The Canada Revenue Agency (CRA) has recently confirmed its position that a supplemental employee retirement plan (SERP) may be subject to the “salary deferral arrangement” (SDA) rules in Canada’s Income Tax Act (ITA) if it provides “unreasonable” superannuation or pension benefits. The Department of Finance agreed with the CRA’s position. If the CRA’s position prevails, SERPs would be subject to annual accrual taxation under the SDA rules (although it is not clear what amount would be taxed annually). The CRA’s view of what benefits provided by a SERP are “unreasonable” is troubling. Its interpretation of the relevant statutory provisions is also not without doubt. Nevertheless, in light of these statements, employers may wish to review their SERPs and their practices in respect of SERPs.
Most SERPs are retirement or pension plans that provide for retirement income payments in excess of those provided under “registered pension plans” (which are qualified or tax assisted plans). Registered pension plans are subject to “defined benefit” or “defined contribution” limits designed to limit the benefits that may be funded through such plans on a tax assisted basis. Because of those limits, registered pension plans often do not provide adequate income replacement for higher income employees, and SERPs are commonly used to supplement or “top up” the benefits provided under registered pension plans. If the SDA rules apply to a SERP (whether funded or unfunded), the employee entitled to the SERP benefits would be subject to annual taxation in respect of the benefits (rather than being taxed only on receipt of such benefits).
The Questions Posed
The CRA had been reviewing the tax treatment of SERPs in recent months. The issue is whether the SERP benefits are “superannuation or pension benefits” and thus are expressly precluded from being “salary or wages” as defined in the ITA. The SDA rules apply only to deferrals of “salary or wages”, and then only if certain other conditions are met. Nevertheless, the CRA’s position was that, although a SERP may be a plan to pay superannuation or pension benefits, it would be subject to the SDA rules if the SERP benefits were unreasonable.
At a recent tax conference in May, the CRA confirmed its view that SERP benefits are unreasonable if they provide for a total benefit (including that provided under the registered pension plan) that exceeds the benefits that could have been paid under the registered pension plan but for the defined benefit or defined contribution limits. Moreover, the CRA confirmed that its current policy is to treat a SERP that provides “unreasonable” benefits as a SDA. The Department of Finance agreed with the CRA.
The CRA and the Department of Finance were responding to specific questions that were submitted to them in advance of the conference:
- Can the CRA explain its reasoning in reaching its position? Can the CRA explain what other factors it considers in determining whether SERP benefits are “superannuation or pension benefits”?
- Does the Department of Finance agree, as a matter of tax policy, with the CRA’s position that unfunded SERPs that provide for “superannuation or pension benefits” (within the ordinary meaning of that phrase) should be considered to be “salary deferral arrangements” if the SERP benefits exceed the defined benefits that could have been paid under a defined benefit “registered pension plan” if the “defined benefit limit” did not apply?
The CRA and Department of Finance Responses
The CRA observed that, although the SDA definition expressly excludes registered pension plans, unregistered pension plans are not excluded. In the CRA’s view, this means that an unregistered pension plan could be a SDA. The Department of Finance agreed, noting that the express exclusion of registered pension plans demonstrates “clearly the tax policy view that a pension plan could have, as one of its main objectives, the deferral of tax on an amount that would otherwise have been received as salary or wages” and that, where this is the case, an unregistered plan (like a SERP) should be treated as a SDA. Although these responses may be read as applying only to unfunded SERPs, the rationale underlying the responses would extend to funded SERPs.
However, as an administrative matter, the CRA said that the SDA rules will not be applied to a SERP where: (i) the plan has the characteristics of an unregistered or supplementary pension plan; and (ii) the amounts that may be paid out of or under the plan can be considered to be reasonable superannuation or pension benefits. Although the CRA acknowledged that the question of reasonableness will be resolved by reference to the particular circumstances of each case, the CRA provided the following non-exhaustive list of factors that it considers for this purpose:
- The reasonableness of the benefits provided under the plan in comparison to the provisions of the registered plan that applies to the particular employees;
- The history of the employer in providing pension benefits;
- The comparability of the benefits provided to other employees of the employer or related employers under other arrangements; and
- The history of the employees’ remuneration and any variations in that income as a consequence of the establishment of the arrangement.
- Again, the Department of Finance agreed, saying that an unfunded SERP which provides unreasonable benefits should be considered to be a SDA and that the determination of “reasonableness” requires consideration of several factors (the relevance of which will depend on the particular circumstances).
CRA’s Position Not Without Doubt
While troubling, the CRA’s position (notwithstanding support by the Department of Finance) is not without doubt for several reasons:
By relying on the exclusion of “registered pension plans” as the basis for implying that the SDA rules were intended to, and do, apply to unregistered plans that pay superannuation or pension benefits (like SERPs), the positions taken by the CRA and the Department of Finance, in effect, override and ignore the relevant definitions: the definition “salary or wages” (which expressly excludes “superannuation or pension benefits”) and the definition “salary deferral arrangement” (which expressly applies only to deferrals of “salary or wages”).
Even if a “reasonableness” criterion must be read into the definition of “superannuation or pension benefit” (a proposition that is not entirely clear), the reasonableness criterion should be based on commercial norms for such benefits and not on statutory criteria designed to limit the benefits that may be provided by tax assisted or registered pension plans.
Certain other conditions must be satisfied before the SDA rules will apply to a SERP. Those conditions are not satisfied merely because the SERP benefits are considered to be unreasonable. For example, (i) it must be reasonable to consider that tax deferral is one of the main purposes of the SERP, (ii) the SERP benefits must be (or must be on account or in lieu of) amounts that are “salary or wages”, and (iii) there must not be a substantial risk that the right to receive the SERP benefits in the future will be forfeited.
Employers should be aware of the positions taken by the CRA and the Department of Finance and may wish to review their SERPs (and their practices in respect of SERPs) in light of these statements.