19 July 2006 External T.I. 2006-0195811E5 - General rules for deferred salary leave plans

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: What are the rules that must be followed in order for a plan to be a prescribed plan under paragraph 6801(a) of the Regulations and be excepted from the SDA rules?

Position: General discussion

XXXXXXXXXX 						2006-019581
W. C. Harding
(613) 957-8953
July 19, 2006

Dear XXXXXXXXXX:

Re: Deferred Salary Leave Plan

This is in response to your letter of July 11, 2006, requesting our comments as to whether a particular plan will qualify as a deferred salary leave plan ("DSLP") within the requirements of paragraph 6801(a) of the Income Tax Regulations (the "Regulations").

We wish to point out that there is no requirement that a DSLP be submitted to the Canada Revenue Agency ("CRA") for review, approval or any sort of registration process. However, if the plan is still proposed, this Directorate can provide written confirmation of the tax implications inherent therein in response to a request for an advance income tax ruling request. For more information about how to obtain a ruling, please refer to Information Circular 70-6R5, "Advanced Income Tax Rulings, dated May 17, 2002. This Information Circular and other CRA publications can be accessed on the internet at http://www.cra-arc.gc.ca. If your DSLP has already been implemented, any plan-specific questions should be addressed to the CRA Tax Services Office ("TSO") that is responsible for providing service to the employer. A list of TSOs is available on the "Contact Us" page of the CRA website. Although we cannot comment on your specific plan, we are prepared to provide the following general comments, which may be of assistance.

Generally, the salary deferral arrangement ("SDA") provisions in the Income Tax Act (the "Act") would require that salary deferrals be included in an employee's income on an accrual basis (i.e., in the year the salary is earned) notwithstanding that the salary may only be received in a subsequent year. However, if an arrangement complies with the DSLP rules, the SDA provisions will not apply and the employee's salary deferrals will be taxed when actually received, rather than when earned.

A DSLP is a plan or arrangement that permits an employee to defer salary or wages in order to fund a leave of absence from his or her employment. The rules governing DSLPs are set out in paragraph 6801(a) of the Regulations. This letter discusses these rules and provides certain additional information that may be of assistance to an employer that is administering a DSLP for its employees. We have included references to the applicable sections of the Regulations in order that you may, if need be, refer directly to the legislation that addresses particular requirements. You may also wish to refer to the attached document, which is an excerpt of the severed version of an advance income tax ruling describing a DSLP that complies with paragraph 6801(a) of the Regulations.

In this discussion of DSLPs, it is important to understand what is meant by certain terms. For example:

Deferral Period: This term refers to the time period between the first salary deferral and the date that the employee commences the leave of absence and starts to receive income benefits from the DSLP, which are as a result of his or her election to defer salary.

Leave Period: This term is used to describe the period during which the individual is absent from employment and during which payments of the DSLP income benefits occur.

A DSLP must be a written agreement between an employer and an employee. Whether an employer-employee relationship exists is a question of fact. If you require additional information in order to make this determination, you may refer to CRA publication RC4100, which is entitled, "Employee or Self-employed?" The terms of the written DSLP agreement must make it clear that its main purpose is to fund, through salary or wage deferrals, a leave of absence from employment. [subparagraph 6801(a)(i)]

This purpose has several implications with respect to the content of a DSLP:

i) it should be clearly stated in the terms of the written agreement that the DSLP has not been established to provide an employee with benefits on or after retirement. Such a statement will support the plan's purpose as being to fund a true leave of absence from employment as opposed to allowing for income averaging as a bridge to retirement.

ii) a DSLP's terms cannot provide for a participant's voluntary withdrawal from the plan. Such a provision would violate paragraph 6801(a) of the Regulations because it means the employee can, at any time, access the funds held in the Plan for his or her benefit.

Although a provision permitting voluntary withdrawal from a DSLP is problematic, a DSLP can provide for early withdrawal in extenuating circumstances such as where continued participation therein would cause financial hardship to the employee. Generally, this withdrawal should only be available with the employer's permission. Where this occurs, and withdrawal from the DSLP takes place prior to the participant's leave of absence, all amounts previously deferred under the plan and any unpaid interest are payable and taxable in the year the employee withdraws from the plan.

The Deferral Period

The arrangement should specify what percentage of salary or wages otherwise payable to the employee will be deferred, and for what period of time. It is important to note that in any given year, this percentage cannot exceed 33-1/3% [subparagraph 6801(a)(ii)].

The Deferral Period cannot exceed six years. This limitation is imposed by subparagraph 6801(a)(i) of the Regulations which requires that the Leave Period commence immediately after a period that is no more than six years after deferrals begin. It should be noted that the Deferral Period can be less than six years.

A DSLP is typically structured in one of two general ways:

i) Deferral of a certain percentage (less than 33-1/3%) of salary for a specified number of years and receipt of the accumulated deferrals during the Leave Period. For example: deferral of 20% of salary for 4 years and receipt of the accumulated 80% of salary during a year 5 Leave Period;

ii) Alternatively, a DSLP could specify a fixed percentage of salary or of the wage scale in place for the employer's employees. The individual must receive this fixed percentage of salary or wage scale during the Deferral Period and also during the Leave Period. Note that although the percentage must be fixed, the wage scale upon which it is based can be variable. For example: a plan may provide that participants will receive 75% of their wage scale each year during a 3-year Deferral Period and 75% of the wage scale in effect during the year 4 Leave Period.

The DSLP agreement must describe how the participant's deferred salary or wages will be held. Clause 6801(a)(iv)(A) of the Regulations applies to the situation in which the deferred amounts are paid by the employer to another person to be held by a trust that is an employee benefit plan ("EBP"). Generally speaking, an EBP is an arrangement by which an employer makes contributions to another person and under which one or more payments will be made to or for the benefit of the employer's employees. Should you be interested in additional information about EBPs, you may refer to Interpretation Bulletin IT-502, "Employee Benefit Plans and Employee Trusts." If the deferred salary is held in this manner, each year during the Deferral Period the trust must pay out to the employee its income reasonably considered to have been earned on his or her deferred amounts in that year. The CRA has expressed the view that the EBP trust may deduct administration costs or plan expenses from the gross interest income. The DSLP participant would then only be taxable on the net interest paid to him or her in the year.

If the deferred amounts are not paid into an EBP trust but are held in some other manner, clause 6801(a)(iv)(B) of the Regulations applies. This would be the case where, for example, the salary otherwise payable to the participant is simply retained and invested by the employer. Similar to the EBP treatment described above, the Regulations require that interest or other amounts that may reasonably be considered to have accrued on the participant's deferred amounts be paid to the employee in the year of accrual.

The interest or income amount paid to a DSLP participant in a year during the Deferral Period is considered employment income and must be reported on the employee's T4 slip. These amounts are subject to income tax withholding requirements.

During the Deferral Period, it is the CRA's position that Canada Pension Plan ("CPP") premiums are to be based on the participant's salary net of DSLP deferrals. DSLP income benefits received during the Leave Period will therefore be subject to CPP premium deductions. However, during the Deferral Period, employment insurance ("EI") premiums are to be based on the participant's gross salary (i.e., the amount that would be received without any deferral of salary). This means that payments during the Leave Period will not be subject to EI premiums.

The Leave Period

Pursuant to subparagraph 6801(a)(i) of the Regulations, the Leave Period must follow immediately after the Deferral Period. As noted previously, the Leave Period must begin no later than six years after the date on which salary deferrals commence. This requirement means that a DSLP must be structured so that all salary deferrals are completed before the Leave Period occurs.

The DSLP rules prescribe the minimum length of time that a Leave Period must last. The minimum duration depends upon the purpose of the Leave Period:

• If the Leave Period is for the purpose of attending a designated educational institution on a full-time basis, the leave must be for at least 3 consecutive months (clause 6801(a)(i)(A)).

The term "designated educational institution" is defined in subsection 118.6(1) of the Act. Generally speaking, a designated educational institution is an institution providing post-secondary education and which has been designated under the Canada Student Loans Act, the Canada Student Financial Assistance Act or Quebec's Act respecting financial assistance for education expenses. The term also includes an institution certified by the Minister of Human Resources Development that furnishes or improves skills in an occupation, as well as a foreign university. For a more detailed discussion of the term, you may refer to Interpretation Bulletin IT-515R2, "Education Tax Credit."

• A Leave Period taken for any other reason must be for no less than 6 consecutive months [clause 6801(a)(i)(B)].

Although the Regulations do not set a maximum length of time for a Leave Period, the plan must specify that all amounts held for the employee's benefit under the arrangement will be paid out by the end of the first calendar year that begins after the end of the Deferral Period. [Subparagraph 6801(a)(vi)] It should be noted that this comment applies where the DSLP continues to exist and is being operated in accordance with the Regulations. If a DSLP falls offside of the Regulations, it would no longer qualify for DSLP treatment and all deferred amounts plus unpaid interest, if any, should be paid to the employee less any applicable withholding tax, and included in his or her income for that year.

During the Leave Period, the participant cannot receive any salary or wages from the employer or from any other person or partnership that does not deal with the employer at arm's length [subparagraph 6801(a)(iii)]. For a more detailed discussion regarding what constitutes "arm's length", you may refer to Interpretation Bulletin IT-419R, "Meaning of Arm's Length." The foregoing prohibition does not prevent the participant from receiving:

• The salary or wages deferred during the Deferral Period or the percentage of wage or salary that is fixed for the Deferral Period and the Leave Period [clause 6801(a)(iii)(A)];
• The reasonable fringe benefits that the employer usually pays to or for the benefit of its employees [clause 6801(a)(iii)(B)]; and
• Salary or wages from an entity completely unrelated to the Employer for whom the individual works during his or her Leave Period.

As noted above, amounts paid during the Leave Period are subject to income tax withholdings and CPP premiums but are not subject to EI premiums.

After the Leave Period

Subparagraph 6801(a)(v) of the Regulations requires that the participant return to his or her regular employment with the employer after the Leave Period for a period at least as long as the Leave Period. With respect to what constitutes "regular employment", it is our position that if the employee is working full time prior to the period of leave he or she would be required to return to full time employment for an equivalent period, otherwise the condition has not been met. An employee working part time prior to the period of leave can return to either the same part time or any greater amount up to and including full time but, regardless, he or she is still required to return to work for the same period as the period of leave. For example, if an employee was working twenty hours per week prior to a six month leave it would not be sufficient to return to work for three months and work forty hours a week. The purpose of this requirement is to ensure that a period of leave of absence from employment is a bona fide period of leave followed by a return to work and not by a subsequent retirement. It should be noted that the Regulations also permit the participant to return to employment with an employer that participates in the same DSLP or in a similar DSLP.

Accordingly, where it is evident that an employee has entered into a salary deferral arrangement with the intention of retiring following his or her leave of absence, the plan would not qualify as a DSLP and any deferred salary would be taxable in the year earned rather than in the year received. In such cases, the CRA may reassess prior year returns if there was unreported deferred salary in those prior years.

It is acknowledged that events may transpire during a Leave Period that make it impossible for an individual to return to work. In a situation where an employee has completed the leave of absence and all amounts have been paid out of the DSLP to the employee, there will be no adverse tax consequences if, due to unforeseen circumstances, the employee cannot return to work. The amounts deferred will not be subject to income tax for years prior to the year in which the period of leave occurred.

We trust that the foregoing comments will be of assistance. If you require additional comfort regarding whether a DSLP that you wish to implement will comply with the Regulations, we recommend that you refer to IC 70-6R5 and make application for an advance income tax ruling.

Yours truly,

Wayne Harding
for Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

Enclosure

Excerpt from a severed paragraph 6801(a) advance tax ruling

Facts

1. The Employer is a tax-exempt entity. Its mailing address is [address] and is served by the [TSO Name] Tax Services Office and by the [TC Name] Taxation Centre.

2. The Employer has agreed to establish a deferred salary leave program (the DSLP) for its employees.

3. The Employer contributes to a defined contribution pension plan (the Pension Plan) on behalf of its employees at the yearly rate of [percentage] % of gross earnings.

Proposed Plan

4. Upon receipt of a favourable advance tax ruling, the Employer will implement the DSLP. Applications for the DSLP will be accepted only from employees with at least [# of years] years of continuous employment with the Employer. Applications will be considered by the Employer's senior management team and written acceptance or denial of the application will be communicated to the employee at least [# of months] months before the anticipated effective starting date. Every employee who is accepted in the DSLP (the "Participant") will be required to sign a document which outlines the terms and conditions of the agreement.

5. The DSLP will provide Participants with the opportunity to enter into an agreement with the Employer to defer a specified percentage of annual salary (the Deferred Salary") during either a 4-year or 3-year period (the "Deferral Period") in order to take a one-year self-funded leave of absence (the "Leave Period") commencing immediately after the Deferral Period.

6. During the Deferral Period, the Participant shall agree to be paid the following percentage of the salary that would normally be paid in each of these years under the current collective agreement between the Employer and its employees:

5 year plan (4-year deferral period, year 5 leave) 80%;
or
4 year plan (3-year deferral period, year 4 leave) 75%

7. The Deferred Salary shall be paid to the Participant during the Leave Period. Income tax will be deducted at source from the amount of salary paid to the Participant during each year of the Deferral Period and Leave Period, in accordance with the Income Tax Regulations in effect at that time.

8. During the Deferral Period and the Leave Period, employee benefits (medical, dental, life, etc.) shall be maintained at a level as if the Participant were being paid at 100% salary. Premium costs during the Leave Period will be paid in full by the Participant. These premiums will be deducted from each pay. Participants have the ability to withdraw from the Long-Term Disability Plan during the Leave Period.

9. The Employer will contribute to the Pension Plan during the Deferral Period on the basis of the Participant's annual salary before any deferral.

10. The Deferred Salary shall be invested by the Employer in an interest-bearing account at the Employer's banking institution in trust for the Participant.

11. Any interest or other additional amounts that may reasonably be considered to have accrued for the benefit of a Participant to the end of a taxation year (calendar year) shall be paid in that year to the Participant. Such amounts paid to the Participant will be considered employment income for the purposes of the Act and will be reported on the Participant's T4 supplementary and shall be subject to tax withholdings.

12. Canada Pension Plan (CPP) premiums will be based on the Participant's salary net of the Deferred Salary during the Deferral Period and on the Deferred Salary during the Leave Period. During the Deferral Period, Employment Insurance (EI) premiums will be based on the gross salary before deferrals. No EI premiums will be withheld during the Leave Period.

13. The Leave Period will commence immediately after the Deferral Period. Under no circumstances will the Deferral Period exceed six years.

14. The Deferred Salary will be fully paid to the Participant no later than the end of the first taxation year that commences after the end of the Deferral Period. Such amounts paid to the Participant will be considered employment income for the purposes of the Act and will be reported on the Participant's T4 supplementary and shall be subject to tax withholdings.

15. The Participant will receive no salary or wages from the Employer or any other person or partnership with whom the Employer does not deal with at arm's length during the Leave Period, other than payment of the Deferred Salary and the statutory benefits that the Employer would normally pay to, or on behalf of, the Participant.

16. Withdrawal from the DSLP at the option of the Participant will be permitted only by reason of extenuating circumstances and on approval of the Employer. "Extenuating circumstances," means those circumstances, including such things as illness and change in family circumstances that would result in financial hardship to the Participant. Such withdrawal will be granted by the Employer unless the Employer has reasonable grounds to believe the request to withdraw is capricious or is not based on bona fide extenuating circumstances. Upon withdrawal, any accumulated funds plus interest owed shall be repaid to the Participant within [# of days] days of the notification of the approval to withdraw.

17. Should a Participant be terminated or die while participating in the DSLP, participation in the DSLP is terminated and any money accumulated, plus interest earned to the date of payment, shall be paid to the Participant or his or her estate, as the case may be, within a reasonable period of time.

18. Upon completion of the Leave Period, the Participant will return to his or her regular employment with the Employer for a period of time at least equal to the Leave Period. If for any reason the Participant must postpone the leave, any planned retirement by the Participant would be sufficiently postponed to allow the Participant to return to his or her regular employment with the Employer for a period of time at least equal to the Leave Period.

19. The Participant shall return to his/her position if it exists, or if it no longer exists, to the position a returning employee would otherwise be entitled under the provisions of the current collective agreement between the Employer and its employees.

20. Seniority is credited on the basis of the number of hours worked. While there will be no seniority accruing during the Leave Period, the seniority will be maintained at the level it was prior to the Leave Period.

21. During the Leave Period, Participants will not accumulate or be eligible for sick leave.

Purpose of the Proposed Plan

22. The Employer has agreed to implement a DSLP subject to the granting of a favourable advance tax ruling. The purpose of the proposed DSLP is to allow employees to defer a specified percentage of annual salary to fund a 12-month leave of absence; it is not to permit deferral of tax on salary nor is it established to provide benefits to an employee on or after retirement.