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The Three Little Pigs’ Perspective On Flex Plans – 10 Years Later

By: Mark Newton

An advance tax ruling made late in 2004 may have opened the door to using bonuses and possibly other forms of cash compensation to fund flex plans. Mark Newton, a lawyer specializing in pension and benefit issues, explains what the ruling means and how it came about.

It has been exactly 10 years since I wrote the article ‘The Three Little Pigs’ Perspectives on Flex Plans.’ You will recall the story of The Three Little Pigs. Fifer Pig built his house out of straw and the big bad wolf came along and blew it down. Fiddler Pig built his house out of sticks. It too was not strong enough and the wolf blew it down also. Practical Pig took a little bit of extra care to build his house out of bricks. It withstood the wolf’s attacks and kept the pigs safe and sound. The article looked at designing flexible benefits plans out of bricks to withstand the scrutiny of the wolf – the Canada Revenue Agency (CRA) – with whom many of us are only too well-acquainted.

Fifer Pig designed the flex plan for the employees of Fifer Pig Company with a salary (and tax) reduction feature. Employees’ pay would be reduced by two per cent in exchange for additional flex credits. The employees would have a choice of purchasing additional benefits with the credits, or directing the credits to a health spending account or cash. Fiddler Pig implemented a flex plan with vacation selling for the employees of Fiddler Pig Company. An employee who elected to sell a vacation would be allocated additional flex credits, supposedly without being subject to tax.

Practical Pig was better informed of CRA policies at that time and stayed clear of salary reduction and vacation selling. Practical Pig’s flex house remained standing, whereas those of Fifer Pig and Fiddler Pig came crashing down as soon as the wolf (CRA) paid a visit. There have been many developments in the taxation of flexible benefits since 1995. Most notable was the publication by CRA of Interpretation Bulletin #529, dated February 20, 1998 (the Bulletin). The Bulletin covers many topics, including an overview of how flex plans operate, overall tax considerations in the design of a flex plan, the taxation of individual benefits, the tax treatment of health spending accounts, vacation buying and selling, and adjustments to cash compensation in exchange for increased flex credits.

Open The Door
This article focuses on the specific issue of salary reduction in a flex plan, or adjusting employees’ cash compensation as a means to fund flex plans. One advance tax ruling late in 2004, in particular, appears to open the door to using bonuses and possibly other forms of cash compensation to fund flex plans. First, let’s take a look at Fifer Pig’s flex plan design from 10 years ago. Fifer Pig’s multiple objective was to create a larger potential pool of funds for its flex plan without increasing the company’s costs on a tax-effective basis while providing more flexibility to its employees.

The idea of reducing employee pay to fund the flex plan seemed to meet all the criteria, but it sounded too good to be true. And it was. The Bulletin later confirmed what CRA had been opining for years, namely, that if an employer tinkers with employee pay, the employee will be taxed on the full amount of pay, regardless of whether the pay is converted to flex credits or how it may eventually be used in a flex plan.

However, the bulletin fails to elaborate on what constitutes the ‘forgoing’ of pay by an employee and when an ‘entitlement’ to pay arises. Is an employee taken to forgo cash compensation when the decision to reduce pay is unilaterally mandated by the employer? Or must the forgoing of pay be a positive act on the part of the employee? Does an entitlement arise when the services have been performed, or the legal consideration for the compensation has been satisfied? What if the employer requires the employee to be employed on the date of payment, notwithstanding that the services may already have been fully performed, as is often the case with bonus plans?

Imply A Contract
The Bulletin does provide an exception for a reduction in pay and an increase in flex credits upon the expiry of an employment contract and negotiation of a new one. This raises the question of what constitutes an employment contract and its termination. The most straightforward examples are a collective agreement and a written employment contract. In these cases, the reduction in an employee’s pay and its replacement by flex credits would not be a taxable event. It arguably also includes a typical employment relationship in which there is no written employment contract, but where the common law would imply a contract. However, CRA has shown some reluctance to agree with this.

While the Bulletin undoubtedly raises a lot of issues and leaves a lot of questions unanswered, the basic thrust of CRA’s thinking has been that it considers almost any reduction in an employee’s pay during the course of employment, and the replacement of the pay by flex credits, to be a taxable event. Using this reasoning, the employee will be subject to tax on the full amount of pay.

Rebalance Pay
I have long been an advocate of an employer’s inherent right to rebalance and reconfigure an employee’s pay in order to optimize the employer’s and the employee’s objectives in the delivery of compensation. An employer should be entitled to allocate more dollars toward pension, benefits, or cash compensation at different points in an employee’s career. (In fact, this already implicitly happens merely due to the cost structure for some benefits and Defined Benefit pensions for older employees.) A change in the structure of compensation should not result in untoward tax consequences, unless one of the main reasons for doing so is the deferral of tax.

An advance tax ruling I obtained in October 2004 – and published by CRA in November – travels some distance down this road. The subject of this ruling was the ability to allocate bonuses to a health spending account on a non-taxable basis. Since the ruling request was successful, the result is that, in appropriate cases, taxable bonuses may be converted to non-taxable credits in a health spending account to pay for eligible medical and dental expenses. (Outside of Quebec, the reimbursement (or direct payment) by an employer of eligible medical and dental expenses for employees is not taxable.) The same logic would permit the conversion of bonuses to flex credits, before the credits are allocated to a health spending account or to pay for other benefits.

Bonus Scheme
The bonus scheme of the employer in respect of whom the ruling was issued is not unlike many others. The employer determines bonuses for each of its employees in respect of each fiscal year (calendar year in this case), based on the company’s financial results for the fiscal year and the achievement of objectives by each employee. The bonuses are not finally determined until the company’s audited financial results are prepared, usually two to three months after the end of the fiscal year. The bonuses are expressed as a percentage of pay, within ranges for different categories of employees.

Most importantly, in this company’s case, an employee must be employed by the company on the date the bonus is paid in order to be entitled to it. If an employee were to terminate employment prior to payment of the bonus, the employee would not be entitled to payment of the bonus (subject to employment standards, labour laws, and common law). The issue of when legal entitlement to the bonus arises was the central issue of the ruling. Employees of the company make their flex plan and health spending account elections in November in respect of the following plan year (calendar year). The elections are irrevocable, except in the case of specified life events (marriage, births, etc.) and employment status changes. With the introduction of the bonus feature, employees could elect to allocate a specified dollar amount from their future potential bonus into their health spending account. CRA permitted annual allocations of up to $25,000.

Several examples were provided in the ruling request, based on an employee’s election to allocate $1,000 to the health spending account. In each example, the bonus paid in March would be reduced by $1,000, except in the case where the bonus was less than $1,000. In this case, no bonus would be paid and the allocation to the health spending account would equal the amount of the bonus. The election could just as easily be stated as the lesser of $1,000 and the declared bonus, to eliminate any possible confusion. Even though the allocation to the health spending account would not occur until March, the amount could be used to reimburse expenses incurred in January or February. The health spending account also included a one-year carry-forward of unused balances.

Earned The Bonus
CRA’s position in the past with this sort of scheme has been that the employee has earned the bonus as of December 31, because the services to earn the bonus have been fully performed. The fact that the employee must remain employed with the company until the payment date, according to this position, was irrelevant. Further, CRA opined that there would be no substantial risk of forfeiture of the bonus after December 31 and, therefore, it is an earned entitlement as of that date and cannot be converted to a non-cash benefit without being subject to tax as if paid in cash. There has always been a lack of logic, legal reasoning, and income tax principles supporting this position.

Finally common sense won out. CRA accepted the argument that a bonus to which an employee has no legal entitlement can be converted to a non-cash benefit, without making the bonus subject to tax in the year in which it would have otherwise been paid. While this goes contrary to the wording in the Bulletin, which refers to amounts to which an employee “is or will become entitled, such as a … bonus,” it is fortunately consistent with the Income Tax Act and legal principles. The ruling is, of course, binding only between CRA and the company in respect of which the ruling was issued. But the principles derived from the ruling may be used by other employers in designing their flex plans and bonus plans.

What does this mean for the future? It will hopefully lead the way for further rulings in which future salary increases and even base pay can be converted to, or exchanged for, non-cash compensation. Who knows, maybe vacation selling will finally be openly permitted! The federal government may eventually draft tax legislation specifically dealing with flex plans, as has been the case in the U.S. for many years, to bring some certainty to this area. In the meantime, it seems the wolf is going off in search of tastier (more lucrative) morsels.


Mark Newton is a lawyer specializing in pension and benefit issues.

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