure that nothing triggers a taxable benefit at the time the credits are conferred, and that employees understand which benefits are taxable.
Maintaining flex status
Timing of benefit selections: The Canada Customs and Revenue Agency (CCRA) is opposed to selections that have retroactive effect. Make sure benefit choices are made in advance of the plan year to which they relate, or they will be recognized as taxable income.
Irrevocability of selections: Benefit choices must be irrevocable by the employee for the duration of the plan year. There are two exceptions: the occurrence of a “life event” and a change in employment status. A life event will be defined in the plan, but it generally includes the birth or death of a dependant, a change in marital status or the loss of insurance coverage under a spouse’s employer’s plan.
A change in status would include, for example, moving from part-time employment to full time, in which case an employee may be eligible for additional flex credits. The employee may modify a benefits selection, provided that the change only applies to the future.
Characterization as another arrangement: Features of a flexible benefit plan may inadvertently fall within the definition of other arrangements defined under the Income Tax Act. The end result could be tax consequences to the plan sponsor, as well as employees, even though the benefits payable will be tax exempt.
Check the definitions of the following arrangements/plans in the Income Tax Act to ensure they don’t apply to your flexible benefits plan: salary deferral arrangement, retirement compensation arrangement, employee benefit plan, employee trust.
Health care spending accounts
Most flex plans include a health care spending account (HCSA). (Ninety per cent of respondents to Hewitt Associates’ 2002 survey Flex-ability: Employer Attitudes toward Flexible Benefits offered an HCSA as part of a flexible benefits program.
The HCSA is used for the payment of medical, dental or vision benefits not covered under an employer’s basic medical plan. An HCSA must qualify as a “private health services plan.” It can only be used to pay “medical expenses” as defined in the Income Tax Act, and a one-year carry-forward of unused credits or unclaimed expenses is allowed, but not both.
If the HCSA does not qualify as a private health services plan, benefits received will be taxable.
Salary reduction
Whenever a flex plan incorporates a salary reduction element, it’s sure to attract attention from the CCRA. Suppose employees have the choice to voluntarily receive 98 per cent of pay and the remaining two per cent as (additional) flex credits.
The two per cent will be taxable because it is a cash entitlement which the employee has decided to direct to the flex plan. If, on the other hand, an employer unilaterally (no employee choice) reduces employees’ pay by two per cent and the two per cent is used to provide flex credits, this may constitute a change to the employment contract and not be subject to tax. (The same arrangement may be used with bonuses or future salary increases.) This is a tricky area, however. Bulletin IT 529 contains CCRA’s policy statement on this issue. (See "Related articles" below for a copy of the bulletin.)
Vacation trading
Vacation buying is a more prevalent option in flex plans than vacation selling. (The Flex-ability survey found 31 per cent of respondents offer vacation buying, while only 20 per cent offer vacation selling.) One reason is likely the CCRA position on vacation selling. If employees sell vacation in exchange for flex credits, the amount credited to the plan is a taxable benefit immediately, even though the flex credits have not been used.
On the other hand, if an employee uses flex credits to purchase additional vacation time, there is no taxable benefit. The only caveat is that the extra vacation time must be used in the year in which it is acquired.
Taxation of individual benefits
Employees should understand that certain benefits are taxable and, if they choose these options, they will receive a taxable benefit. The following points summarize the taxability of some common options under flex plans:
•premiums paid by an employer to an insurance company to provide medical benefits to employees are not taxable to employees;
•medical benefits are non-taxable, as long as they are “medical expenses” under the Income Tax Act and the plan is characterized as a private health services plan — dental and vision care benefits are included in the definition of medical benefits, provided the procedures are incurred for medical reasons;
•medical benefits are taxable in Quebec;
•employer-paid premiums for life insurance are taxable benefits;
•life insurance benefits paid on death are not taxable to the beneficiary;
•neither premiums paid for accidental death and dismemberment coverage nor benefits paid out are taxable to employees; and
•long-term disability benefits are taxable if paid from an employer-funded plan, but not if paid from an employee-funded plan.
Payments to registered plans
When an employee chooses, prior to the beginning of the plan year, to receive a portion of her flex credits in cash or deposited to an RRSP, that amount is included in the employee’s income as soon as it is received or deposited. The employee is entitled to a deduction in accordance with the rules governing RRSPs, however.
Because flex credits are considered employer dollars, they may be deposited into a deferred profit sharing plan or money purchase pension plan. In this case, they would be treated as an employer contribution to the plan.
Retiree benefits
The Flex-ability study indicated that, while most organizations today do not offer flex to retirees, 19 per cent of respondents plan to extend flex to retirees. It’s important for retirees to realize that the benefits they will receive will be subject to the same income tax treatment as those received by employees. For example, life insurance coverage is taxable for retirees. Medical insurance coverage is not taxable, except in Quebec.
Tax effectiveness can be achieved in any flexible benefits plan, provided care is taken in plan design and the implications are communicated successfully to employees.
Christopher Newton is a lawyer and the head of Hewitt Canada’s legal group. He may be contacted at (416) 225-5001 or [email protected].
