The Income Taxation of Flexible Benefit Plans in Canada Lara Friedlander and Jana Steele* PRÉCIS Au cours des dernières décennies, les régimes d’avantages sociaux adaptés aux besoins des employés sont devenus usuels au Canada. Malgré la popularité croissante de ces régimes, le traitement fiscal qui leur est appliqué est loin d’être clair. La Loi de l’impôt sur le revenu ne contient aucune mention explicite aux régimes d’avantages sociaux adaptés aux besoins des employés et, jusqu’à récemment, Revenu Canada n’en traitait que par le biais d’interprétations techniques. De plus, les régimes d’avantages sociaux adaptés aux besoins des employés n’ont pas fait l’objet d’examens détaillés de la part des commentateurs canadiens. En février 1998, Revenu Canada a publié un bulletin d’interprétation sur l’imposition des régimes d’avantages sociaux adaptés aux besoins des employés. Les auteurs examinent ce bulletin, ainsi que l’élaboration de régimes d’avantages sociaux adaptés aux besoins des employés au Canada, le traitement fiscal de régimes similaires aux États-Unis et diverses questions de politiques découlant de l’octroi d’avantages sociaux adaptés aux besoins des employés. Les auteurs concluent que le nouveau bulletin d’interprétation de Revenu Canada est utile en ce sens qu’il fournit une certitude accrue quant au traitement fiscal des régimes d’avantages sociaux adaptés aux besoins des employés. Toutefois, ils concluent également que de nombreuses questions de politiques reliées à ces régimes ne peuvent pas être réglées efficacement au moyen de mesures administratives, mais qu’elles doivent plutôt l’être grâce à une modification des dispositions législatives. ABSTRACT Over the past several decades, flexible benefit plans have become commonplace in Canada. Despite the increasing popularity of such plans, their tax treatment has been far from clear. Flexible benefit plans are not referred to explicitly in the Income Tax Act and, until recently, were addressed by Revenue Canada only by way of technical interpretation. * Lara Friedlander is of Stikeman Elliott, Toronto and Jana Steele is of Goodman Phillips & Vineberg, Toronto. The authors would like to thank Marivic Bernal, Julie Muirhead, Gary Nachshen, Donna Shepherd, Hemant Tilak, and the editors of the Canadian Tax Journal. 786 (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 787 Additionally, the income taxation of flexible benefit plans has not been discussed by Canadian commentators in any significant detail. In February 1998, Revenue Canada published an interpretation bulletin on the income taxation of flexible benefit plans. The authors examine this bulletin, as well as the development of flexible benefit plans in Canada, the income tax treatment of similar plans in the United States, and a selection of policy issues arising in connection with the delivery of flexible benefits. The authors conclude that Revenue Canada’s new interpretation bulletin is helpful in that it provides increased certainty with respect to the income tax treatment of flexible benefit plans. However, they also conclude that many of the policy issues associated with these plans cannot be addressed effectively by administrative measures, but rather must be dealt with by legislative change. INTRODUCTION A “flexible benefit plan,” sometimes referred to as a “cafeteria plan,”1 is a plan or arrangement established by an employer for the purpose of delivering employee benefits, under which an employee may choose among two or more classes and/or levels of benefit options. Under the classic flexible benefit plan, the employee typically selects types and levels of benefits up to a prescribed maximum for a given period of time. Benefit choices may be denominated in terms of “credits”2 or monetary amounts and are often limited to a specified number of credits or a specified monetary amount for each employee. Under an alternative form of flexible benefit plan, known as a “modular” or “core-plus” plan, an employer provides a basic bundle of benefits with an option to increase benefits partially or wholly at the employee’s expense. Approximately 100 large Canadian corporations are known to have or have had flexible benefit plans in place, including Warner-Lambert, American Express, DuPont, McDonald’s Restaurants, Northern Telecom, Canada Trust, Cominco, and Xerox. 3 It is expected that the number of employers 1 As explained below, neither flexible benefit plans nor cafeteria plans are referred to explicitly in the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). (Unless otherwise stated, statutory references in this article are to the Act.) In the United States, however, “cafeteria plans,” which are a subset of flexible benefit plans, are recognized by section 125 of the United States Internal Revenue Code of 1986, as amended (herein referred to as “the Code”). In this article, we will use the term “flexible benefit plan” to refer to Canadian plans and reserve the term “cafeteria plan” exclusively for discussion of those plans recognized as such under US law. 2 These “credits” are typically called “flexible credits” or “flex credits.” 3 These plans are a matter of public record. See Julie Charles, “Some Assembly Required” (January 1995), 19 Benefits Canada 24-28, at 25 and 28; M. Gulens, “Lights! Cameras! Re-Action!” (November 1995), 19 Benefits Canada 89; and Jan Kauk, “The Stretch to Flex” (December 1996), 20 Benefits Canada 61-64. (1998), Vol. 46, No. 4 / no 4 788 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE with flexible benefit plans will increase in the future.4 In early 1995, approximately half of the major employers in the United States had some form of flexible benefit plan,5 and interest in such plans is continuing to grow.6 This article will first provide some background on flexible benefit plans. Second, it will discuss the taxation of benefit plans generally, then specifically the taxation of private health services plans (PHSPs) and health and welfare trusts (HWT s), and the current tax treatment of flexible benefit plans in Canada.7 Third, the article will review the taxation of flexible benefit plans (in particular, cafeteria plans) in the United States. Fourth, it will consider some important policy issues associated with flexible benefit plans. Finally, the article offers a critique of the current Canadian income tax regime as it applies to flexible benefit plans, together with some suggestions for reform. BACKGROUND Flexible benefit plans came into vogue in the United States in the late 1960s and early 1970s, when the influx of women into the workplace began to result in a duplication of employment benefits at the household level.8 As the 1970s progressed, employers became increasingly interested in flexible benefit plans to provide employees with an opportunity to avoid such duplication. Benefit “menus” were seen as a means of attracting skilled employees. 9 Today, two considerations underlie most decisions to establish flexible benefit plans. First, such plans are viewed by employers as a means of controlling costs.10 They allow employers to offer benefit coverage at a lower cost but with a higher value as perceived by the employee. Rather 4 Kristine Gordon, “The Flexed Generation” (March 1995), 19 Benefits Canada 21-24; and Victor Pywowarczuk, “School’s in on Flex Plans” (September 1994), 18 Benefits Canada 47-49. Since these articles appeared, employer response to flexible benefit plans may not have been as great as the authors anticipated, perhaps because changes to benefit plans can be difficult to market to employees in a unionized environment. (Kauk, supra footnote 3.) 5 Charles, supra footnote 3, at 25. 6 M.O. Howard, “Serving Up Benefits: Although Cafeteria Plans Don’t Work for Every Company, They’ve Become Popular due to Their Flexibility,” Richmond Times Dispatch, February 1, 1997. 7 This article will consider only the income tax treatment of flexible benefit plans under the Act. Provincial and other tax considerations are not discussed. 8 For example, each spouse might have a dental plan that covered all members of the employee’s immediate family. 9 Daniel C. Schaffer and Daniel M. Fox, “Tax Law as Health Policy: A History of Cafeteria Plans, 1978-1985” (Spring 1989), 8 American Journal of Tax Policy 1-67, at 9. 10 For example, Montreal’s École des Hautes Études Commerciales introduced a flexible benefit plan to help offset rising costs of health care and dental benefits. (Pywowarczuk, supra footnote 4, at 47.) (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 789 than offering the same benefit package to everyone, which can be extremely costly if the package in question is comprehensive, an employer can offer employees a choice of benefits, thereby delivering benefits at a lower cost by eliminating the delivery of unwanted or undervalued benefits, yet still fulfilling employee demand. Employees generally find that such cost-cutting works to their advantage: although the benefits offered under a flexible benefit plan are less comprehensive, individual employees can allocate their flexible credits or amounts to the benefits they value most.11 Second, flexible benefit plans are perceived as an effective means of meeting employees’ varied needs, particularly in view of the increasing diversity of the workforce (such as the increase in single-parent families).12 Flexible benefit plans may also be established to increase employees’ understanding of their benefits and to allocate benefit dollars in a taxeffective manner (for example, educating employees as to the types of benefits that can be received without tax).13 Flexible benefit plans take a number of different forms. One popular type of plan is the account structure (often labelled a “benefit bank” or a “flexible spending account”).14 Under this kind of plan, funds are credited (perhaps only notionally) to each employee’s flexible spending account.15 When the employee incurs an expense covered by the plan, the employee files a claim with the employer and is reimbursed out of the balance remaining in the account. The accounts can be unfunded and may exist solely as bookkeeping entries. 16 Some plans may require or permit employee contributions, which are also credited to the employee’s flexible spending account. 11 Gordon, supra footnote 4, at 22. See also Arthur F. Woodward, “Cafeteria Plans,” in Proceedings of the New York University Forty-Fifth Annual Institute on Federal Taxation, vol. 1 (New York: Matthew Bender, 1987), chapter 15, at section 15.02. 12 Gordon, supra footnote 4, at 21; and Pywowarczuk, supra footnote 4, at 49. In the United States, cafeteria plans are the most common method by which employers offer dependant care assistance programs. (Giselle Sered, “Day Care and Tax Policy” (Spring 1995), 12 American Journal of Tax Policy 159-206, at 193.) 13 Gordon, supra footnote 4, at 21. 14 This type of plan is similar in concept to the “medical savings account” that was discussed so frequently during the 1996 US presidential election, although the medical savings account was to be offered directly to individuals rather than through employers. (For a description, see William V. Roth, “Legislative Commentary: Medical Savings Accounts” (Fall 1994), 11 Journal of Contemporary Health Law and Policy 149-64.) In Canada, these accounts are sometimes called “health care spending accounts” or “health care expense accounts.” A national survey conducted by Hewitt Associates in 1995 indicated that 75 percent of employers with flexible benefit plans used health care spending accounts, compared to 50 percent in 1992. (Gordon, supra footnote 4, at 21.) 15 For a detailed discussion of the flexible spending account structure, see Hewitt Associates, Canadian Handbook of Flexible Benefits (Toronto: Wiley, 1996), chapter 7. 16 Woodward, supra footnote 11, at section 15.02. (1998), Vol. 46, No. 4 / no 4 790 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE A typical flexible benefit plan in Canada might take the following form. Employees receive a basic level of benefits with respect to accidental death and dismemberment, salary continuance, short-term disability, life insurance, long-term disability, and health care. Each employee is then credited with flex dollars to upgrade coverage with respect to one or several of the benefits already offered. The number of flex dollars allocated to each employee will be determined by his or her salary. Each employee selects his or her allocation of flex dollars annually, before the beginning of the plan year. Flexible benefit plans have become increasingly common in Canada during the past 20 years, yet relatively little information regarding the taxation of such plans has been published. 17 Revenue Canada did not publish its position on flexible benefit plans until 199118 and did not issue an interpretation bulletin addressing the tax treatment of such plans until the publication of Interpretation Bulletin IT-529 on February 20, 1998. It is the dearth of literature concerning the taxation of flexible benefit plans and the publication of IT -529 that has prompted this article. THE INCOME TAX TREATMENT OF FLEXIBLE BENEFIT PLANS IN CANADA The Existing Statutory Regime for the Taxation of Employee Benefits and Benefit Plans There are four basic questions regarding the tax treatment of flexible benefit plans:19 1) If an employer contributes to a plan, is the employee taxed on this contribution and, if so, does taxation occur when the funds are contributed to the plan or when the funds are eventually paid to the employee out of the plan in the form of benefits? 17 There have been only a few articles published in Canada that have considered the taxation of flexible benefit plans in any detail. See Elizabeth M. Brown and Christopher M. Newton, “Tax Considerations in the Design of a Flexible Benefits Plan” (September 1995), 7 Taxation of Executive Compensation and Retirement 22-29; and Claude Boulanger, “Administrative Guidelines for ‘Cafeteria’ Style Benefit Arrangements Are Published at Tax Conference” (July/August 1991), 3 Taxation of Executive Compensation and Retirement 477-80. The leading book on flexible benefit plans, Canadian Handbook of Flexible Benefits, supra footnote 15, contains a chapter dealing with the taxation of flexible benefit plans. See also, generally, James A. Norton, “Flex—A Strategic Benefit—A Real World Solution” (September 1995), 7 Taxation of Executive Compensation and Retirement 19-22; and Jo-Anne Billinger, “Flexible Benefits a Practical Approach for Employers and Employees in the Cost-Conscious ’90s” (April 1993), 4 Taxation of Executive Compensation and Retirement 747-51. 18 Bryan W. Dath and Paul D. Fuoco, “Flexible Employee Benefit Arrangements,” in Income Tax and Goods and Services Tax Planning for Executive and Employee Compensation and Retirement, 1991 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1992), 6:1-27. 19 There are, of course, a variety of other issues relating to the tax treatment of benefit plans, including the treatment of plan trusts. For the sake of simplicity, this article will focus on the four key questions listed above. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 791 2) If an employer contributes to a plan on behalf of an employee, can the employer deduct the contribution and, if so, is the deduction available when the funds are contributed to the plan or when the funds are eventually paid to the employee out of the plan in the form of benefits? 3) If an employee contributes to a plan, does the employee receive a deduction for that amount? 4) Is the employee taxed on the benefits received and, if so, when does this taxation occur? The Act does not address any of these questions directly. In fact, unlike the US Code,20 the Act does not specifically address the taxation of flexible benefit plans at all. Accordingly, the Canadian tax treatment of such plans must be determined by trying to fit each flexible benefit plan into one or more of the various provisions and defined terms in the Act relating to benefit plans generally. Typically, any benefit received by an individual in the course of employment will be included in that individual’s income in the year of receipt. Paragraph 6(1)(a) provides that an employee must include in computing his or her taxable income the value of all benefits received in the year from an office or employment.21 In this context, the term “benefits” encompasses “benefits of any kind whatever” that are received by the taxpayer “in respect of, in the course of, or by virtue of an office or employment,” subject to certain specified exceptions. Thus, this provision is the starting point for any analysis of employee benefits. Any benefit received by an employee in the course of his or her employment will either be included in income by virtue of paragraph 6(1)(a) or fit within one of the exceptions to this general rule. Generally, any payment made by an employer to or for the benefit of an employee will be deductible to the employer in the year of payment.22 Employee expenses are generally not deductible by the employee.23 Overlaying these general rules are provisions applicable to various categories of benefit plans, each of which is taxed in a specific manner. Each category is mutually exclusive as defined in the Act; a plan cannot fit into two categories. Several categories of plans referred to in the Act are relevant to this article: employee benefit plans (EBPs), employee trusts (ETs), 20 As noted earlier, the Code addresses one particular type of flexible benefit plan, referred to as a “cafeteria plan” and defined in section 125(d). 21 “Employment” is defined in subsection 248(1) to mean “the position of an individual in the service of some other person . . . and ‘servant’ or ‘employee’ means a person holding such a position.” Subsection 248(1) defines “employee” to include an officer. 22 Payments to employees are deductible under section 9 because they are made for the purpose of gaining or producing income from a business. 23 Subsection 8(2). (1998), Vol. 46, No. 4 / no 4 792 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE and salary deferral arrangements (SDAs).24 Each category is described in turn below. Employee Benefit Plans An EBP is a funded arrangement under which contributions are made by an employer or by a person dealing not at arm’s length with the employer, and payments under such arrangements are made to or for the benefit of employees.25 Under an EBP, an employer ordinarily may not deduct its contribution until the employee actually receives a corresponding benefit out of the plan. 26 Employee contributions are not deductible to the employee but are not taxed upon return to the employee.27 Employees must include in income from office or employment plan benefits in the taxation year in which the benefits are received (except to the extent that these benefits constitute a return of the employee’s contribution to the EBP).28 Employee Trusts An ET is a funded arrangement under which an employer makes payments to a trustee for the benefit of employees. The right to benefits under an ET vests at the time each payment is made, and the amount of the benefit does not depend on the individual’s position, performance, or compensation as an employee.29 The trustee of an ET is obligated to allocate funds annually to all employees who are beneficiaries of the trust. The employee’s right to the contributions allocated to him or her vests in the employee immediately upon contribution.30 Employer contributions to the trust are included in the employee’s income in the year in which the contribution is made and 24 See also the discussion of PHSPs and HWTs below. The rules in the Act relating to retirement compensation arrangements (defined in subsection 248(1)) also may be relevant where a flexible benefit plan provides for a payment to be made to an employee upon termination of employment; however, discussion of this type of arrangement is beyond the scope of this article. 25 Subsection 248(1), definition of “employee benefit plan.” See Interpretation Bulletin IT-502, “Employee Benefit Plans and Employee Trusts,” March 28, 1985, as amended by a special release dated May 31, 1991; Julie Y. Lee, “Deferred Compensation in the Wake of the 1986 Federal Budget,” Personal Tax Planning feature (1986), vol. 34, no. 2 Canadian Tax Journal 429-45; and John M. Solursh and Jeff Sommers, “Employee Benefit Plans,” in Deferred Income Arrangements: A Practitioners Guide to Proper Tax Planning (Toronto: Canadian Tax Foundation, 1997), tab 6. 26 Paragraph 18(1)(o) and section 32.1. 27 Subsection 8(2) and paragraph 6(1)(g). 28 Paragraph 6(1)(g). 29 Subsection 248(1), definition of “employee trust.” See IT-502, supra footnote 25. 30 Subsection 248(1), definition of “employee trust.” (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 793 are deductible to the employer upon contribution to the plan.31 Employee contributions are not deductible to the employee.32 Salary Deferral Arrangements An SDA is a plan or arrangement that satisfies all of the following criteria: 1) any person has a right in a taxation year to receive an amount after the year; 2) it is reasonable to consider that one of the main purposes for the existence of the right to receive an amount after the year is to postpone tax payable under the Act by the taxpayer; and 3) the amount is on account or in lieu of salary or wages of the taxpayer for services rendered by the taxpayer.33 An SDA may be funded or unfunded. If a plan is an SDA, any amounts to which the employee has a right in a given taxation year are included in the employee’s income for that taxation year under subsection 6(11) and are deductible by the employer under paragraph 20(1)(oo). The amount to be included or deducted is the “deferred amount,” defined in subsection 248(1) as “any amount that a person has a right under the arrangement [ SDA] at the end of the year to receive after the end of the year . . . unless there is a substantial risk that any one of those conditions will not be satisfied.” Revenue Canada’s Administrative Position Regarding the Treatment of Flexible Benefit Plans Under the Act As stated above, the tax treatment of a flexible benefit plan depends on the application of current provisions of the Act to the particular plan. Revenue Canada takes the position that so long as an employer properly segregates contributions to and distributions from a flexible benefit plan, for tax purposes each benefit offered under the plan will be considered on a stand-alone basis; that is, Revenue Canada will ignore the fact that the benefit was delivered as a component of a flexible benefit plan. However, if contributions and distributions are not properly segregated, Revenue Canada will characterize the entire flexible benefit plan as a single plan (such as an EBP ). As Revenue Canada states in Interpretation Bulletin IT -85 R2 in the context of HWTs for employees: Where part of a single plan could be regarded as a plan described in 1(a) to (d) above [a group sickness or accident insurance plan, a PHSP, a group 31 Paragraph 6(1)(h) (inclusion), section 9, and paragraph 18(1)(a) (deduction). 8(2). 33 Subsection 248(1), definition of “salary deferral arrangement.” For a detailed discussion of the mechanics of the SDA rules, see Hugh A. Gordon, “Deferred Compensation,” in Report of Proceedings of the Thirty-Eighth Tax Conference, 1986 Conference Report (Toronto: Canadian Tax Foundation, 1987), 34:1-30. 32 Subsection (1998), Vol. 46, No. 4 / no 4 794 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE term life insurance policy, or any combination thereof ] and another part as an employee benefit plan or an employee trust, the combined plan will be given employee benefit plan or employee trust treatment in respect of the timing and amounts of both the employer’s expense deductions and the employees’ receipt of benefits under the plan. However, if contributions, income and disbursements of the part of the plan that is described in 1(a) to (d) above are separately identified and accounted for, the tax treatment outlined in this bulletin will apply to that part of the plan.34 Again, in its discussion of EBPs in Interpretation Bulletin IT-502, Revenue Canada states: Where an employer makes contributions to a custodian which are then used to fund several types of benefit plans, some of which are excluded from the definition of an employee benefit plan, it is necessary for the employer to identify the portion of each contribution that relates to each separate plan. If the custodian of such an omnibus arrangement does not account separately for the income and disbursements of the component plans, it may be necessary to regard the total arrangement as an employee benefit plan and treat it accordingly in respect of the timing and amounts of both the employer’s expense deductions and the EBP beneficiaries’ receipt of benefits or income under the arrangement. 35 Suppose, for example, that an employer offers a benefit plan that allows employees to choose among benefits under a PHSP, contributions to a pension plan, child care, and cash. If each one of those four benefits is accounted for separately, the tax treatment of each will be determined separately, as if the others did not exist. However, if the benefits are not accounted for separately and, for example, Revenue Canada takes the position that the entire plan is an EBP, then each benefit will be taxed as an EBP benefit.36 The fact that benefits under a PHSP might have received more favourable treatment had they been offered on a stand-alone basis is irrelevant.37 Taxable benefits provided under the flexible benefit plan will be taxed upon receipt by the employee (and will simultaneously become deductible to the employer) regardless of the other elements of the plan,38 and taxation of the non-taxable benefits will depend on the characterization of the plan as a whole. 34 Interpretation Bulletin IT-85R2, “Health and Welfare Trusts for Employees,” July 31, 1986, paragraph 4. 35 IT-502, supra footnote 25, at paragraph 4. 36 For a discussion of the effect of the EBP rules on flexible benefit plans, see Solursh and Sommers, supra footnote 25. 37 IT-502, supra footnote 25, at paragraph 4; and Interpretation Bulletin IT-529, “Flexible Employee Benefit Programs,” February 20, 1998, paragraph 5. 38 See Dath and Fuoco, supra footnote 18; and “Flexible Benefit Plans, Health Care Expense Accounts,” Revenue Canada document no. 9304605, July 14, 1993. Note Revenue Canada’s position with respect to vacation selling. If an employee chooses to exchange vacation days for other benefits, Revenue Canada considers the exchange to be a “sale” of vacation days and takes the position that the value of the benefits received in the exchange (The footnote is continued on the next page.) (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 795 Most likely, a flexible benefit plan that is not properly segregated will be treated as either an EBP or an SDA, depending on a number of factors (such as whether the plan is funded by contributions to a third party).39 A flexible benefit plan could receive SDA treatment if it were being used for the purpose of deferring compensation. For example, a plan might allow an employee to choose to take vacation days rather than other types of benefits. Revenue Canada has indicated that a plan that permitted the rollover or cashing out of purchased vacation might be considered an SDA .40 Alternatively, if the employer were to make payments to a trustee, the plan might be characterized as an ET; for example, under a plan that failed to constitute an HWT because it offered a cash option (as discussed below), an employee would have to include in income amounts allocated to him or her by the trustee rather than including benefits on actual receipt. When is a flexible benefit plan “properly segregated” such that Revenue Canada will look through the plan and tax the benefits on a stand-alone basis? In a technical interpretation, Revenue Canada stated: While separate employer records and separate insurance policies are not required in order to consider the plans as separate, there must not be any cross-subsidization between the plans and the level of benefits, the premium rates, the qualifications for membership and other terms and conditions of each of the plans must not be dependent upon the existence of the other plan or plans. If the policy is experience-rated, separate experience ratings must be established for each plan. 41 38 Continued . . . should be included in the employee’s income under subsection 5(1) or paragraph 6(1)(a). (“Taxation of Flexible Benefit Plans,” Revenue Canada document no. June 1991-196, June 10, 1991.) Revenue Canada justifies its position on the ground that “an employee’s entitlement to vacation each year is a right which has value to that employee. . . . We can see no difference, from an income tax perspective, between ‘cashing out’ vacation entitlement to [sic] trading it for something of value to the employee such as credits in a flexible benefit plan.” Revenue Canada takes the same position even where the employee must forfeit vacation days because the annual vacation allotment has expired. (“Vacation Trading in Flexible Benefit Plans,” Revenue Canada document no. August 1991-5, August 30, 1991; and Dath and Fuoco, supra footnote 18, at 6:11.) Revenue Canada maintains this position even where the employee trades vacation entitlement for flexible credits used to purchase health-related coverage that would have been exempt. It is Revenue Canada’s position that “it is the trading of vacation entitlement by the employee that triggers the taxable event and not the use of the flexible credits obtained.” (“Flexible Benefits Plan—Vacation Trading,” Revenue Canada document no. 9128165, January 14, 1992; “Trading Vacation or Bonus for Health Care,” Revenue Canada document no. 9531035, January 17, 1996.) If the employee trades the vacation for medical benefits, the employee may still be entitled to a medical expense credit. (Ibid.) 39 “Carryforward of Health Care Expense Account Credits in a Private Health Services Plan,” Revenue Canada document no. 9309625, October 6, 1993. 40 Revenue Canada document no. June 1991-196, supra footnote 38. 41 See “Disability Plans with Employee Pay Option,” Revenue Canada document no. 9507035, July 5, 1995. (1998), Vol. 46, No. 4 / no 4 796 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Additionally, Revenue Canada requires each employee to make an irrevocable42 selection of benefits with respect to a particular plan year before the beginning of the plan year. In Revenue Canada’s view, if a flexible benefit plan permits an employee to exchange unallocated or newly allocated credits for cash, to transfer credits between benefit options, or to select benefits after the beginning of the plan year, the lookthrough approach will not apply. 43 It is not entirely clear how Revenue Canada’s approach applies to a plan that offers employees a choice among benefits not included in income under paragraph 6(1)(a) when the plan does not segregate contributions and distributions relating to different benefits. For example, employer contributions to a supplementary unemployment benefit plan,44 a deferred profit-sharing plan,45 a registered pension plan,46 or a retirement compensation arrangement47 should not be included in income under paragraph 6(1)(a) and should be immediately deductible to the employer if the benefits are offered individually. However, a plan that offers employees a choice among these benefits but does not account for them separately might, technically, trigger EBP treatment (and thus deferred deductibility to the employer). Where the benefits are combined in a single plan, the plan will presumably fall outside the definitions of supplementary unemployment benefit plan, deferred profit-sharing plan, etc., which are mutually exclusive plan categories.48 Revenue Canada’s administrative position and the existing statutory regime are significantly affected by the concepts of constructive receipt and indirect receipt.49 Constructive receipt is a common law concept that has been explained as follows: where an amount of income is readily available to a cash basis (as opposed to an accrual basis) taxpayer, it will be considered to have been received by the taxpayer whether or not he or she chooses to take possession of it. Indirect receipt is a related (although 42 Revenue Canada makes two exceptions for changes in an employee’s selection of benefits: (1) the occurrence of a “life event,” such as the birth or death of a dependant or a change in marital status; and (2) a change in employment status. See IT-529, supra footnote 37, at paragraph 6. 43 Ibid., at paragraph 8. 44 Paragraph 18(1)(i) and subsection 145(5). 45 Paragraph 18(1)( j) and subsection 147(8). 46 Paragraph 20(1)(q) and subsection 147.2(1). 47 Paragraph 18(1)(o.2) and paragraph 20(1)(r). 48 See “Flexible Benefit Plan,” Revenue Canada document no. 9632073, February 21, 1997. Here Revenue Canada ruled on a flexible benefit plan that included the use of flex dollars for contributions to a group registered retirement savings plan (RRSP). It is unclear whether the plan provided for true segregation of contributions and benefits. 49 B.J. Arnold, Timing and Income Taxation: The Principles of Income Measurement for Tax Purposes, Canadian Tax Paper no. 71 (Toronto: Canadian Tax Foundation, 1983), 91. See also Patricia A. Metzer, “Constructive Receipt, Economic Benefit and Assignment of Income: A Case Study in Deferred Compensation” (Spring 1974), 29 Tax Law Review 525-87. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 797 not identical) concept50 found in subsection 56(2) of the Act. Under subsection 56(2), an amount will be included in a taxpayer’s income if a payment or transfer of property • was made to a person other than the taxpayer; • was made at the direction or with the concurrence of the taxpayer; • was for the taxpayer’s own benefit or for the benefit of some other person on whom the taxpayer desired to have the benefit conferred; and • would have been included in computing the taxpayer’s income if it had been received by the taxpayer instead of the other person. 51 The doctrines of constructive receipt and indirect receipt are both relevant to flexible benefit plans because they frequently serve as the bases upon which Revenue Canada claims that benefits or credits under such plans are immediately taxable to the employee. For example, IT-502 states: 10. The Department considers an amount to have been paid by an EBP beneficiary out of the plan upon the earlier of the date upon which payment is made and the date upon which the EBP beneficiary has constructively received a payment. Constructive receipt is considered to apply in situations where an amount is credited to an EBP beneficiary’s debt or account, set apart for the EBP beneficiary or otherwise made available to the EBP beneficiary without being subject to any restriction concerning its use. Consideration will be given to the application of subsection 56(2) (indirect payments) where payments are made to persons other than the employee or former employee while living. 11. Where the terms of an employee benefit plan provide that an employee entitled to benefits thereunder may elect to defer the receipt of a lump-sum amount payable on death, retirement or other termination of employment, it is the Department’s view that the amount so deferred would normally be taxed in the year of actual receipt provided the election to defer is made prior to the termination of employment. 50 The concepts of constructive receipt and indirect receipt are sometimes confused. For example, in Fraser Companies Ltd. v. The Queen, [1981] CTC 61, at 70 (FCTD), Mr. Justice Cattanach stated, “[t]he often repeated statement is that the subsection (both 16(1) and 56(2)) embodies a portion of the general concept of constructive receipt. The general rule is that a taxpayer is only taxed upon the receipt of income or when it becomes receivable by him in the legal sense. There are certain circumstances where income receivable may be caused not to be received by him and by that device he achieves benefits that amount to income. In those circumstances as set forth in subsection 56(2) that is income constructively received by the taxpayer. If the taxpayer had actually received the money or moneys worth and passes it on he would have been taxable on that amount. Therefore he should not be permitted to avoid tax liability by the simple expedient of directing payment to a third party without having actually received the money himself.” Subsection 56(2) does not seem to codify the concept of constructive receipt since it is difficult to find in the language of the provision support for the view that subsection 56(2) applies only when the taxpayer would have received the amounts in question but for the redirection of those amounts to someone else. However, see the decision of the Supreme Court of Canada in Neuman v. The Queen, 98 DTC 6297. 51 Fraser Companies, supra footnote 50, at 71; aff ’d. in Neuman, supra footnote 50, at 6301. (1998), Vol. 46, No. 4 / no 4 798 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Revenue Canada takes the position that the doctrine of constructive and/or indirect receipt allows the imposition of tax when an employee chooses to “cash out” vacation pay or give up other taxable benefits in exchange for non-taxable benefits.52 Constructive receipt may also allow Revenue Canada to impose tax when an employee redirects benefits from one plan to another. Revenue Canada has taken that position in respect of a redirection by an employee of benefits from an EBP to a retirement compensation arrangement even though the employee would not have been taxed on EBP benefits until the benefits were actually received.53 To the extent that subsection 56(2) is not applicable, Revenue Canada’s position regarding constructive receipt may be overstated. First, the case law that refers to constructive receipt is sufficiently confused as to prevent certainty that such a doctrine actually exists in Canada. Second, Revenue Canada has not always applied the doctrine with consistency; contrast paragraph 10 of IT -502 above with paragraph 8 of IT -529, which states that certain amounts (such as redirected benefits) will cause “the employee [to] be considered to have constructively received employment income equal to the value of the allocated credits (unless the entire Flex Program is considered to be an employee benefit plan.)” However, these ambiguities may be of little relevance if Revenue Canada can claim that the flexible benefit plan is designed to defer tax and is therefore an SDA . Note also that it is Revenue Canada’s view that, generally, where salary or benefits under an existing contract (including bonuses, vacation, or salary increases) are converted to flex credits, the employee will have a taxable benefit under subsection 5(1), subsection 56(2), or paragraph 6(1)(a).54 This result arises whether or not the acquired credits are used to 52 See supra footnote 37. See also “Qualifying Stock Option Agreement,” Revenue Canada document no. 5-9559, April 9, 1990, in the context of an agreement to purchase shares in lieu of compensation, and “Mandatory Conversion of Salary to Flex Credits,” Revenue Canada document no. 9606655, April 18, 1996, in the context of a redirection of benefits on the implementation of a new flexible benefit plan. The latter technical interpretation suggests that Revenue Canada takes a strict stance on constructive receipt. Conversion of benefits to a flexible benefit plan was considered constructive receipt even though the conversion was mandatory; the technical interpretation states, “While you stressed the fact that the initial redirection of salary is mandatory and that the employee has no choice as to the amount of salary redirected to the flexible benefit credit pool, an employee typically has a degree of control over the amount of salary redirected by means of the choices made by the employee under the flexible benefit plan.” 53 IT-529, supra footnote 37, at paragraph 8; and “Employee Benefit Plan Conversion to Retirement Compensation Arrangement,” Revenue Canada document no. 9632316, October 8, 1996: “[t]he fact that . . . it is the employee who causes the amendment may indicate that the employee has control over the disposition of the funds in the plan and that there is no trust arrangement at this point. This could indicate that the employee had constructive receipt of the amounts and should be taxed in accordance with paragraph 6(1)(g) of the Act.” 54 “Mandatory Conversion of Salary to Flexible Benefits,” in Window on Canadian Tax (Toronto: CCH Canadian) (looseleaf ), paragraph 4171; “Salary Rollbacks and Increased Benefits,” Revenue Canada document no. 9633255, November 13, 1996; and Revenue Canada document no. 9606655, supra footnote 52. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 799 obtain non-taxable benefits, on the ground that where an employee converts salary or benefits to flex credits, it cannot be said that the employer has contributed to the plan or provided a benefit. Here, the conversion of salary or benefits will be considered tantamount to the purchase of benefits with after-tax dollars. The immediacy of the income inclusion is based (at least in part) on the application of the doctrines of constructive and/or indirect receipt.55 However, if the employee does not yet have a legal right to salary (for example, where an employment contract is renegotiated upon expiry), a reduction in salary in exchange for an increase in benefits exempt under subparagraph 6(1)(a)(i) should not be taxable. 56 To summarize, a Canadian employer that wishes to offer a flexible benefit plan should be aware that establishing such a plan may give rise to three problems: 1) additional costs incurred to ensure that contributions to and disbursements from different plans under the flexible benefits plan umbrella are sufficiently segregated; 2) deferred deductions for the employer; and/or 3) accelerated inclusions for the employee. Examples Consider the following examples where X co, a Canadian company, offers its employees a flexible benefit plan containing these elements: • plan #1: group term life insurance policy, • plan #2: PHSP, 57 • plan #3: group short-term and long-term disability coverage, • plan #4: dependant care plan, • plan #5: dental plan, • plan #6: RRSP contributions, and • plan #7: fitness club membership. In order to ensure that preferred tax treatment is maintained for the nontaxable options, such as employer contributions to a PHSP, X co must carefully segregate contributions to and distributions from each of the benefit plans. If Xco grants every employee the same number of flex credits—for example, 3,000—to allocate among the above choices, the tax treatment 55 “Flex Plans and Conversion of Salary to Credits,” Revenue Canada document no. 9505455, June 29, 1995. Recall that tax-free treatment of benefits arises under paragraph 6(1)(a) only when the employer contributes to the plan or provides the benefit. 56 “Conversion of Salary to Non-Taxable Benefits,” in Window on Canadian Tax, supra footnote 54, at paragraph 4419; “Conversion of Salary to Non-Taxable Benefits,” ibid., at paragraph 4232; and Revenue Canada document no. 9633255, supra footnote 54. 57 PHSPs are discussed below. (1998), Vol. 46, No. 4 / no 4 800 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE of each employee will differ depending on his or her selections. As noted above, it is critical that individuals allocate their flex credits before the start of the plan year. Once the plan year has commenced, employees cannot reallocate their flex credits, except where there is a change in the employee’s family circumstances in the year (for example, marriage or childbirth) or a change in employment status. Example 1 Employee A is a young, single woman with no dependants. She allocates her flex credits to the following plans: • plan #2: PHSP, • plan #6: RRSP contributions, and • plan #7: fitness club membership. A will not receive a taxable benefit where Xco reimburses her for eligible claims under the PHSP , up to the amount of credits in her health care spending account. A PHSP is a plan of insurance. Accordingly, the employer is obligated to reimburse A for eligible expenses incurred up to the amount of credits allocated to the account. The RRSP contributions made by Xco on behalf of A will be included in A ’s income as salary or wages under subsection 5(1). However, A will still be entitled to claim any deduction permitted under the RRSP rules. Whether A is taxed on the fitness club membership depends on whether the membership is primarily for the benefit of A or of Xco. Provided that the fitness club membership is primarily for the benefit of Xco, A will not be taxed on the value of the benefit.58 Example 2 Employee B is a middle-aged, married woman with two children. She allocates her flex credits to the following plans: • plan #3: group short-term and long-term disability coverage, and • plan #4: dependant care plan. B ’s husband has an extensive benefits package through his job. Consequently, B wants to participate in only the two indicated plans. She also wants to take a portion of her flex credits in cash. The amount received by B in cash will be included in her income as income from employment. The value of the benefit of contributions made by an employer to a group disability insurance plan is generally not included in the employee’s income by virtue of subparagraph 6(1)(a)(i). Further, under paragraph 6(1)(f ), amounts received by an employee pursuant to a disability insurance plan 58 Interpretation Bulletin IT-470R, “Employees’ Fringe Benefits,” April 8, 1988. Whether a fitness membership is primarily for the benefit of the employer is a question of fact to be determined on the basis of the individual circumstances. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 801 are not taxable where the employee has made all the contributions to the plan. However, where the employer has contributed to the disability plan, benefits received by the employee under the plan are taxable.59 Since B has opted to use her flex credits to obtain disability coverage—that is, the contributions are being made by X co—any resulting benefit will be taxable to her under paragraph 6(1)(f ). Contributions to dependant care expenses are not exempt from tax under paragraph 6(1)(a).60 Therefore, B will be taxable on the value of the benefits she receives for dependant care. For the purposes of the section 63 deduction, B is considered to have paid these expenses and can claim the deduction if she otherwise qualifies.61 THE USE OF PRIVATE HEALTH SERVICES PLANS AND HEALTH AND WELFARE TRUSTS TO PROVIDE CHOICE TO EMPLOYEES In this section, two particular types of plans are described—PHSP s and HWTs. These plans are frequently offered as components of flexible benefit plans. They may be viewed as “mini” flexible benefit plans, in that they offer employees a degree of choice with respect to benefits received. An examination of these two types of plans demonstrates the difficulty in adapting the concept of employee choice to the current taxation of benefit plans under the Act. PHSPs The Act specifically refers to the type of benefit plan known as a “private health services plan.” Subsection 248(1) defines a PHSP as a contract of insurance in respect of hospital or medical expenses (or any combination of such expenses), or a medical or hospital care insurance plan (or any combination of such plans), subject to two exceptions.62 The plan must include an insurance element to qualify as a PHSP. Therefore, in Revenue Canada’s view, it must contain an undertaking by 59 Paragraph 6(1)(f ) provides for a reduction of tax with respect to any premiums paid by the employee. See K.M Dagenais et al. v. The Queen, [1995] 2 CTC 100 (FCTD); and “Employee-Pay-All-Plans,” Revenue Canada document no. 9705555, May 17, 1997. 60 In “Child Care Fund—Taxable Benefits,” Revenue Canada document no. 9519423, October 12, 1995, the department comments, “Generally, where an employer reimburses an employee or provides for the payment of all or a portion of an employee’s child care expenses, the employee is considered to be in receipt of a taxable benefit pursuant to paragraph 6(1)(a) of the Income Tax Act.” 61 See Interpretation Bulletin IT-495R2, “Child Care Expenses,” January 13, 1997; and Dath and Fuoco, supra footnote 18. 62 The two exceptions are contracts or plans established pursuant to (1) a provincial law that establishes a health care insurance plan where the province receives contributions from Canada for insured health services provided under a plan pursuant to the FederalProvincial Fiscal Arrangements Act, or (2) an act of Parliament that authorizes the provision of a medical or hospital care insurance plan for employees of Canada and their dependants and for RCMP force members and their dependants where such employees were appointed in Canada and are serving outside Canada. (1998), Vol. 46, No. 4 / no 4 802 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE one person to indemnify another person for an agreed consideration from a loss or liability in respect of an event the happening of which is uncertain.63 Revenue Canada considers a “cost-plus” plan to be one that satisfies these requirements.64 As contemplated in the Act, a PHSP is not a true flexible benefit plan but rather a single benefit. 65 However, to the extent that an employee may choose which expenses to claim, the plan resembles a flexible benefit plan. For example, under a PHSP, an employee may be eligible for reimbursement of $1,000 worth of medical expenses. If she actually incurs $3,000 worth of medical expenses, she can choose which expenses to claim. The ability to choose expenses becomes particularly valuable if the employee enjoys insurance coverage from other sources, such as a spouse’s benefit plan. Employer contributions to a PHSP are not included in the employee’s income under subparagraph 6(1)(a)(i), and they are deductible to the employer under section 9. This tax treatment should encourage employers to provide such plans. The employer will not forgo the immediate deduction for salary paid directly to an employee because the employer receives an immediate deduction for contributions to a PHSP. At the same time, the employee is not taxed on either the employer contributions or the benefits paid under the plan. Employee contributions to a PHSP are not deductible from the employee’s income, but they do generate a “medical expense credit” to the employee,66 presumably because the employee would have received a medical expense credit even if she had spent her after-tax dollars directly on the expenses. A plan that falls outside the definition of a PHSP will generally be considered by Revenue Canada to constitute an EBP. 67 There are a number of ways in which a plan may fail to qualify as a PHSP. The plan may cover expenses other than medical expenses. Alternatively, the plan may allow for an indefinite carryforward of unused credits or the transfer of unused credits to other plans that are not PHSPs. 68 Revenue Canada does not allow an unlimited carryforward of unused credits or expenses on the ground 63 Interpretation Bulletin IT-339R2, “Meaning of ‘Private Health Services Plan’,” August 8, 1989, paragraph 3. 64 Under a “cost-plus” plan, an employer contracts with a trustee or insurance company to indemnify employees for named risks. The employer reimburses the trustee or insurance company and pays an administration fee. 65 An employer may offer a single plan that qualifies as a PHSP under the Act. Alternatively, an employer may offer a flexible benefit plan that includes qualifying PHSP contributions as one of the options. In the latter case, the PHSP must satisfy the definition in the Act, and (as discussed above) contributions to and distributions from the PHSP must be segregated from those relating to the other benefit options. See the text accompanying footnote 34 and following. 66 Paragraph 118.2(2)(q). 67 Dath and Fuoco, supra footnote 18, at 6:6. 68 Ibid., at 6:10. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 803 that the employer does not retain a reasonable element of risk and therefore the plan ceases to be a “plan of insurance.”69 A plan that allows an employee to “cash out” unused credits also will not qualify because cash is not one of the benefits that may be offered to an employee under a PHSP. 70 The number of flex credits allocated to an employee must be fixed at the beginning of the plan year.71 The amount of predetermined flex credits allocated to each employee may be varied annually (before the beginning of the plan year) according to the employer’s ability to pay.72 Revenue Canada allows an employee to depart from his or her annual allocation of flex credits only to “accommodate a life event such as marriage, birth of a child or the loss of a dependant” so long as the changes are internal to the PHSP; reallocation between a PHSP and another benefit plan is not possible without incurring adverse tax consequences except in very limited circumstances.73 Revenue Canada has also indicated that flex credits may be reallocated where there is a change in the employment status of an employee (for example, a part-time employee becomes full-time).74 In Income Tax Ruling ATR-23, dated July 14, 1987, an employer established a plan whereby employees were allocated an annual amount of “spending account dollars” to be used for health-related benefits such as dental benefits, prescription drugs, and vision care. The employees were required to submit claims to the employer, which would reimburse 80 percent of the eligible expenses to a maximum of $500 per year (thus, a maximum reimbursement of $400). If an employee incurred more than $500 of eligible expenses, the plan permitted a carryforward of the additional expenses to the next year. At the end of the year, unused credits were forfeited. Revenue Canada ruled that the plan was a valid PHSP even though there was a one-year carryforward of excess expenses. Revenue Canada has since clarified its position, stating that eligible medical 69 Revenue Canada document no. June 1991-196, supra footnote 38; Revenue Canada document no. 9304605, supra footnote 38; and “Health Spending Account with Varying Plan Years and Amount of Credit,” Revenue Canada document no. 9522905, October 24, 1995. 70 Revenue Canada document no. 9309625, supra footnote 39; and Revenue Canada document no. 9505455, supra footnote 55. Presumably such a plan would not satisfy the requirement that there be an element of insurance present. 71 A plan that calculates credits as a percentage of an employee’s salary might fall outside the definition of a PHSP because the number of credits allocated to the employee could, depending on the particular plan, change over the plan year as the employee’s salary changes over the plan year. (Revenue Canada document no. 9522905, supra footnote 69.) 72 “Variations in the Annual Flex Credits Allocated,” Revenue Canada document no. 9623445, October 11, 1996. However, as discussed elsewhere, if an employee converts an existing right to salary or benefits to more flexible credits, the employee will incur a taxable benefit, whether the flex credits are used to obtain non-taxable or taxable benefits. See the text accompanying footnote 43. 73 Reallocation among different plans may be possible if the credits accrue to the employee on a periodic basis. (Revenue Canada document no. 9522905, supra footnote 69.) 74 IT-529, supra footnote 37, at paragraph 6. (1998), Vol. 46, No. 4 / no 4 804 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE expenses or flex credits (but not both) may be carried forward for a maximum of one year.75 It is Revenue Canada’s position that a plan that allows a carryforward of expenses or credits in excess of one year is more in the nature of a savings plan than a plan of insurance and, as such, does not qualify as a PHSP. 76 HWTs A second type of benefit plan that resembles, to a limited degree, a flexible benefit plan, is not defined in the Act but rather has been created by Revenue Canada. As defined in IT -85 R 2, a “health and welfare trust” is a plan that is “administered by an employer through a trust arrangement and which is restricted to (a) a group sickness or accident insurance plan. . . , (b) a private health services plan, (c) a group term life insurance policy, or (d) any combination of (a) to (c).”77 IT -85 R2 imposes further requirements on an HWT: • “the funds of the trust cannot revert to the employer or be used for any purpose other than providing health and welfare benefits for which the contributions are made”;78 • the funds contributed must not exceed the level required to fund the benefits;79 • the employer must have a legal obligation to make contributions to the plan;80 and • two or more employees must be covered by the plan (unless it is a PHSP). 81 If these criteria are met, certain tax consequences arise. First, the employer may deduct contributions to the trust in the year of contribution. Second, neither the employer’s contributions nor the premiums paid by the trustees to the insurer or the PHSP will be included in the employee’s income at the time such payments are made. Benefits eventually enjoyed by the employee may or may not be included in the employee’s income, 75 Ibid., at paragraph 16. of Credits and Expenses in a Health Spending Account—Flex Plan,” Revenue Canada document no. 9311525, August 9, 1993; and Revenue Canada document no. 9309625, supra footnote 39. 77 Supra footnote 34, at paragraph 1. Revenue Canada takes the position that a “group sickness or accident insurance plan” includes a “sickness or accident insurance plan,” a “disability insurance plan,” and an “income maintenance insurance plan” as found in paragraph 6(1)(f ) of the Act. (IT-85R2, supra footnote 34, at paragraph 2.) The rules pertaining to HWTs were originally published in 1966 in Information Bulletin no. 31, “Health and Welfare Trusts for Employees,” August 4, 1966. 78 IT-85R2, supra footnote 34, at paragraph 6. 79 Ibid. 80 Ibid. 81 Ibid., at paragraph 7. 76 “Carryforward (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 805 depending on the type of benefit involved.82 Employees do not receive deductions for employee contributions to the trust and are not taxed on the proportion of their benefits that corresponds to those contributions.83 The trust will be taxed on any funds that it retains after premiums, benefits, and certain expenses are paid out. 84 If an employee purchases insurance or contributes to plans other than a PHSP, a sickness or accident insurance plan, or a group term life insurance plan, the entire trust loses its characterization as an HWT and will likely be considered an EBP or perhaps an ET.85 An HWT under IT -85 R2 is generally not considered to be a flexible benefit plan. IT-85 R2 was introduced in response to industry practice of combining all three benefits within one plan, rather than offering employees a choice among benefits.86 The effect of IT-85 R2 is that a plan that combines all three benefits will preserve the same tax treatment for each benefit. In other words, premiums paid by employers for group sickness or accident insurance plans and PHSPs are excluded from an employee’s income under paragraph 6(1)(a) and are immediately deductible to employers under paragraph 18(1)(a). It appears that an HWT will not receive EBP treatment even if the three components of the plan are offered on a non-segregated basis.87 TAXATION OF FLEXIBLE BENEFIT PLANS IN THE UNITED STATES As noted earlier, the US tax system provides a specific taxation regime for cafeteria plans, in section 125 of the Code.88 A product of a series of legislative and regulatory changes made primarily in the mid-1980s, section 125 was enacted to prevent employees from being caught by constructive receipt rules.89 82 Benefits provided to an employee under a PHSP are not subject to tax. (Ibid., at paragraph 9.) Benefits under a group term life insurance plan are normally subject to tax under subsection 6(4) of the Act. Full taxability of group term life insurance was added to the Act in 1994. IT-85R2 has not yet been revised to reflect this change. If the benefit is funded by a combination of employer and employee contributions, the portion of the benefit that can be attributed to the employee contributions will not be included in the employee’s taxable income for the year. (IT-85R2, supra footnote 34, at paragraph 9.) 83 Subsection 8(2); IT-85R2, supra footnote 34, at paragraph 10. 84 IT-85R2, supra footnote 34, at paragraphs 11 and 12. 85 Ibid., at paragraph 3. 86 The term “health and welfare trust” was originally introduced by construction unions, which developed these combined benefit plans for workers in the construction industry. IT-85R2 reflects the format typically used for these plans. 87 A group sickness or accident insurance plan, a PHSP, and a group term life insurance plan all fall outside the definition of “employee benefit plan.” 88 For a more detailed review, see Woodward, supra footnote 11; Schaffer and Fox, supra footnote 9; and M.J. Canan and W.D. Mitchell, Employee Fringe and Welfare Benefit Plans (St. Paul, Minn.: West, 1996), chapter 15. 89 See Wiedenbeck, infra footnote 97. (1998), Vol. 46, No. 4 / no 4 806 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Cafeteria plans and flexible benefit plans are different concepts in the United States. Cafeteria plans are those plans that qualify under section 125; they are funded by pre-tax dollars and may provide tax advantages to both employers and employees. In contrast, a flexible benefit plan is any benefit plan that provides an employee with choice. The US cafeteria plan regime is carefully crafted to ensure favourable income tax treatment only for specific types of flexible benefit plans. Section 125(d) of the Code defines a “cafeteria plan” as a written plan under which— ( A ) all participants are employees, and ( B ) the participants may choose among 2 or more benefits consisting of cash and qualified benefits. The Code defines a “qualified benefit” as any benefit that “is not includible in the gross income of the employee by reason of an express provision of this chapter [excluding certain sections]”90 as well as other specified benefits.91 In contrast to Canadian PHSP s and HWTs, US cafeteria plans require employers to offer a combination of taxable benefits and cash. A cafeteria plan may offer employees taxable benefits, including property or any other benefit that would be taxable to the employee, without endangering the characterization of the plan as a cafeteria plan.92 A plan may also provide that employees can purchase certain benefits with after-tax dollars; these benefits will not be taxed again merely because they are offered in a cafeteria plan. 93 However, if a benefit is generally to be included in an employee’s income, the employee cannot escape taxation by opting for the benefit within a cafeteria plan. A cafeteria plan may be funded by a salary reduction agreement between the employee and the employer.94 A salary reduction agreement is an agreement under which an employee agrees to forgo salary increases or to 90 With the exception of certain benefits such as scholarships and tuition programs, certain fringe benefits, and employer education assistance programs. See section 125(f ) of the Code. 91 These specified benefits include group term life insurance up to $50,000, certain accident or health plan benefits, some medical expense reimbursements, some dependant care assistance benefits, and participation in certain cash or deferred arrangement plans. (Section 125(f ) of the Code and temp. Treas. reg. section 1.125-2T, A-1.) Vacation days are taxable benefits under the Code that can be purchased under a cafeteria plan without jeopardizing the validity of the plan. However, the validity of the cafeteria plan will be jeopardized if the employee is permitted to use or “cash out” the vacation days in a subsequent plan year. (Temp. Treas. reg. section 1.125-2T, A-1.) 92 Prop. Treas. reg. section 1.125-1, A-2 provides that a plan is not a cafeteria plan unless it offers at least one taxable benefit and at least one non-taxable benefit. A nontaxable benefit that is not a “qualified benefit” will be considered a taxable benefit if it is offered within a cafeteria plan. (Prop. Treas. reg. section 1.125-1.) 93 Prop. Treas. reg. section 1.125-1, A-5. 94 Prop. Treas. reg. section 1.125-1, A-6. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 807 decrease salary in exchange for contributions by the employer to the cafeteria plan of the amounts forgone or subtracted. The employee will not be liable for tax on those amounts to the extent that they were not currently available to the employee. A plan does not qualify as a cafeteria plan if it discriminates in favour of “highly compensated individuals or participants” with respect to eligibility to participate in the plan or with respect to contributions or benefits.95 A “highly compensated individual or participant” is defined in section 125(e) as an officer, a shareholder owning more than 5 percent of the voting power or value of all classes of stock of the employer, a person who is highly compensated, or a spouse or dependant of any of the above. In addition, non-taxable benefits provided to “key employees”96 may not exceed 25 percent of the total non-taxable benefits offered to all plan participants. A plan is not a cafeteria plan if it provides for deferred compensation.97 For example, proposed regulations suggest that an arrangement whereby unused credits from a given plan year could be retrieved in cash in a subsequent plan year would constitute deferred compensation and thus would disqualify the plan from section 125 treatment.98 In addition, the proposed regulations state that a plan that allows an employee to purchase vacation days will not qualify as a cafeteria plan if the employee has the opportunity to use those vacation days in the next plan year;99 the inability of the employee to convert the purchased vacation days into other benefits is irrelevant. The proposed regulations also state that an employee may not purchase benefits in the current year for consumption in subsequent years. 100 Elections among benefits made by an employee must be irrevocable within the coverage period, subject to certain exceptions.101 Although the 95 Section 124(b)(1) of the Code. in section 416(i)(1) of the Code to include certain officers of the employer, the 10 employees who own the largest interests in the employer, employees who own more than 5 percent of the employer, and employees who own more than 1 percent of the employer and earn more than $150,000 annually. 97 Section 125(d)(2)(A) of the Code. Some exceptions to this general rule are found in the remaining provisions of section 125(d)(2) of the Code. An example of deferred compensation that would be prohibited by the section might be the US equivalent of an SDA. The Code contains a number of anti-discrimination provisions in the area of deferred compensation. The purpose of these provisions is twofold: first, to encourage employers to provide benefits to a wider range of employees; and second, to ensure that benefits are allocated fairly. See Peter J. Wiedenbeck, “Nondiscrimination in Employee Benefits: False Starts and Future Trends” (Winter 1985), 52 Tennesee Law Review 167-267, at 170 and 175. 98 Prop. Treas. reg. section 1.125-1, A-7. 99 Ibid. 100 Ibid. 101 These exceptions include marriage or divorce of the employee, birth or adoption of a child, and death of a covered family member. (Temp. Treas. reg. section 1.125-4T.) 96 Defined (1998), Vol. 46, No. 4 / no 4 808 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Code does not specify the length of a coverage period, it may be assumed that the period will generally be a plan year. Therefore, for example, if an employee has the right to change an election from a particular benefit to cash midway through the plan year, the employee will have to include the amount of cash in taxable income for the current taxation year whether or not he or she has actually received the cash.102 Thus, section 125 of the Code provides an exception to the constructive receipt rules, but only to the extent that the employee makes choices among benefits before those benefits become currently available. 103 A popular type of cafeteria plan in the United States is the flexible spending account. This kind of plan can be funded by both employer and employee contributions. A cafeteria plan can be funded solely by employee contributions. Benefits may also be uninsured and delivered on a “pay-as-you-go” basis. However, in the case of health care benefits, amounts contributed by the employer to reimburse the employee’s medical expenses must relate to expenses incurred within the coverage period. If a plan provides for reimbursement of the employee for a specific amount (say, $1,000) but allows the employee to “cash out” the unused portion of the amount, the benefit is not a “qualified benefit.”104 The total payroll of an employer administering a flexible spending account will be reduced by the amount of money put into that account. The employer will therefore enjoy a tax advantage, since its social security and unemployment taxes will be reduced. 105 Once a plan meets the definition of a cafeteria plan in section 125 of the Code, employer contributions are not taxable to the employee at the time of contribution, whether or not the employee could have elected (before the beginning of the plan year) to receive that contribution in cash.106 Once an employee receives cash, the cash is taxed in the employee’s hands as compensation. A plan that fails to meet the definition of a cafeteria plan results in taxation of the employee on all benefits that could have been received in cash or in the form of taxable benefits. 102 Prop. Treas. reg. section 1.125-1, A-15. Treas. reg. section 1.125-1, A-9. A benefit is currently available to an employee “if the participant is free to receive the benefit currently at his discretion or the participant could receive the benefit currently if an election or notice of an intent to receive the benefit were given.” A benefit will not be considered currently available merely because the employee must give notice if he or she wishes to receive the benefit, nor will it be considered currently available if the employee is ineligible to receive the benefit until some time in the future and “there is a substantial risk that, if the participant does not fulfil specified conditions during the period preceding this time, the participant will not receive the benefit.” (Prop. Treas. reg. section 1.125-1, A-14.) 104 Prop. Treas. reg. section 1.125-1, A-17; sections 106 and 105(b) of the Code. 105 R. McCarthy, “Do-It-Yourself Flexible Benefits: Tips To Enable a Benefits Manager To Help Employees Navigate Through Choices” (1996), 14 Business and Health 63. 106 Section 125(a) of the Code. 103 Prop. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 809 The US cafeteria plan regime attempts to resolve many of the problems faced in Canada in connection with flexible benefit plans (for example, the use of options to defer compensation). There is, however, a key conceptual difference between the US and Canadian regimes, other than their treatment of cash benefits: the United States has chosen to implement a legislative regime, while Canada has (thus far) opted for an administrative regime. The importance of this distinction is addressed in the next section. IS THERE A NEED FOR LEGISLATIVE CHANGE? Although flexible benefit plans have existed in Canada for well over a decade, Revenue Canada has only recently begun to provide guidance with respect to their tax treatment. Until this year, the regulatory response to flexible benefit plans has been piecemeal, consisting largely of Revenue Canada opinions relating to specific factual situations. IT-529 is the first attempt by Revenue Canada to provide a comprehensive guide to the tax treatment of such plans. However, the bulletin generally represents a collection of Revenue Canada’s views already published in the area. There is no specific tax legislation in Canada pertaining to flexible benefit plans, and the Department of Finance has not indicated any intention of amending the Act in this regard in the near future. The lack of legislative activity in this area is not surprising. The provisions in the Act dealing with employee benefits have been primarily reactive and have seemingly responded to the changing demographics of the Canadian workforce over the past few decades. 107 There are now more women in the workforce and many families in which both partners work.108 These changes have led to innovative approaches to work and compensation, and flexible benefit plans are one measure that has become widely accepted by both employers and employees. Perhaps the government has been reluctant to recognize such plans through legislative amendments because it is concerned about loss of tax revenues. As will be discussed below, an increase in the use of flexible benefit plans would arguably result in an increase in the absolute dollar value of non-taxable benefits being consumed. Nevertheless, given that many plans are already in place and interest in them is still growing, it is timely now to consider the introduction of legislation clearly specifying the tax treatment to employers and employees who participate in these plans. The remainder of this article presents arguments in support of a legislative framework for the taxation of flexible benefit plans. 107 Canadian Handbook of Flexible Benefits, supra footnote 15, at 443. Canada, Labour Force, Employed and Unemployed, Numbers and Rates by Sex, 1995, catalogue no. 71F-004-XCB. 108 Statistics (1998), Vol. 46, No. 4 / no 4 810 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Flexible Benefit Plans Generally The absence of legislation governing flexible benefit plans may indicate neutrality toward or even discouragement of such plans by Parliament. On the other hand, Revenue Canada has provided limited administrative guidance regarding their tax treatment and thereby seems to have encouraged the use of such plans. If parliamentary inactivity indicates an intention to discourage flexible benefit plans, arguably tax legislative policy and tax administration are at odds with each other. The first question to be addressed, then, is whether the Canadian taxation system ought to encourage flexible benefit plans. Arguments in Support of Flexible Benefit Plans There are two basic arguments in favour of flexible benefit plans. First, flexible benefit plans respect and enhance individual choice.109 A flexible benefit plan allows each employee to select a benefit package that best represents his or her preferences.110 Moreover, a flexible benefit plan accommodates changes in the requirements of employees. Factors such as wage increases, fluctuations in family size, and age of plan participants all affect employee preferences. An individual employed by a firm with a flexible benefit plan is not bound by the benefit package chosen at the beginning of his or her career. Second, flexible benefit plans allow for efficient allocation of resources. 111 Flexible benefit plans transfer decisions regarding benefit 109 It could also be argued that enhancement of individual choice of benefits allows Canadian firms to compete better in international labour markets. Given the range of other variables that determine where individuals choose to work, this argument may not carry much weight; however, it may be more persuasive in the case of markets suffering from labour shortages. 110 With the dramatic changes that have taken place in the demographics of the workforce, employers have generally had to reassess their benefit packages. Similarly, employers have taken a closer look at the pension plans they offer to employees and have been exploring the possible uses of flexible pension plans. Revenue Canada has recently published its position on flexible pension plans (Revenue Canada, Registered Plans Division, Newsletter, no. 96-3, November 25, 1996), approving of their use. Revenue Canada has clearly established that flexible pension plans (as approved in the newsletter) can be registered under the pension rules in the Act. Contrast the department’s approach to flexible benefit plans, for which there is no formal registration procedure and no requirement for the plan documents to be approved by Revenue Canada before implementation. For further discussion of flexible pension plans, see Sheldon Wayne, “Switch Hitting” (April 1995), 19 Benefits Canada 23-25. 111 Consider the following example offered by Julie A. Roin, “United They Stand, Divided They Fall: Public Choice Theory and the Tax Code” (November 1988), 74 Cornell Law Review 62-134. An employer with three employees decides to raise wages in order to provide its employees with additional non-taxable benefits. The employer is willing to raise wages only to the level required to fund one type of benefit for each person. However, each employee would like to receive a different benefit. Each employee could simply take the wage raise and buy the benefit herself, but she would receive less of a benefit (The footnote is continued on the next page.) (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 811 allocation from employers to employees. Employees are most familiar with their own requirements and therefore are in the best position to make appropriate allocation decisions. For example, it is the employee who will know whether benefits will be duplicated within her family if her partner participates in a similar plan. Furthermore, requiring employees to make choices regarding the allocation of their benefit dollars forces them to measure the value of one benefit against others. This more efficient allocation of resources means that the costs of providing benefits should be set at the correct level. It is likely that an employee will use only benefits that she believes she requires, since under a flexible benefit plan an employee generally must sacrifice one benefit in order to obtain another. Accordingly, the overuse of benefits should not be a problem. These arguments, of course, do not take tax into account, but a review of the efficiency of flexible benefit plans under various tax regimes is beyond the scope of this article. These arguments do support the position that attempts to design a tax regime governing flexible benefit plans should begin with the premise that such a tax regime should encourage (through neutrality or even, perhaps, preferences) the efficiency of flexible benefit plans that would exist in a tax-free world.112 Arguments Against Flexible Benefit Plans There are at least four arguments against the encouragement of flexible benefit plans. First, policy makers may be concerned that if employees are permitted to choose their benefits, they may opt out of those benefits that legislators deem important. Such a rationale may explain why currently the only 111 Continued . . . because the benefit would be purchased with after-tax dollars. The employee could participate in the plan offered by the employer, but she might not receive her preferred benefit. Many employees may choose this option because it is less expensive, and because they do not have the knowledge to purchase other benefits. Continued receipt of less desirable benefits could eventually lead to the termination of the benefit plan owing to decreased employee participation and increased expense to employers. (Ibid., at 97.) Under a flexible benefit plan, the employer in this example can offer each employee the benefit she prefers for the same cost. Employee choice is enhanced, and resources are allocated more efficiently because the employee receives the benefits she most desires, rather than incurring costs for unwanted benefits. Roin argues that even if the three employees are allowed to vote on the benefit to be offered, the “impossibility theorem” of public choice theory dictates that a majority of employees will be dissatisfied with the outcome in that they would have preferred a different benefit. (Ibid., at 65.) Hence, argues Roin, “the Code operated to minimize revenue loss by exploiting the effects of the impossibility theorem.” (Ibid., at 66.) 112 We recognize, of course, that designing such a tax regime may cause unintended distortions and is thus fraught with difficulty. (See, for example, Boris I. Bittker, “A ‘Comprehensive Tax Base’ as a Goal of Income Tax Reform” (March 1967), 80 Harvard Law Review 925-85.) However, this article does not argue for a specific tax regime; instead, it argues that an attempt to design a specific regime ought to be made because the current tax regime appears to undermine non-tax efficiencies. (1998), Vol. 46, No. 4 / no 4 812 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE plans referred to in the Act that offer individual choice are those providing health benefits (under PHSP s). 113 Arguably, policy makers have determined that such benefits are important and should be encouraged. Some may immediately dismiss this argument as paternalistic; however, given that the benefits are subsidized by taxpayers, it may be appropriate for the federal government to curtail individual choice in favour of the pursuit of specific national policies. A second concern is that although flexible benefit plans result in a more efficient allocation of resources generally, they may have an adverse effect on tax revenues. While non-taxable benefits may be allocated more efficiently among employees, the absolute dollar value of non-taxable benefits being consumed will likely increase for two reasons: first, it is likely that more employees will choose to participate in flexible benefit plans; and second, it is more likely that employees will consume the benefits actually offered. Thus, an increase in the use of flexible benefit plans may result in decreased revenues. Accordingly, Parliament may hesitate to encourage the use of such plans. Third, some may argue that the introduction of legislation would needlessly complicate an area that is already adequately regulated. Perhaps a legislative regime would only cause new problems and raise compliance costs. Finally, it has been suggested that flexible benefit plans may not ultimately benefit employees, since they may make the valuation of taxable benefits easier for Revenue Canada.114 For example, where an employee elects to forgo salary in exchange for a package of benefits, it is easier to place a monetary value on that package of benefits. Similarly, if flex credits are used, where each credit has a specific value, it may be easier for Revenue Canada to place a value on the taxable benefits selected by the employee. However, as increased transparency is always beneficial to the functioning of the tax system and therefore to taxpayers generally, this argument lacks persuasiveness and, in fact, likely provides support for the encouragement of flexible benefit plans. Conclusion Flexible benefit plans are desirable because they enhance employee choice, because they permit employers to provide benefits at equal or reduced cost, and because they encourage a more efficient allocation of resources. 113 Many employers that offer flexible benefit plans do not allow employees to opt out of medical coverage. According to the 1995 survey by Hewitt Associates, referred to in Gordon, supra footnote 4, at 22, 31 percent of employers surveyed did not allow opting out, while 21 percent of employers allowed opting out with proof of coverage elsewhere. In 1992, 56 percent of employers surveyed allowed employees to opt out of medical coverage. 114 Barrie M. Philp, “Executive and Employee Compensation After Tax Reform,” in Report of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto: Canadian Tax Foundation, 1989), 28:1-56. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 813 The arguments against encouraging flexible benefit plans can largely be resolved satisfactorily. Legislative adjustments can be made to respond to the concern that choice may undermine national policy objectives. For example, if policy makers want to encourage the receipt of medical benefits (such as PHSPs) by employees, the Act can be amended to provide for minimum coverage requirements for those employees who participate in a flexible benefit plan.115 Arguments raising the spectre of legislative complexity can be countered by reference to the US example, which, setting aside complexities made necessary by the uniqueness of the US tax system, is not significantly more complicated than the current Canadian system. Concerns regarding the valuation of benefits are easily set aside since the efficient and equitable functioning of the current taxation system requires the accurate valuation of benefits. Perhaps the most powerful argument against the encouragement of flexible benefit plans is the possibility of forgone revenue by the national treasury. This question cannot be resolved from the viewpoint of tax policy alone but rather demands a much broader analysis. It appears, then, that there are sound non-tax arguments that may be marshalled in favour of flexible benefit plans. Nevertheless, as explained above, the Canadian tax system is not neutral toward these plans; indeed, employers may have to incur additional costs to ensure that their plan adheres to Revenue Canada’s guidelines, or risk deferred deductions or accelerated inclusions for their employees. Accordingly, this article argues that legislation is needed to ensure that, at least, neutrality toward flexible benefit plans is achieved. The remainder of this article will address several specific aspects of the taxation of flexible benefit plans and will suggest that the tax system should provide outright encouragement rather than mere neutrality. Specific Issues The Cash Option When the Canadian and US approaches are compared, the most striking difference is the tax treatment of a “cash option” under a flexible benefit or cafeteria plan. In the United States, a cash option is a required component of a cafeteria plan, subject to certain restrictions.116 In Canada, a cash option is not directly addressed and may, depending on the structure 115 For example, the Act could specify that any employee participating in a flexible benefit plan must use a given percentage or amount of credits for the reimbursement of medical expenses. 116 Section 125(d)(B) of the Code. Cash is not a valid option of a cafeteria plan if it is offered in the form of “deferred compensation” (section 125(d)(2)(A) of the Code). Proposed regulations may substantially alter the cash option. Under prop. Treas. reg. section 1.125-2, an arrangement that allowed an employee to cash out unused benefits in subsequent years would be considered “deferred compensation.” Note, however, that although the Canadian and US systems appear to treat the cash option in radically different ways, the US proposed regulations resemble the current Canadian administrative position. (1998), Vol. 46, No. 4 / no 4 814 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE of the plan, result in the current taxation of benefits that would otherwise be either non-taxable or taxable only at a later date.117 A cash option does not render all allocated credits immediately taxable, so long as the employee makes an irrevocable election at the beginning of the plan year. However, if an employee can change the election in the middle of a plan year and withdraw cash, Revenue Canada considers all credits or benefits offered by the plan to be immediately taxable to the employee whether or not the credits or benefits were actually withdrawn in cash.118 The problem with providing a cash option is that a flexible benefit plan could be used as a tool to defer compensation. For example, if a plan allows an employee to roll over unused benefits from one year to the next, and then cash out those unused benefits at a later time, the result is a deferral of compensation.119 If a plan spans a year other than a calendar year and the employee elects to cash out at the end of the plan year, compensation may be deferred from one calendar year to the next. Another argument against the allowance of a cash option is that lowerpaid workers will always choose cash instead of benefits. Consequently, only higher-paid employees will participate in the plan. Schaffer and Fox explain that plans that “discriminate” in favour of highly paid employees defeat the justification for preferred tax treatment for certain benefits, such as health and disability insurance, and pension schemes: The only justification for leaving employer-provided benefits untaxed was that it encouraged the use of health insurance, disability insurance, and pension schemes “so that individuals, particularly lower income employees, will be assured of protection against certain contingencies—sickness, disability, retirement—which are particularly difficult to plan for at low income levels.” This justification failed if employers provided tax-free benefits only to their more highly paid employees.120 117 Yet the cash option remains popular in Canada. According to the 1995 survey conducted by Hewitt Associates (Gordon, supra footnote 4, at 22), 58 percent of employers surveyed allowed employees to cash out unused benefits, and 58 percent allowed employees to deposit unused benefit dollars into RRSPs. 118 Dath and Fuoco, supra footnote 18, at 6:2-3; and IT-529, supra footnote 37, at paragraph 8. See also “Treatment of a Flexible Benefit Plan,” Revenue Canada document no. June 1991-161, June 13, 1991; and Revenue Canada document no. June 1991-196, supra footnote 38. 119 In “Vacation Buying and Selling in a Flex Plan,” Revenue Canada document no. 9500075, July 17, 1995, the department notes that “a plan which permits the rollover or cash out of purchased vacation leave may be a salary deferral arrangement.” It is clear that the rollover of vacation entitlement to a future year postpones the tax payable. Such an arrangement would likely fall within the definition of an SDA in subsection 248(1) if “the deferment of tax is one of the main purposes of the arrangement.” 120 Schaffer and Fox, supra footnote 9, at 12, citing United States, Department of the Treasury, The President’s 1978 Tax Program: Detailed Descriptions and Supporting Analysis of the Proposals (Washington, DC: US Government Printing Office, January 30, 1978), 145. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 815 From a social policy standpoint, favourable tax treatment is given to certain benefit plans because policy makers want all employees to participate; allowing some employees to escape from participation defeats the policy. On the other hand, employees may not participate if there is no cash option: Flexible spending accounts that are forfeitable may at first seem to be unattractive to employees. An employee can choose to reduce his taxable salary by $1,000 in return for his employer’s promise to reimburse him (without tax) for up to $1,000 in, say, uninsured medical expenses and day care. But what if he should have the misfortune of good health? Then he has lost $1,000 of salary and gotten nothing for it. . . . At the end of the year he would have been better off with taxable cash instead.121 The employees for whom such a situation creates the most concern are low income earners. For them, the risk that reductions in salary will never pay off is greater than the risk that any of the situations insured against (such as disability) will occur. Therefore, particularly for low-income employees, non-participation is likely. Most arguments in favour of providing a cash option can be addressed by allowing employers to provide employees with unlimited opportunity to roll over unused credits into future years. Although lower-paid employees will still choose cash over benefits in kind, they will likely do so to a lesser extent because they will pay less tax and will be assured of being able to use the benefits at some point in the future. Participation of employees in benefit plans will increase for the same reasons. Under the current system, benefits cannot always be rolled over to subsequent plan years. This issue is addressed below. Rolling Over Benefits Through Time The concept of rolling over credits from one year to the next within a flexible benefit plan means that an employee who allocates credits to a plan for a given plan year is not required to consume the benefits associated with those credits in that year. 122 The ability of employees to roll over credits in this fashion is determined by the particular plan or benefit in issue. Under the current regime, the rolling over of credits is limited with respect to certain benefit plans. The most clear limitation is specific to PHSPs, and it follows from the requirement that a PHSP contain an insurance element. It is questionable whether the requirement that PHSPs contain an insurance element continues to be a reasonable one, since these plans have moved away from being a form of “insurance.” The concept of 121 Schaffer and Fox, ibid., at 44-45. concept is analogous to the provisions in the Act that currently permit the rolling over of unused RRSP contribution room from one year to the next, to a maximum of seven years. 122 This (1998), Vol. 46, No. 4 / no 4 816 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE insurance has been described as involving four general characteristics (at least from the point of view of the insured): low incidence of claims, high amounts, unpredictability, and uncontrollability.123 Arguably, PHSP s do not satisfy these criteria. PHSP s are extremely common, and generally there is a high incidence of claims under them, for relatively low amounts. In addition, many of the service claims under these plans are predictable (for example, regular dental or visual checkups).124 The insurance requirement dates back to 1983 125 (or perhaps earlier) and has not been revised despite the increased use of PHSPs in Canada, particularly within flexible benefit plans. One of the consequences of this requirement is that employees can roll over unused eligible medical expenses or flex credits in a PHSP only for a maximum of one year; they cannot roll such expenses or credits forward to fund claims in subsequent years. The inability of employees to roll over credits indefinitely within a PHSP or other insurance plan presents a serious problem in the context of flexible benefit plans. For example, it has already been argued that flexible benefit plans encourage the efficient allocation of resources by employees. Requiring employees to estimate the monetary value of their medical claims on a year-by-year basis does not entirely undermine this advantage, but it does decrease efficiency to a significant extent, especially if the result is that employees deliberately under- or overestimate future medical claims. In addition, if employees perceive credit rollovers to be extremely limited, the discrimination or non-participation problems described above may arise in connection with lower-paid employees. On the other hand, allowing employees an indefinite rollover of unused credits could result in long-term benefits from a social cost standpoint. Although these credits will escape immediate taxation, they will be available to fund future needs such as increased health care costs associated with age, which are not covered by the public health care system. So long as the funds accumulated must be used for designated non-taxable benefits, employees will be encouraged to “save” for future contingencies. It is also apparent that the policy decision to provide for a deduction upon taxation for some benefits, rather than labelling the benefit “nontaxable” under paragraph 6(1)(a), has an impact with respect to the design of flexible benefit plans. For instance, section 63 provides a deduction in respect of certain child care expenses. If instead such child care expenses were non-taxable benefits under paragraph 6(1)(a), it might be appropriate to allow these benefits to be included under an HWT.126 Under both 123 Melvin J. Norton, “Taxation of Benefit Plans,” paper presented at the Infonex Seminar on Employee Compensation and Benefits Taxation, June 24-25, 1997. 124 Ibid., at 5. 125 Interpretation Bulletin IT-339R, “Meaning of ‘Private Health Services Plan’,” June 1, 1983. 126 However, given the current governmental trend toward greater fiscal responsibility, it is unlikely that the federal government would be willing to expand the categories of benefits eligible to receive preferred non-taxable treatment. (1998), Vol. 46, No. 4 / no 4 INCOME TAXATION OF FLEXIBLE BENEFIT PLANS 817 this suggested plan and the current legislation, the employer would receive a deduction for the amount paid (either as salary or as a payment to an HWT), and in both cases the employee would pay less tax (either as a non-taxable benefit or as a deduction). Arguably, the reason for providing a deduction instead of making such expenses non-taxable is that the deduction is limited to a specific amount based on a carefully crafted formula; total non-taxability under paragraph 6(1)(a) would presumably undermine this deliberate policy choice. It is questionable, however, whether it would be possible to limit non-taxability under paragraph 6(1)(a) to a monetary amount equivalent to the current section 63 deduction. If this limitation were possible, child care expenses could be included in an HWT without endangering the tax treatment of the other benefits in the plan. 127 Alternatively, Revenue Canada could simply take the position that taxable benefits that are wholly or partially deductible to employees should be includible in an HWT to the extent of the deduction, without endangering the status of the HWT. Such a change would not provide employees with an opportunity to defer taxation of compensation because the benefits (at least to the extent of the deduction) would not have been taxed in any event. Transfer of Credits Among Plans A third issue surrounding the treatment of flexible benefit plans under the current Act is the ability—or inability—of employees to transfer credits from one plan or benefit to another within a given plan year. As discussed above, to avoid treatment of a flexible benefit plan as an EBP (or possibly an SDA ), an employer must segregate contributions and distributions relating to each plan or benefit at the beginning of each plan year. 128 Accordingly (subject to limited exceptions), an employee may not alter the allocation of credits in the middle of a plan year. For example, consider a flexible benefit plan whose plan year corresponds to the calendar year. An employee realizes in November that she will not use all of the credits that she has allocated to her PHSP, and she would like to transfer any unused credits to her RRSP. If she does, she will have to include in income the value of all the benefits received under the entire flexible benefit plan, whether or not the benefits would have been otherwise taxable.129 As discussed above, the reason for this limitation on interplan rollovers is that such rollovers would constitute constructive receipt or “indirect payments” under subsection 56(2). 130 It is unclear whether this effective prohibition on interplan credit rollovers is desirable, or even sensible, if credits are being rolled over 127 Recall that currently, if an employer offers a taxable benefit within an HWT without adequately segregating the valid HWT benefits and the taxable benefits, the plan loses its status as an HWT. 128 See the text accompanying footnote 34. 129 IT-529, supra footnote 37, at paragraph 8. 130 See the text accompanying footnote 54. (1998), Vol. 46, No. 4 / no 4 818 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE from one non-taxable benefit to another. This article has already examined the problems associated with “cashing out” unused credits at the end of a plan year; the same arguments can be made in relation to the rolling over of credits from non-taxable benefits to taxable benefits such as vacation days. However, if credits are being rolled over from one non-taxable benefit to another (for example, from a PHSP to an RRSP), there is no policy rationale for the imposition of adverse tax consequences to the employee. In fact, in view of the arguments presented above regarding the efficient allocation of resources and the enhancement of employee choice, such interplan transfers ought to be encouraged. Under the current system, adverse consequences do occur (at least in Revenue Canada’s view) under subsection 56(2) when such interplan transfers take place. THE NEED FOR CHANGE Flexible benefit plans are now in wide use in Canada. Nevertheless, they are not recognized in the Act, and administrative guidance with respect to their tax treatment has been primarily reactive. As a result, taxpayers are faced with considerable uncertainty in determining the tax treatment of benefits provided under a flexible benefit plan. At least until the issuance of IT-529, taxpayers frequently needed to submit requests to Revenue Canada for rulings or technical interpretations regarding these plans. Further complications have arisen with respect to plan design, since employers have had to take great care to ensure that their plans do not inadvertently fall into categories of plans or arrangements defined in the Act (EBPs, ET s, SDA s, etc.) and thereby attract adverse tax consequences. To avoid this risk, employers have incurred additional costs in segregating contributions and distributions on a plan-by-plan basis. Revenue Canada has recently attempted to clarify the treatment of flexible benefit plans by issuing a number of new technical interpretations as well as IT-529. However, the department can only provide guidance within the parameters of the legislation, and in this area the legislation is silent. Many of the specific problems addressed above, such as intra- and interplan credit rollovers, require legislative solutions. Furthermore, taxpayer uncertainty is increased by the possibility of conflict between the policy goals of the Department of Finance and the administration of the Act by Revenue Canada. In our view, it is time for Parliament to turn its attention to the governance of flexible benefit plans. (1998), Vol. 46, No. 4 / no 4