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Generally speaking, performance enhancement programs are intended to motivate employees to repeat the type of behavior that is considered desirable by an organization. Typically, this may include both a shorter term profitability component and/or a longer term financial health or wealth component. Programs aimed at improving profitability tend to have a shorter horizon and are often referred to as “profit sharing programs”. Other programs, with a longer term horizon, tend to emphasize those aspects that improve the financial health and wealth of an organization in the longer term; approaching or including an equity participation by the employee.
The commentary that follows will provide a brief overview of the many options that exist for employee benefit plans and performance enhancement.
While the income tax consequences of any of the available options should not drive the decision, they are important to the decision in terms of the true cost to the organization and the true benefit to the employee. Typically, shorter term profit sharing arrangements are taxable in the short term as the realization of the benefits is essentially immediate. Alternatively, programs with a longer horizon tend to be of a nature that deferral of the resultant tax implications to the employee is desirable as the longer term programs may not involve a payment of cash to the employee. Therefore, an income tax liability creates a negative tax impact that may impede the very point of the performance enhancement program.
The Income Tax Act (“the Act”) contains provisions, primarily under Section 6 of the Act, that generally include as taxable income of an employee the value of benefits of any kind whatever received or enjoyed by the employee in respect of, in the course of, or by virtue of employment. Exceptions to this general rule include certain registered and unregistered employee benefit plans.
Common examples of registered plans include:
Registered plans allow for the deferral of the taxable benefit received until the employee takes the funds out of the plan. However, such plans have fairly stringent regulatory restrictions and requirements that limit their application in the context of a performance enhancement program. A group RRSP for example, generally provides a benefit equal to the amount contributed to the RRSP in cash. RPP’s also provide a benefit, either in reference to the amount contributed (defined contribution plans) or in reference to the employee’s salary (defined benefit plans). Lastly, DPSP’s are registered plans where the contributions are defined in reference to the employer’s profits from the business, subject to a maximum amount of 18% of the employee’s salary, similar to the maximum for group RRSP’s and RPP’s.
Registered plans are generally aimed at the financial well being of the employee and provided as an employee benefit, but other than the DPSP, have only an indirect or no reference to the employer’s profitability.
Unregistered plans may include plans otherwise referred to as:
One common consideration in each of the above unregistered programs or variation thereof is to avoid what is referred to in the Act as a Salary Deferral Agreement (SDA). Benefits under a SDA, which could include any of the above unregistered programs if not structured correctly, are taxable to the employee in the year the right to receive them is earned, regardless of when the benefit is actually received. As such, this can create a “negative” cash flow position for the employee which is generally de-motivational.
1. Employee Profit Sharing Plan
Similar to a DPSP, an EPSP provides for a certain amount to be payable to employees on the basis of profitability. However, unlike a DPSP, the taxable benefit to the employee is not deferred and any earnings on funds held by the EPSP are not tax-sheltered.
2. Retirement Compensation Agreement
A RCA involves the establishment of a trust to hold funds for the future benefit of employees. The trust pays a 50% refundable tax to the government, so an RCA is not the most tax efficient option. However the employer may design the key performance indicators and vesting provisions for the benefits with fewer restrictions. Benefits from the RCA are not taxable to the employee until the employee receives them, at which time the refundable tax is recovered and the employee then pays tax on the benefits they have actually received at that future date.
3. Deferred Stock Unit Plan
A deferred stock unit plan (“DSU”) is a plan under which benefits may be received as shares or cash, but must always be calculated in reference to the stock price. As such, this type of plan lends itself most commonly to public corporations. Among other prescribed restrictions, in order to qualify, a DSU plan must be reasonably attributable to employment duties and no benefit or stock may be transferred until after retirement or death of the employee, but no later than the end of the first calendar year after retirement or death.
4. Employee Stock Option Plan
An ESOP is a program that provides the right for an employee to acquire shares at or after a specified future date at a price that is fixed. For income tax purposes, when dealing with a Canadian Controlled Private Corporation (“CCPC”), the difference between the option price that is required to be paid by the employee and the fair market value of the share at the date the share is acquired is deemed to be a taxable employment benefit that can be deferred until the shares are sold. If the employee holds the shares for at least two years prior to disposition, the employee is entitled to an income tax deduction of ½ of this taxable employment benefit, paralleling capital gains treatment. The difference between the ultimate sale price and the fair market value at acquisition date is considered to be a capital gain (or loss) that may qualify for the capital gains deduction.
The income tax legislation pertaining to an ESOP of a public company is considerably more complex and outside the scope of this paper.
The above commentary was intended only to provide an introduction into the considerations of designing a performance enhancement program. Please consult with your local MNP tax advisor to discuss the options best suited to your specific situation.
Related Topics:Employees; Income Tax; RRSP
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