Recent decisions from the Tax Court of Canada could mean changes in the way the Canada Revenue Agency treats company-sponsored student scholarships.

Three Tax Court rulings found scholarships funded by companies for the children of employees were not employee benefits and, therefore, not taxable in the hands of employees. They were instead taxable in the hands of the relatively low-income children who received the scholarships. The CRA has said it will appeal the cases to the Federal Court of Canada.

All three decisions found that, contrary to current CRA policy, some scholarships — generally, non-exclusive plans that do not require high academic grades — did not fit the definition of taxable employee benefits.

In each case, the employers had given the adult children of their employees scholarship money for post-secondary education.

Two of the cases involved Dow Chemical Canada Inc.’s program. At the time the Dow program was established, Dow treated the scholarships as income in the hands of the students. A 2003 CRA policy bulletin also treated such scholarships as the students’ income, although that policy required that students be “selected on the basis of their scholastic records or other achievements or qualities.” The Dow program required an average of 70% for students to be eligible, the minimum entrance standard at many Canadian universities.

But in 2004, when the Dow scholarships were given to the employees’ children, the CRA conducted an audit of the Dow program. It concluded that the non-exclusive nature of the scholarships meant that they were intended as general employee benefits and were, therefore, taxable in the hands of the employees, not the students.

The Tax Court disagreed. In a decision in one Dow case (which was adopted in the other), Judge Eugene Rossiter concluded that the benefit accrued to the student and was taxable as the student’s income. His reasons included: the employee was not enriched by the payment because it was made to the student; and the child’s education expenses were personal, not the family’s.

In other words, for a benefit to be taxable to the employee, it must be received and enjoyed by the employee.

“In the court’s mind, there was no benefit to the employee. The benefit was to his child,” says Paul Woolford, tax partner with KPMG LLP in Toronto. “What skewed this decision was that the individual employee paid for the tuition and the taxpayer’s son actually received the $3,000.”

In all three cases, the taxpayers’ children were adults, which played a significant part in the court’s reasoning. Because the students receiving the scholarships were above the age of majority, the parents were under no legal obligation to assist them financially with their post-secondary education.

Prashant Patel, vice president of high net-worth planning services with Royal Bank of Canada in Toronto, says this is a key point in the case. If there was no obligation to provide education, then the scholarship was of no benefit to the parent. Or so the logic goes.

So, what’s the practical effect? Despite these rulings, the CRA’s stated policy on the issue stands, says Jordan Fremont, senior associate in the pensions and benefits group at Toronto-based law firm Hicks Morley Hamilton Stewart Storie LLP — at least, until the appeal is heard or the CRA changes its policy. In the meantime, these cases could prompt some taxpayers to challenge an adverse CRA ruling.

“If I’m an individual and I’m getting assessed a tax because my employer gave my child [who is going to university] some money for a scholarship,” he says, “I might be more inclined to look at whether I should be objecting to CRA’s assessment. But what is most likely to affect policy is the outcome of the Federal Court of Appeal decision, rather than others taking similar action.”

The debate may be overshadowed by recent changes in tax legislation. As of the 2007 tax year, scholarships are not taxable in the hands of students. Some tax experts have concluded that, as a result of these cases and the new legislation, more companies will offer scholarships to the children of employees as part of a retention strategy. As long as the scholarship program is structured as set out by the Tax Court (and these decisions stand), it’s likely that such scholarships will be tax-free.

@page_break@“If [these rulings are] upheld, you could see a lot more activity around scholarships for employees’ children, more employees applying for them and more corporations offering them,” says Patel. “If [such scholarships] end up being both tax-free [to the student] and not a taxable benefit — and CRA is OK with it — then you could see a lot more activity.”

From a taxpayer’s perspective, Fremont says, this should be looked upon as an opportunity. “In many cases,” he says, “it will require someone who has some knowledge of these issues, or their advisors, to be able to spot the opportunities.” IE