Incentivizing employees is a critical component of most business strategies. Employers may implement arrangements for deferred cash bonuses, often subject to the satisfaction of certain criteria. From a tax perspective, the efficacy of any such arrangement requires that no tax be payable prior to the time an individual receives a cash payout. To ensure that result, it is critical to avoid the application of the "salary deferral arrangement" (SDA) rules under the Income Tax Act (Canada) (ITA).
A key exception to the SDA rules applies where a right to a cash bonus is granted to an employee for services rendered in a particular year where the cash amount is paid no later than December 31st of the third calendar year following that service year. Although seemingly straight-forward in its application, recent commentary of the Canada Revenue Agency (CRA) confirms that care needs to be taken in structuring an incentive plan based on this exception. As employers consider their strategies for the new year and beyond, it is important to keep this recent guidance in mind.
Background
An SDA is defined broadly by the ITA, and includes any plan or arrangement under which an employee has a right to receive an amount in a future year where (i) it is reasonable to consider that one of the main purposes for the creation or existence of the right is to postpone tax payable under the ITA (Purpose Test), and (ii) the amount is on account salary or wages of the employee for services rendered in the year or a preceding taxation year. The definition includes a right that is subject to one or more conditions unless there is a substantial risk that any one of those conditions will not be satisfied. Where the SDA rules apply, the employee is subject to tax on the grant of the incentive award, in the year of grant, notwithstanding that he or she will not have yet received a payment.
Because incentive plans typically have several purposes—including, to some extent, tax efficiency—it is rare for a plan to rely on the Purpose Test to avoid the SDA definition. Rather, most incentive plans, including cash bonus plans, are implemented based on an explicit exception to the SDA rules. The most common of these exceptions (set out in paragraph (k) to the SDA definition in the ITA) is engaged where a bonus or other incentive award is paid within three years following the end of the year (Service Year) in which the services respecting the award are rendered (Three-Year Bonus Exception).
In relying on this exception, a key component is determining the appropriate Service Year—is the Service Year the year that the award was granted or a preceding year? The CRA has previously indicated that an incentive award will be assumed to be for a Service Year which precedes the date of grant if the award has intrinsic value at the date of grant, and in a specific scenario that concerned restricted share unit (RSU) awards, the CRA stated that:
…as the RSUs will be granted early in Year One and will have a positive value on the grant date (subject only to vesting conditions which do not carry a substantial risk of forfeiture) it is likely that they would be granted partly in respect of past services rendered […] prior to Year One. If the RSUs are settled in Year Four, more than three years after the end of the year in which these services were rendered, the paragraph (k) exception would not apply and the Plan would be an SDA.
According to the CRA, this position would generally apply unless all the facts and circumstances established that the grant of RSUs was wholly unrelated to the recipient's past services (or section 7 of the ITA or one of the other specific exceptions in the SDA definition applies).
For additional background on the issue of whether a particular grant is in respect of past services or future services, and has any value at or after the time of grant, see our blog respecting formula-based employee appreciation rights awards.
Updated CRA Guidance
More recently, the CRA re-iterated its previously stated positions respecting incentive awards having intrinsic value on the date of grant, but also acknowledged that there might be circumstances where this will not be the case, such as in the case of a signing bonus for a new employee or a bonus awarded to an existing employee for accepting an overseas assignment.
The CRA also considered the possibility that an award granted in the later part of a year might be considered in respect of a Service Year that is the same as the grant year where, for example, the facts and documents establish that the grant was made in recognition of a performance accomplishment (such as a large sale) occurring in the same year.
Finally, the CRA clarified how, in connection with the Three-Year Bonus Exception, the past services principle would apply to awards made by an employer that has an off-calendar fiscal year. Specifically, the CRA confirmed that the Three-Year Bonus Exception requires that the cash payment be made before the end of the third calendar year following the calendar year containing the end of the corporate fiscal year in which the services were rendered. In other words, the relevant Service Year is the calendar year which contains the end of the applicable corporate fiscal year end. As an example, an award that is granted in respect of services rendered in a corporate fiscal year ending on November 30, 2021, would have a Service Year of 2021 and would need to be paid on or before December 31, 2024 (regardless of whether the grant is made in December 2021 or early in 2022).
The foregoing evidences a clear principle - it cannot simply be assumed that an award that vests within three years from the end of the grant year will automatically fall within the Three-Year Bonus Exception. In this regard, the service period, the employer’s fiscal year-end date and the grant date are all important variables that must be considered.
Practical Takeaway
If an incentive award is structured such that payouts are made in the third year following the year of grant, with the objective of fitting within the Three-Year Bonus Exception to the SDA rules, the conservative approach would be to have each such award granted in the later part of a fiscal year, and for the written documentation and surrounding facts to be consistent with the award/grant being in respect of service for that fiscal year and/or future service. If the award must be made earlier in a fiscal year, care should be taken to ensure that any corresponding payment is made no later than the end of three years that follow the calendar year in which the prior fiscal year ended.
