There are many different means for employers to provide tax-effective compensation to their employees. Through this tax-efficiency, employers can reward employees for good performance, compete for talent, improve talent retainment and compensate their employees based on the company’s share value performance.
A significant drawback of employee compensation arrangements is that if they fall under the Income Tax Act’s definition of a salary deferral, then there may be delays as to when the compensation can be included into the employees’ taxable income and to the employer’s payroll compliance obligations.
Timing of Expenses and Employment Benefits
Employee compensation is normally included as annual income. There can be cases where this does not apply. One such case is in a salary deferral agreement, which involves employees including compensation in their income before they receive it. Another exception is when an employee is granted stock options.
Expenses are normally deducted in the year that the company becomes unconditionally legally liable for the expense, even if the actual payment dates for the expense fall in a different year. This is generally the case for compensation expenses but is also subject to anti-avoidance rules.
Other Considerations for Timings of Employee Income and Deductions
Another consideration affecting the timing of business expenses is the application of “net” concept annual profits. Companies have to use accounting systems—which includes accounting expenses—that provide an accurate description of their annual profit for each tax year. This accounting must be done by applying commonplace business rules. Known as a “net” concept, the annual profit is determined by setting the revenues for the year against the expenses for the year. It is important to note that although the accounting standards and principles applied here may adopt commonplace business rules, these rules do not hold the power of legally binding principles. For example, the Income Tax Act contains many rules for the specific timings of expenses that taxpayers must follow, regardless of commonplace business rules.
One example of this is the matching principle for reporting of expenses. A business should report specific expenses on its income statement for the time-period that any revenue associated with the expense is reported. This principle suggests that an expense for sale commission should be reported on the same statement as the revenue made from the sales commission. Taxpayers commonly use this principle to calculate their annual profit for the purposes of Canadian taxation. Within the context of taxation, the matching principle suggests that expenses, or their appropriate portions, should be filed as a deduction in the same year that the associated revenue is recognized. However, these principles are not legal rules, and can therefore only be considered one of many commonplace business principles for evaluating annual profits. In the case of Canderel Ltd. v. Canada, the CRA’s failed in attacking the taxpayer’s decision to deduct their full tenant inducement expense when incurred instead of amortizing the expense.
For wages, salaries, bonuses and many other forms of employee 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 determined to have incurred in the tax year that the employment amount is paid. This makes it possible for employees to defer taxation for some types of income for up to a year after the employer reduces the tax payable for the corresponding employment expense.
The timing of employment income and expenses can seriously impact the tax positions of employees and employers. To avoid tax traps, it is vital to consult an experienced Canadian tax lawyer.
Statutory Definitions under the Income Tax Act: Salary Deferral Arrangements
A salary deferral arrangement is any arrangement—with some specific exceptions—made between an employer and an employee that allows the employee to postpone receiving their salary or wages until a later year.
It may be considered that the right to this arrangement exists to postpone payable income tax for the taxpayer, for an amount that is—or is a substitute for—salary or wages for services carried out in that particular year. 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
- employee life and health trusts
- 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.
In order for many of the above exceptions to be valid, they must meet other specific legislative requirements. One example of this is employee profit-sharing plans. ‘Employee profit-sharing plans’ is a technical term under Canadian Income Tax Law, and must meet specific requirements to qualify as such a plan.
There are explicit exceptions for salary deferral arrangement rules set out by the Income Tax Regulations as of July 2020, including:
- sabbatical arrangements,
- deferred salary arrangements for certain on-ice officials of the National Hockey League, and
- deferred share unit plans.
To ensure your compensation arrangement or plan does not fall under the definition of a salary deferral agreement, it is vital to consult an expert Canadian tax lawyer to assist you in designing your plan.
The Tax Consequences of Salary Deferral Arrangements
If an employee is permitted deferred payment under a salary deferral arrangement, they must include the full amount of the future payment in their income for the tax year in which they were granted the right to deferred payment. Any extent interest or similar accrues associated with the future payment should be included in the employee’s income in the year that the interest is accrued.
The consequence of this is that under the salary deferral agreement, employees can end up paying tax on payments years before they receive them. Such employees must be made aware of these consequences, or else they may under-report their income, leading to hefty tax penalties in addition to becoming unexpectedly liable for the taxes and related interest.
Under salary deferral arrangements, there is no employer entitlement for deductions of any deferred amounts 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 closely aligns the employee’s income inclusion and the employer’s deduction, corresponding to the date that the employee receives the right to future payment as opposed to the date that the future payment is made. Deferred compensation amounts must be included in employee’s income for filing T4 information returns, otherwise, the employer may be penalized. Under salary deferral arrangements, it is also vital that employers accurately determine the correct payments due to employees under Salary Deferral Arrangements.
Key Takeaways on Salary Deferral Arrangements
Any employee compensation plans are subject to complex legal requirements imposed by Canadian tax laws. When designing or implementing compensation plans, employers should always consult with top Canadian tax lawyers. It is usually advantageous to design such plans so as not to be a salary deferral arrangement, which has specific and complex terms under the Income Tax Acts statutory definition. This can be a significant hurdle in designing a compensation plan and requires considerable care and expertise.
If a taxpayer finds themself in a situation where a compensation plan unexpectedly turns out to be a salary deferral arrangement, they should consult with an experienced Toronto tax lawyer to determine whether a voluntary disclosure application is appropriate. Voluntary disclosure applications can reduce associated interest and tax penalties. It may also be possible to apply to a court to correct the error in the compensation plan.