The canada revenue Agency is proposing changes to its policy governing the taxation of health and welfare trusts, which may have an adverse effect on owner/manager clients who use these trusts to fund certain employee benefits.

Although the CRA has yet to make the details of its proposed changes public, it did ask select advisor organizations — including the Ottawa-based Conference for Advanced Life Underwriting and the joint committee of the Canadian Bar Association and the Canadian Institute of Chartered Accountants — to submit comments. They responded this fall.

The CRA included these proposed changes in a new draft of its IT-85R2 interpretation bulletin. The CRA is responsible for preparing this bulletin because the tax policy that governs health and welfare trusts is not included in the federal Income Tax Act.

Health and welfare trusts are commonly set up by employers for employees and their families to provide benefits such as life insurance and accidental death and dismemberment insurance. Individual accident and sickness policies may also be “grouped” within an health and welfare trust. The employers’ payments are tax-deductible.

One of the main concerns shared by CALU and the joint committee is the CRA’s “prepaid-expense rule.” This rule is based on the agency’s view that “contributions made during an employer’s tax year are deductible only to the extent that the contributions are made to fund benefits that may reasonably be expected to be paid out in the year,” wrote Paul Hickey, chairman of the CICA’s taxation committee, and Bill Holmes, chairman of the CBA’s taxation section, in a Sept. 12 letter to the CRA.

“The CRA’s view is based on a fundamental misunderstanding of the nature of insurance. Insurance consists of an undertaking to make payments on the occurrence of specified events,” wrote Hickey and Holmes.

CALU affirms the CBA-CICA position. “Small employers are disadvantaged,” says Ted Ballantyne, CALU’s director of advanced tax policy.

“It’s not fair to employers,” echoes Terry Zavitz, president of London, Ont.-based Terry Zavitz Insurance Inc. Comparing a self-funded health and welfare trust with an employer-sponsored insurance plan, the employer would be able to deduct the premiums, even when a claim is not made, Zavitz says.

This concern is even more important when the trust includes long-term disability benefits.

“When a small employer establishes a trust to fund LTD benefits, it may be a number of years before an employee becomes disabled and disability benefits are paid from the trust,” Ballantyne wrote in an Oct. 13 letter to the CRA.

In order to fund a health and welfare trust, employers have to build up a reserve, but in the draft proposal the CRA is asking that any “surplus” be eliminated within a reasonable period of time. The CBA and the CICA want to see the surplus revisions deleted from the bulletin or, at least, have it modified to provide guidance on what constitutes a surplus.

CALU agrees on this point, too. In his letter, Ballantyne asks for clarification. And if the CRA decides to cap the amount of surplus, CALU is suggesting it be “the maximum amount of disability benefit payments that would be payable in the subsequent five years, if an employee were to become disabled in the current year.”

And claims will fluctuate, notes Zavitz: “Employers should be able to set a claims fluctuation reserve to provide a cushion — as long as it makes sense actuarially.”

One of the concerns not addressed by the draft bulletin is the tax treatment of health and welfare trusts according to different professional corporations, says Kim Moody, a chartered accountant and partner with RSM Richter LLP in Calgary, and chairman of the national technical committee of the Toronto-based Society of Trust and Estate Practitioners (Canada) .

Often, the professional — a doctor, dentist or lawyer — is both the sole shareholder and the sole employee of the corporation, says Moody. The CRA could, therefore, consider any benefits received from the trust to be shareholder benefits, which are taxable, he says.

“It would be nice to have some guidance in the [bulletin],” he says. “There is nothing in the new draft [about professional corporations.]”

Tax experts say the CRA may be revising the interpretive bulletin because of the practice of setting up health and welfare trusts in offshore jurisdictions in which they are not taxed. This was a common tax-planning strategy in the late 1990s and early 2000s. It enables the employer to receive the benefit of a tax deduction for any contributions made to the trust. Meanwhile, the money in the trust isn’t taxed.

@page_break@The as yet undefined rule against surpluses could reduce this kind of tax planning by employers. Employers may also find that offshore health and welfare trusts will become taxable under the CRA’s proposed rules for non-resident trusts, point out tax practitioners. IE