Income Deferral for Employees An Overview of Non ... Estate_Planning/Income deferal... · Income...

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.

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Income Deferral for Employees by E.M. Krasa and M.A. Scullion


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2

conditions in respect of the plans which permit income deferral. The tax deferral

vehicles available to employees under the Tax Act may be divided into two types:

"registered” plans and "non-registered” plans. Employees often use both types

of plans in an effort to maximize tax deferral opportunities.

Registered plans include registered retirement savings plans (“RRSPs”),

registered retirement income funds, deferred profit sharing plans and registered

pension plans (“RPPs”). The Tax Act sets out a complex and detailed regime for

each of the various registered plans. Such plans are not the topic of this paper.

Rather, the paper focuses on non-registered income deferral plans. Each of the

plans discussed could be the subject of its own paper. The paper, therefore,

explains the plans in general terms only and directs the reader to other sources

for more detailed analysis.

There are two overarching concerns which must be taken account of when

implementing a non-registered income deferral plan: the doctrine of constructive

receipt and the rules in the Tax Act relating to salary deferral arrangements.

Being "off-side" either of these can result in immediate taxation to the employee

of the income being deferred. The doctrine of constructive receipt and the salary

deferral arrangement rules are discussed in Part I of the paper. The remainder

of the paper discusses different types of non-registered income deferral plans.

Part II considers plans which are in the nature of supplemental pension plans. A

supplemental pension plan is essentially a plan or arrangement which provides

benefits upon or after retirement which are in addition to those provided to the




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employee under a registered pension plan. Part III of the paper then describes

some other types of income deferral plans which are statutory exceptions to the

salary deferral arrangement rules.

PART I

As mentioned in the Introduction, opportunities to defer the recognition of

employment income are limited by the doctrine of constructive receipt and the

salary deferral arrangement rules. Each of these concepts and their implications

in the context of income deferral plans are discussed separately below.

Salary Deferral Arrangement

The Tax Act was amended in 1986 to add the salary deferral arrangement

rules, which are designed to prevent the deferral of compensation where the

deferral is for the purpose of postponing income tax. A salary deferral

arrangement (“SDA”) is defined in subsection 248(1) of the Tax Act. The

definition is broadly drafted and, in general terms, means any arrangement,

whether funded or unfunded, under which any person has the right in a taxation

year to receive an amount after the year where it is reasonable to consider that

one of the main purposes for the creation or existence of the right is to postpone

tax payable under the Tax Act by the taxpayer in respect of salary or wages for

services rendered by the taxpayer in the year or a preceding year. A number of

points merit mention:




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• 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).




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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).




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“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.)




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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.




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• Participants: Who will be eligible to participate in the SERP (e.g.

executives only or also rank and file employees)?

• Benefit Formula: What formula or criteria will be used to determine

a participant’s benefit (e.g. will the formula mirror that of the

underlying RPP; will a defined benefit or a defined contribution

formula be used)?

• Funded vs. Unfunded: Will the pension promise be funded or

otherwise secured or will it be “unfunded?”

• Vesting: When will a participant's entitlement to receive amounts

under the SERP vest (e.g. will the vesting requirements mirror

those of the underlying RPP or will they be more onerous)?

• Payment of Benefits: How will the benefits under the SERP be

paid (e.g. for life or for a fixed period of years; periodically at the

same time as payments are made under the RPP or on some other

basis)? Will the payment of benefits be subject to any conditions

(e.g. compliance with non-competition covenants or the provision of

periodic consulting services)?

• Documentation: What documents are needed to articulate the

SERP promise and to otherwise formalize the arrangement?




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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.




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in the Tax Act (e.g., RPPs, employees profit sharing plans, deferred profit sharing

plans and RRSPs) are excepted from the RCA definition.

The income tax rules applicable to RCAs may be summarized as follows:

• Contributions made by the employer to the RCA are immediately

deductible to the employer (subject to the usual reasonableness

test).

• Contributions to the RCA and the annual income of the RCA

(including the full amount of any capital gains) are subject to a 50%

refundable tax. The tax on contributions is required to be withheld

by the employer and remitted directly to CCRA. The custodian of

the RCA is responsible for remitting in each year any balance of

refundable tax owing by the RCA.14

• The tax is refunded to the RCA when benefits are paid out of the

RCA (at retirement, termination of employment or death) at the rate

of one dollar for every two dollars of benefits paid.

• The refundable tax does not earn any interest while held by CCRA.

• The RCA beneficiary is subject to tax on benefits from the RCA in

the year that benefits are received.

14 The 50% refundable tax rate was designed to approximate the top personal marginal tax rate for individuals. As

a result, however, of reductions in personal tax rates in recent years, the 50% rate now exceeds the top personal tax rate in most provinces.




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• 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.




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• 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.




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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.




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part, those benefits. Subsection 207.6(2) provides that in these circumstances an

RCA is deemed to exist. The employer who acquires the interest in the life

insurance policy is deemed to be the custodian of the RCA and the interest in the

policy is deemed to be subject property of the RCA. Two times the premiums

paid for the policy (as well as any policy loan repayments) are deemed to be

contributions to an RCA. As a result, the employer is required to remit on

account of the 50% RCA refundable tax an amount equal to the premium paid for

the life insurance policy but will be entitled to a deduction equal to the amount of

the tax and the premium.

The above-described situation should be distinguished from that where an

already established RCA trust uses its after-tax funds to purchase a life

insurance policy. This type of policy investment is not subject to the rules in

subsection 207.6(2) since the regular RCA rules will apply to the arrangement.

The life insurance policy will usually be one which qualifies as an “exempt” policy.

The growth within an exempt insurance policy is not subject to annual accrual

taxation.21 If the policy is held until the death of the life insured, the proceeds

may be received by the RCA trust free of tax. When, however, the proceeds are

used to make payments out of the RCA trust to the beneficiary, tax will be

payable by the beneficiary in respect of such payments.22

21 See: Subsection 12.2(1). 22 The use of split dollar life insurance policies and other more complex insurance arrangements in the context of

RCAs are beyond the scope of this article. For a discussion of such issues, see supra note 10.




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PART III

Other Income Deferral Plans

Three Year Bonus Deferral

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




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The Tax Act does not define “a bonus or similar payment.” A bonus,

however, is generally considered to be something that is in addition to, or in

excess of, that which is ordinarily received.25 Whether a particular payment to an

employee is “a bonus or similar payment” is a question of fact. CCRA generally

takes the view that “a bonus or similar payment” would only include those

payments that have the characteristics of a bonus, i.e. a payment in addition to

that which would normally be received by an employee for services rendered.26

For example, CCRA has said that it would not typically consider amounts

received in respect of overtime to be similar to a bonus as an employee who

works overtime would normally be entitled to receive payment for that work.27

In addition to deferring the taxation of the bonus, an employee may also

defer taxation of the amount of any interest that accumulates on the bonus.

Under the interest accrual rules, taxpayers are generally required to include any

accrued interest with respect to an “investment contract” in income for the year

that the interest accrued.28 The interest accrual rules, however, do not apply to

arrangements that qualify for the three year bonus deferral. Such arrangements

are excluded from the definition of “investment contract” because of the definition

of that term in subsection 12(11).

services rendered in more than one taxation year. See: Income Tax Technical News No. 7 dated February 21, 1996.

25 See: Great Western Garment Co. Ltd.v. M.N.R., [1947] 3 D.T.C. 1055 Ex.Ct. at 1059; aff’d [1949] 49 D.T.C. 526 (S.C.C.). 26 See for example: Document 9222235 dated September 8, 1992. 27 See: Ibid and Memo 9709717 dated May 27, 1997. 28 See: Subsection 12(4).




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Deferred Stock Unit Plan

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.




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CCRA’s view that the phantom units are granted in respect of the employee’s

past services and the SDA rules will generally apply.30

A deferred stock unit plan (“DSU plan”) is a type of full value phantom

stock plan that is specifically excluded from the SDA definition. The

requirements for a DSU plan are set out in Regulation 6801(d) to the Tax Act.

The plan must be an arrangement in writing between a corporation and an

employee of the corporation (or of a related corporation) where:

• the employee may receive an amount that is reasonably

attributable to the duties of the employee’s office or employment;

• the amount that may be received by the employee under the

arrangement will be received after the termination of employment

(including death or retirement) but no later than the end of the first

calendar year commencing after such termination;

• the amount that may be received depends on the fair market value

of shares of the capital stock of the corporation (or a related

corporation) at a time within the period that commences one year

before the termination of employment and ends at the time the

amount is received; and

30 See: “Revenue Canada Roundtable,” in Report of Proceedings of the Fortieth Tax Conference, 1988

Conference Report (Toronto: Canadian Tax Foundation, 1989) Question 26 at 53:44; Technical Interpretation 1999-0007315, supra note 7; ATR-45 dated February 17, 1992.




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• 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.




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benefit is subject to tax32 and as well, in certain circumstances, the taxation of all

or a portion of the benefit may be deferred until disposition of the stock.33 In

contrast, the full amount of any cash payment received under a DSU plan is

subject to tax as employment income.

Leave of Absence Plans

A leave of absence plan (also known as a “sabbatical leave plan” or

“deferred salary leave plan”) is another prescribed exception to the SDA rules

allowing for the deferral of income. Provided the leave of absence plan conforms

to certain conditions, which are described below, the arrangement will allow for

income to be deferred to a period during which the employee will be on a leave of

absence from his or her employment. Such plans are found most often in the

public sector, especially in educational institutions, but are also sometimes found

in the private sector, particularly at the executive level.

Pursuant to Regulation 6801(a) to the Tax Act, a leave of absence plan

which meets the following requirements is not subject to the SDA rules:

• the plan between the employer and the employee is in writing;

• the period of salary deferral leading up to the leave of absence

(referred to as the “deferral period”) does not exceed six years;

32 See: Paragraph 110(1)(d) of the Tax Act. 33 See: Section 7.




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• the leave of absence commences immediately after the deferral

period ends;

• the leave of absence period is at least six consecutive months,

except where the leave is taken for the purpose of permitting full-

time attendance at a designated educational institution, in which

case the minimum leave period is three consecutive months;

• no more than one third of the employee’s annual salary or wages is

deferred in each year during the deferral period;

• the employee receives no compensation during the leave of

absence period, except for the deferred amounts and regular fringe

benefits;

• the arrangement provides that the employee is to return to his or

her regular employment with the employer (or an employer that

participates in the same or a similar arrangement) after the leave of

absence for a period of time at least equal to the duration of the

leave of absence;

• all leave of absence benefits are paid to the employee no later than

the end of the first taxation year that commences after the end of

the deferral period;




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• 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.




23

more commonly used types of non-registered income deferral plans. Such plans

can be an important and valued component of an employee's compensation

package, but must in every case be carefully structured to avoid unintended and

adverse tax consequences.

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