On February 26, 2010, the Department of Finance (Finance) announced amendments to the Income Tax Act (Canada) (the ITA) which introduce a new type of employee benefit trust called an Employee Life and Health Trust (ELHT). Finance solicited comments on the draft legislation that was released on the same day. On August 26, 2010, Finance released a revised version of the draft legislation taking into consideration many issues identified by commentators. On December 15, 2010, new section 144.1 of the ITA received Royal Assent and the ELHT rules now apply to trusts established after 2009.
The ELHT is similar in many respects to the health and welfare trust. It is clear that the amendments are intended to replace and codify the current administrative practices of the Canada Revenue Agency (the CRA) with respect to the health and welfare trust. These practices are not specifically addressed in the ITA but rather are set out in IT-85R2.
Initially, Finance and the CRA did not provide much clarity on the interaction between ELHTs and health and welfare trusts. However, the Explanatory Notes to the legislation, confirmed that (at the time) the government did not intend to make any changes to the tax rules applicable to health and welfare trusts. Accordingly, it appears that health and welfare trusts established before 2010 will not have to be converted to ELHTs in order to maintain their status. However, it is not clear whether Finance intends to release any grandfathering or transition rules for existing health and welfare trusts in the future.
This article provides a brief overview of the ELHT rules as enacted and further comments on the relationship between ELHTs and health and welfare trusts.
Employee Life and Health Trust
Section 144.1 defines an ELHT as a Canadian resident trust established for employees of one or more participating employers and which meets certain conditions. The only purpose of the trust must be to provide "designated employee benefits". The definition of designated employee benefits includes benefits from a group sickness or accident insurance plan, a group life insurance policy or a private health services plan.
Each beneficiary must either be a current or former employee, an employee's spouse or common law partner, certain relatives of the employee, another ELHT, or the Crown. Employees include individuals for whom the participating employer has assumed the responsibility of providing designated employee benefits as a result of the acquisition of a business.
A major difference between ELHTs and health and welfare trusts is the new provision regarding "key employees". Key employees are generally significant shareholders or "high income" employees. The ELHT is required to have at least one class of beneficiaries that contains 25% or more of all employee beneficiaries with at least 75% of that class not considered a key employee. The rights of each key employee may not be more advantageous than the rights of the beneficiaries of that class.
The rights of participating employers with respect to ELHTs are also restricted under the rules. Employer representatives may not control the ELHT, either by constituting the majority of trustees, or by other means. ELHTs are not allowed to loan to or invest in the participating employer or those not acting at arm's length. Finally, the participating employer, and those not acting at arm's length, may not have any rights to distributions from the trust except for designated employee benefits and other types of benefits specifically listed in the ITA and the regulations.
2. Employer Deductions and Pre-Funding of the ELHT
The ELHT rules specify the timing of deductions available to an employer who funds an ELHT. Each year, a participating employer may only deduct contributions that may reasonably be regarded as having been contributed to enable the trust to do one of three things: (i) to pay premiums to a licensed life insurer for insurance coverage for the year in respect of designated employee benefits for qualifying beneficiaries; (ii) to provide pre-paid life insurance coverage; or (iii) to provide designated employee benefits payable in the year for qualifying beneficiaries.
There is a rebuttable presumption that a contribution to an ELHT may deducted if the employer relies on an independently prepared actuarial report that specifies the amount reasonably required to enable the ELHT to provide the above listed benefits. To the extent that the employer has contributed amounts that are not deductible under the above mentioned rules, but where the amounts are contributed in respect of benefits for a subsequent year, the amounts are deductible in that subsequent year.
If an employer's obligation to an ELHT is satisfied with a promissory note or similar indebtedness, the issuance of the note is not considered a contribution to the ELHT. Rather, interest and principal payments on the note are considered to be contributions to the ELHT at the time of payment and are subject to the ELHT deduction limitations. The rules also deem the payments not to be a payment of principal or interest on the note.
The total amount that an employer deducts in the year and has deducted in all preceding years cannot exceed the total amount of contributions for all years. This rule is intended to prevent a participating employer who pre-funds an ELHT from claiming deductions on amounts arising from inflation or returns from investment performance.
3. Employee contributions
Employee contributions are permitted and are treated on a look through basis such that contributions will not be eligible for a deduction or credit unless the amounts are an expense otherwise entitled to a deduction or credit. For example, if the employee contribution is identified as a private health services plan contribution that qualifies for the medical expense tax credit then the contribution to the ELHT will similarly be deductible.
The trust must identify the contributions as being in respect of a particular designated employee benefit at the time they are made. The Explanatory Notes state that it is anticipated that this will be achieved in most cases by the trust notifying the employer and the employer reporting the contributions on the employee's pay stub.
4. Employee Benefits
Contributions by an employer for its employees to an ELHT will generally not be treated as taxable benefits. Benefits paid out of an ELHT to an employee will have the same tax treatment as if the benefits had been provided directly by the employer rather than through the ELHT. For example, private health services plan benefits will be tax free to the employee. Payments of designated employee benefits made to non-resident employees or former employees are not subject to Part XIII non-resident withholding tax.
5. Taxation of the ELHT
The ELHT is a taxable inter vivos trust and will generally be taxable on its net income at the highest marginal rate. Special rules will permit the trust to minimize or eliminate its income tax payable for the year. Amounts payable in the year as designated employee benefits are deductible in computing the trust's income for the year. If the trust's expenses exceed its revenue for a particular year, the excess will be treated as a non-capital loss of the trust, which may be carried back three years and forward three years to offset income in those years.
A trust that qualifies as an ELHT throughout a taxation year will be excluded from the rules governing employee benefit plans, retirement compensation arrangements and salary deferral arrangements. An ELHT will also be exempt from the 21-year deemed disposition rule applicable to most trusts as well as from the alternative minimum tax.
An ELHT that administers employee benefits on behalf of employees of more than one employer may elect to be treated for income tax purposes as two or more separate trusts, provided certain conditions are met.
ELHT status is determined on a year-by-year basis and a trust that looses its status in a particular taxation year will not be able to deduct payments of designated employee benefits for that year nor will the trust be able to deduct non-capital losses from other years in that non-qualifying year.
Comparisons with Health and Welfare Trust
Over the years, the CRA identified several tax issues involving the use of health and welfare trusts, particularly in non-arm's length situations. Specific examples cited include the use of offshore trusts and the over-funding of benefits through lump sum payments by employers.
These concerns are likely the source of the major differences between the ELHT and the health and welfare trust including the introduction of the key employee provision, the requirement that the ELHT must be a Canadian resident trust and the requirement that contributions be "reasonably be regarded" to do one of three listed purposes.
Also, the statutory ELHT rules do provide some additional certainty over the health and welfare trust administrative practices such as defining the class of eligible beneficiaries and the provision of a statutory rebuttable presumption if the ELHT relies on a properly prepared actuary report.
The Explanatory Notes help provide some certainty regarding the CRA's approach to the interaction between ELHTs and health and welfare trusts. For now, advisors will have to be familiar with both sets of rules as it appears that, generally, existing health and welfare trusts can co-exist with newly created ELHTs. However, advisors are still waiting for further clarification on this issue.