29 July 2004 External T.I. 2004-0081361E5 - Education trust established on termination.

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: Will the arrangement be an RCA or an EBP.

Position: General comments provided.

Reasons: They requested comments on the treatment of a trust. We also provided comments on the payments of Gifts and death benefits should a trust not be used

XXXXXXXXXX 2004-008136
W. C. Harding
July 29, 2004

Dear XXXXXXXXXX:

Re: Establishment of an Education Trust

This is in reply to your correspondence of June 15, 2004, in which you requested our comments in respect of the tax implications inherent in the establishment by an employer of an education trust for the benefit of the children of an employee who will be terminating his employment for health reasons.

Written confirmation of the tax implications inherent in particular transactions can be provided by this Directorate where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advanced Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, any inquiries should be addressed to the relevant tax services office. However, we are prepared to provide the following comments that may be of assistance to you. Please note that these comments are general in nature, may not be applicable to your situation and are not binding on the Canada Revenue Agency ("CRA"). All publications referred to herein can be accessed on the CRA website at the following address: http://www.cra-arc.gc.ca/formspubs/menu-e.html.

Where an employee is expected to terminate his employment as a consequence of his declining health, it may often be that the employee will not be immediately terminating his employment but will first begin receiving benefits under an employer's long term disability plan (an "LTDP"). In this event, benefits under the LTDP may be provided through to the date of death of the employee. Accordingly, it may first be necessary to determine when the employment will terminate before consideration can be given to the tax treatment of benefits that may arise.

A death benefit is defined in subsection 248(1) of the Income Tax Act (the "Act") to be an amount received on or after the death of an employee and in recognition of the employee's service with the employer. Death benefits are discussed in detail in IT-508R entitled Death Benefits. In general, for the purposes of this reply, a death benefit could encompass an amount paid by an employer as a consequence of the death of an employee where it is to be used to pay the educational costs of the children of a former employee. Death benefits are generally deductible by an employer when they are paid and are taxable to non-resident recipients (the children) under subparagraph 56(1)(a)(iii) and paragraph 212(1)(j) of the Act to the extent the amount exceeds $10,000. Please refer to IT-508R for additional information in this respect.

In our view, Article XXII (Other Income) of the Canada-U.S. Income Tax Convention (the "Convention") will apply to the receipt of death benefits by a non-resident and Paragraph 1 of Article XXII provides that Canada may tax a death benefit in accordance with domestic tax law to the extent that it arises in Canada.

An amount that is gratuitously paid by an employer after the death of an employee to the employee's children might also qualify as a tax-free gift where it is not paid in respect of the employment of the employee. However, it should be noted that the amount of such a payment would not be deductible by the employer. Furthermore, where it is paid at the direction of a shareholder, the provisions of subsection 15(1) of the Act would have to be considered. Any resolution of these issues would be a question of fact and cannot be addressed in this reply.

When an employer establishes a trust to provide funds for the education of an employee's children, the arrangement will, in general, be either an "employee benefit plan" (an "EBP") or a "retirement compensation arrangement" (an "RCA").

Generally, an EBP as defined in subsection 248(1) of the Act, will exist where an employer establishes, and contributes to, a trust under which payments will be made to, or for the benefit of, an employee, a former employee or a person who does not deal at arm's length with the employee. Accordingly, an education trust established by an employer for the benefit of its employees' children would usually be regarded as an EBP. EBPs are discussed in detail in Interpretation Bulletin IT-502 entitled "Employee Benefit Plans and Employee Trusts" and in IT-502SR, the special release to IT-502. Reference should be made in particular to paragraph 10 of this Bulletin in respect of the taxation of payments made to someone other than the employee. The definition of an EBP provides a number of exceptions to the definition and one of these excludes plans or arrangements that are RCAs.

An RCA is also defined in subsection 248(1) of the Act, and, generally, includes an arrangement under which an employer makes contributions to a trust under which payments will be made to, or for the benefit of, an employee, a former employee or a person who does not deal at arm's length with the employee, where the benefits are to be paid on, after or in contemplation of a termination of, or a substantial change in, the employment of the employee.

In general terms, it would appear that the contemplated arrangement could be an EBP if it is being established to fund benefits from employment that would otherwise be taxable under subsection 6(1) of the Act. However, it may be an RCA if it is, in fact, being established as a consequence of or in contemplation of the employee's failing health and the termination or contemplated termination of employment. In this respect, given that the establishment of the arrangement is only being considered as a consequence of the employee's poor health, the better view may be that the arrangement will be an RCA.

We would also note that an RCA may be structured to fund the payment of retiring allowances and, in this respect, you may wish to consider the provisions of the Act pertaining to retiring allowances as discussed in IT-337R4 entitled Retiring Allowances.

The following chart sets out the tax consequences for the arrangement where it is either an EBP or an RCA. In providing this information, we have presumed that the employee was resident and worked in Canada, that the trust will at all times be resident in Canada and that the employee and his children will become residents of the United States prior to the payment of any benefits.

Tax Issue
EBP
RCA

Deduction of Employer Contributions.

The employer's contributions are deductible. However, section 32.1 of the Act provides that employer contributions are not deductible until taxable payments are made out of the capital of the trust. Refer to paragraphs 16 to 24 of IT-502 for details.

The employer contributions are deductible as they are made in accordance with subsection 20(1)(r) of the Act.

Taxation of income earned in the trust.

The trust is taxable on its annual income in accordance with subdivision (k) of the Act. However, the taxable income earned by an EBP may be reduced by the amounts paid to beneficiaries. A beneficiary of an EBP may include the contributing employer.

An RCA is not subject to taxation under Part 1 of the Act but is subject to a special 50% refundable tax under Part XI.3 of the Act on its accumulation of retained contributions and income. For details refer to T4041 entitled Retirement Compensation Arrangements Guide 2003

Taxation of benefits

Benefits paid out of an EBP to non-residents are not subject to Part XIII non-resident tax but are taxed as income from employment as discussed below.

Benefits paid out of an RCA to non-residents are subject to taxation under Part XIII of the Act, subject to the Convention as discussed below.

Benefits paid from EBPs to non-resident beneficiaries

Payments made from a trust governed by an EBP to non-resident beneficiaries (including the children of a former employee) are characterized as employment income by virtue of paragraph 6(1)(g) of the Act, unless one of the exceptions in paragraph 6(1)(g) applies. In this respect, paragraph 6(1)(g) does not apply if the payment from an EBP is a death benefit.

If payments out of an EBP are death benefits, they are taxable as described in IT-508R as discussed above, and are taxable to the recipient under subparagraph 56(1)(a)(iii) and paragraph 212(1)(j) subject to the provisions of Article XXII (Other Income) of the Convention. As noted above, Article XXII provides that Canada may tax a death benefit to the extent that it arises in Canada.

If payments out of an EBP are not death benefits, by virtue of subparagraph 115(1)(a)(v) and paragraphs115(2)(c.1) through 115(2)(e) of the Act, non-resident beneficiaries of an EBP are deemed to be employed in Canada in the year, and the EBP payments are included in income under Part I as remuneration from the duties of employment performed in Canada. There is no Part XIII tax on payments from an EBP by virtue of subsection 212(17).

In our view, Article XV (Dependent Personal Services) of the Convention applies to payments from an EBP. Paragraph 2 of Article XV of the Convention provides that employment income in respect of employment exercised in a calendar year in the state of source (Canada) will not be subject to tax in Canada if it does not exceed $10,000. Our view is that the "calendar year" referred to in this provision is the year in which the employment was exercised. Accordingly, if EBP benefits are not in respect of any particular year of employment, it is our view that they are in respect of all of the taxpayers' years of service. In the present situation, if the employee rendered all of his services in Canada and earned more than $10,000 in each year, Canada would not be precluded from taxing the EBP payments by virtue of the Convention. We note that there is no requirement in Article XV that the employment has to be exercised by the recipient of the payment.

Benefits paid from RCA to non-resident beneficiaries

If the trust is an RCA, payments from the trust are generally taxable to the recipients by virtue of paragraphs 56(1)(x) and 212(1)(j). Payments from an RCA to U.S. residents are governed by Article XVIII (Pensions) of the Convention. If they are "periodic pension payments"(as defined in the Income Tax Conventions Interpretation Act (the "ITCIA")), withholding will be limited to 15% because of definition of "pension" in the ITCIA. However, in our view, payments from an RCA that are death benefits are subject to Article XXII (Other Income), not Article XVIII.

We trust our comments will be of assistance to you.

Yours truly,

Roberta Albert, CA
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch

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