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August 30, 2011
Consultations on the Tax Rules for Employee Profit Sharing Plans
Note: A consultation is not a poll. Please do not send multiple or duplicate submissions.
Closing Date: October 25, 2011
Who may respond:
These consultations are open to anyone.
Comments regarding any element of this paper are invited and can be e-mailed to
Also, written comments can be forwarded to:
Tax Policy Branch
Department of Finance
140 O’Connor Street
Once received by the Department of Finance, all submissions will be subject to the Access to Information Act (ATI Act) and may be disclosed in accordance with its provisions. If a request pertaining to your submission is received under the ATI Act, you will be consulted under Section 27 of the ATI Act.
Budget 2011 announced the Government’s intention to consult stakeholders on the rules governing Employee Profit Sharing Plans (EPSPs).
Employee Profit Sharing Plans (EPSPs) are an important vehicle that enables business owners to align the interests of their employees with those of the business by sharing the profits of their business with their employees.
In recent years, these plans have increasingly been used as a means for some business owners to direct profit participation to members of their families with the intent of reducing or deferring taxes on these profits. Some employers are also using EPSPs to avoid making Canada Pension Plan contributions and to avoid paying Employment Insurance premiums on employee compensation.
To ensure that EPSPs continue to be a useful vehicle for employers that are used for their intended purpose, the Government will review the existing rules for EPSPs to determine whether technical improvements are required in this area.
Before proceeding with any proposals, the Government will undertake consultations to seek the views of stakeholders, and ensure that any amendments to the tax rules applicable to EPSPs continue to accommodate the appropriate use of such plans.
This consultation document identifies several issues associated with current EPSP rules, followed by suggestions as to how the Government might address each issue. Stakeholders are invited to provide their comments on the issues of interest and to propose alternatives where applicable. It is recognized that no one proposal will likely resolve all of the issues identified.
What is an Employee Profit Sharing Plan?
EPSPs are trust arrangements that enable employers to share profits with employees, assist employees to save, and better align the economic interests of management and labour.
In general, an EPSP is a tax neutral instrument, as the trustee is required to allocate to beneficiaries each year all employer contributions, profits from trust property, capital gains and losses, and certain amounts in respect of forfeitures. These allocations, with certain exceptions, are included in computing the income of the beneficiaries for income tax purposes in the year in which they are allocated. They are also generally recognized as employment income for various measures in the income tax system (e.g., to calculate an employee’s contribution limit for a Registered Retirement Savings Plan).
Payments out of the trust are generally not subject to tax when received by the beneficiaries. The timing of EPSP payments from the trust to the beneficiary is determined in accordance with the terms of the individual plan (e.g., after a minimum vesting period, only upon retirement or termination).
Figure 1: How an EPSP Functions
EPSPs are one of a set of tools that employers may use to provide additional remuneration to their employees. Others include employee stock options or share ownership plans, bonuses, deferred profit sharing plans and employee benefit plans. Each of these instruments has its own tax treatment.
EPSPs are a very flexible instrument for employers. For example:
- There is no restriction on employees who do not deal at arm’s length with their employer from participating in an EPSP (e.g., specified employees, related persons);
- There is no specific maximum contribution limit for EPSPs;
- Employees may contribute to their EPSPs;
- There is no requirement to register EPSPs with the Canada Revenue Agency or any other federal government agency;
- EPSP contributions are not subject to a minimum or maximum vesting period for the trust to hold EPSP contributions made by the employer;
- There are no restrictions on the qualifying investments that the trust may make; and
- EPSP contributions are not subject to withholdings (e.g., Canada Pension Plan, Employment Insurance, income tax).
Recent Increase in the Number of EPSPs
EPSPs have recently grown in popularity. Between 2005 and 2009, the number of EPSPs has increased about fivefold, mostly among small, closely-held Canadian-controlled private corporations.
EPSPs are widely marketed by tax planning professionals as a means for business owners to reduce their tax liability by splitting their income with family members, to delay the payment of income taxes and/or to avoid or reduce Employment Insurance (EI) premiums and Canada Pension Plan (CPP) obligations.
Options for Consultation
The current rules governing EPSPs in the Income Tax Act are designed to facilitate profit sharing between employers and employees. As part of the review of current rules, the Government is seeking stakeholder input on the questions below.
1. Eligibility to participate in an EPSP
The Income Tax Act contains provisions that limit the ability of employees who do not deal at arm’s length with their employer to enter into certain compensation arrangements with their employer. For example:
- To be accepted for registration, a deferred profit sharing plan must exclude persons related to the employer and specified shareholders from participating in the plan; and
- To qualify for a deduction, employees who exercise stock options must deal at arm’s length with the employer.
EPSP provisions do not include similar restrictions on the participation of employees.
Is there a specific rationale for allowing non-arm’s length employees to participate in an EPSP?
What would be the impact on your business or clients if employees who do not deal at arm’s length with the employer, such as related persons, were excluded as eligible EPSP beneficiaries?
2. Role of Minor Children
The Income Tax Act contains provisions to limit income-splitting techniques that seek to shift certain types of income (e.g., certain capital gains, taxable dividends, income from partnerships) from a higher-income individual to a lower-income minor. Under the tax on split income provisions, for example, income received by minor children is taxed at the highest federal marginal income tax rate (29 per cent). In Budget 2011, the Government extended the tax on split income to certain capital gains on shares of most unlisted corporations. EPSP allocations are not subject to these provisions.
Is there a specific rationale for excluding EPSP allocations from the tax on split income provisions?
What would be the impact on your business or clients if EPSP allocations to minor children were subject to the tax on split income?
3. Limitations on contributions
Under the Income Tax Act, employers may deduct expenses and outlays only to the extent that they are reasonable in the circumstances. The Income Tax Act also includes specific limits to employer contributions to certain plans. For example, consistent with limits on other retirement savings vehicles, employer contributions to a Deferred Profit Sharing Plan may not exceed the lesser of 18 per cent of an employee’s compensation, or one-half of the money purchase Retirement Pension Plan limit (for 2011, one-half of the money purchase limit is $11,485).
While studies have indicated that a profit pool between 3 and 5 per cent of salaries/wages is sufficient to positively influence the behaviour of employees, the Income Tax Act does not place a specific limit on the size of EPSP employer contributions .
Is there a specific rationale for allowing unlimited EPSP employer contributions?
What would be the impact on your business or clients if employer contributions to an EPSP were subject to a specified limit, such as a certain percentage of an employee’s salary or wages paid directly by the employer for the year? What would be an appropriate limit?
4. Withholding Requirements
The Income Tax Act imposes withholding requirements on several sources of income and includes tax by instalment rules. EPSP allocations are not subject to the same income tax withholding requirements as salary and wages paid directly by the employer, and can be structured to avoid tax by instalment rules. This can allow related persons to delay the payment of income taxes.
As EPSP contributions are allocated directly from the trust rather than the employer, they are also not subject to EI and CPP withholding requirements.
What would be the impact on your business or clients if EPSPs became subject to income tax withholding requirements similar to those applying to salary or wages paid directly by the employer for the year? What would be the effect of this change if EPSP allocations were also considered employment income paid by the employer for EI and CPP purposes (and, therefore, subject to EI and CPP withholdings)?
5. Additional Questions
In the context of reviewing EPSP rules, are there additional aspects of EPSPs that you think should be reviewed, or taken into consideration, to ensure that EPSPs remain an effective compensation tool? Are there any technical improvements that could be proposed as part of the review of EPSP rules?
Comments can be sent to the Department of Finance by e-mailing ConsultationsEPSP-RPEB@fin.gc.ca or by mailing them to the address below. The closing date for comments is October 25, 2011.
Tax Policy Branch
Department of Finance
140 O’Connor Street
1 When an employee leaves a plan before his or her profit share has vested, the employer’s contribution to his/her EPSP remains in the trust and is often redistributed among the remaining plan members.
2 Tyson, David E., Profit Sharing in Canada. Etobicoke: John Wiley & Sons, 1996.