17 January 1996 External T.I. 9531035 - TRADING VACATION OR BONUS FOR HEALTH CARE

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

general info on health care spending accounts and vacation trading in particular

Position:

employee is taxed on the amount of entitlement forgone at the time it is exchanged for other benefits

Reasons:

6(1)(a) exemption only applies to benefits from EMPLOYER's contribution although employee will be entitledd to a medical expense deduction for his or her contribution to a phsp

A. Humenuk
XXXXXXXXXX		953103

Attention: XXXXXXXXXX

January 17, 1996

Dear Sirs:

Re: Health Care Spending Account

Your letters of November 7 and 21, 1995 addressed to Peter Murphy of our Trust Accounts Division have been referred to us for reply.

In your November 7th letter, you describe two types of plans to provide employees with health care coverage, one in which the employer provides benefits to employees up to a specified dollar limit under a flexible benefit plan and one in which an employee elects to direct a portion of his or her salary, vacation or performance bonus into a plan for the purpose of saving funds to pay for health care costs. Prior to addressing your questions and comments concerning the second type of plan, we would like to clear up any potential misunderstanding concerning the first type of plan.

The term "health care spending account" and "flexible benefit plan" are not defined in the Act and can be used to describe any type of arrangement between an employer and its employees. However, we understand that the term "health spending account" is being used to describe an arrangement under which an employer agrees to reimburse an employee for medical expenses incurred in the year to a specified amount and that the term, "flexible benefit plan" is being used to describe an unfunded arrangement under which an employee chooses, prior to the beginning of the plan year, which benefits will be provided by the employer up to a predetermined dollar amount.

While it is possible to design a flexible benefit plan so that the taxability of a benefit is not altered by the fact that it is provided under the umbrella of the plan, all amounts received by an employee out of a plan which meets the definition of "employee benefit plan" (other than a return of employee contributions) will be taxable as employment income in the year of receipt.

An employee benefit plan is defined in subsection 248(1) of the Act and occurs where there is:

- an arrangement,
- a custodian,
- an employer,
- an employee, and
-a payment made to the custodian by the employer for the benefit of the employee.

From this definition, it can readily be seen that virtually all funded plans to provide employees with benefits (including payments by an employer under an insurance policy) could meet the definition of an employee benefit plan unless the plan fits within one of the statutory exclusions. The statutory exclusions which are common to flexible benefit plans are:

-private health services plans (PHSP),
- group term life insurance policies and,
- group sickness or accident insurance plans,

Failure to be excluded from the employee benefit plan rules can result in adverse tax consequences where the intention is to provide non-taxable benefits to employees. For example, if payments are made to a funded, health care spending account or plan that does not squarely fit the definition of a PHSP, not only is the timing of the deduction to the employer affected, but all payments to the employees out of the fund become taxable. For more information on employee benefit plans, you may wish to refer to Interpretation Bulletin IT-502 "Employee Benefit Plans and Employee Trusts".

Thus the taxation of benefits received under a health care spending account will depend on whether the arrangement to provide health care benefits to employees qualifies as a PHSP as defined in the Act. As stated in paragraph 7 of Interpretation Bulletin IT-339R2 "Meaning of "Private Health Services Plan", an arrangement where an employer is obligated to reimburse its employees for medical or hospital expenses may come within the definition of a PHSP where the employer is obligated by the employment contract to pay for such expenses.

In order for a particular plan or arrangement to qualify as a PHSP, it must involve a reasonable element of risk which is assumed by the employer. If the plan or arrangement is such that there is little risk that the employee will not eventually be reimbursed for the full amount allocated to that employee annually, then the arrangement is not a plan of insurance and therefore, not a PHSP. While a carry forward period undoubtedly reduces the risk of loss to the employee, it is our view that a plan which permits the carry forward of either the unused allocation or eligible medical expenses (but not both) up to a maximum of 12 months will not be disqualified as a PHSP solely by reason of the carry forward provision in the plan.

If a flexible benefit plan permits withdrawals or transfers between plans the employee will be required to include in income the value of all benefit credits allocated in the year. This is because the plans which are excluded from the employee benefit plan rules are all plans of insurance. A flexible benefit plan can incorporate the principles of insurance and maintain its flexibility in providing a variety of benefits by requiring the employee to allocate the flex credits prior to the beginning of the plan year. However, if a change in the employee's family circumstances occurs during the plan year (e.g. he or she marries or has a child) it is permissable for the employee to adjust his or her coverage by re-allocating credits accordingly.

Thus the first type of plan described in your November 7th letter may not qualify as a PHSP depending on the timing of the choices made by the employee and the period during which the credits in the health care spending account can be carried forward.

With respect to the second type of plan described in your November 7th letter and expanded upon in your November 21, 1995 letter, the issue of whether the plan would qualify as a PHSP is somewhat moot in that any amount transferred to the employee's health spending account in respect of the employee's entitlement to salary, whether derived from sale or forfeiture of vacation, production bonus', salary increases or the forfeiture of any other amount to which the employee is entitled, will be included in the employee's income under subsection 5(1) of the Act at the time it is credited to the employee's account.

The fact that an employee trades vacation entitlement for health related coverage, which would have been non-taxable to the employee by virtue of subparagraph 6(1)(a)(i) of the Act if his or her employer had made the contribution, does not render the trading of vacation entitlement non-taxable. It is the trading of vacation entitlement by the employee that triggers a taxable event and not the use of the flexible credits obtained. The specific exemption from employment income in subparagraph 6(1)(a)(i) of the Act is intended to apply in respect of benefits received or enjoyed by an employee from his employer's contribution to the plans listed in that subparagraph; it does not apply in a situation where an employee purchases coverage under a plan mentioned in subparagraph 6(1)(a)(i) of the Act through the use of vacation trading since the contribution in such a situation is not made by the employer. However, provided that the plan qualifies as a PHSP, the employee would be entitled to claim the amount of his or her contribution as a medical expense to the extent permitted by section 118.2 of the Act.

Please note as well that coverage under a PHSP is limited to medical expenses which would normally have otherwise qualified as a medical expense for the employee under subsection 118.2(2) of the Act. Interpretation Bulletin IT-519R "Medical Expense and Disability Tax Credits and Attendant Care Expense Deduction" describes which expenses qualify as medical expenses for the purposes of the Act. While we have not reviewed all the items on the list submitted November 21, we note that some items on the list may not qualify as medical expenses depending on the way in which the plan is administered. For example, drugs, medicaments or other preparations or substances (other than the substances described in paragraph 62(a) of IT-519R) must be prescribed by a medical practitioner and be recorded by a pharmacist in a pharmaceutical register in order to qualify as a medical expense for the purposes of the Act. If the services and expenses covered by a plan include non-prescription drugs, medicaments or other preparations, the plan will not qualify as a PHSP unless the non-qualifying coverage is provided under a separate taxable plan. Similarly the cost of care for an individual must meet the criteria of one of the relevant provisions in subsection 118.2(2) as explained in paragraphs 26-33 of IT-519R in order to qualify as a medical expense for the purposes of the Act.

We trust our comments will be of assistance to you.

Yours truly,

P.D. Fuoco
for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch

c.c. Barb Larocque,
Trust Accounts Division,
Policy and Technical Services Section