The Income Taxation of Flexible Benefit Plans in … · INCOME TAXATION OF FLEXIBLE BENEFIT...

786 (1998), Vol. 46, No. 4 / no 4

The Income Taxation of FlexibleBenefit Plans in Canada

Lara Friedlander and Jana Steele*

PRÉCISAu cours des dernières décennies, les régimes d’avantages sociauxadaptés aux besoins des employés sont devenus usuels au Canada.Malgré la popularité croissante de ces régimes, le traitement fiscal quileur est appliqué est loin d’être clair. La Loi de l’impôt sur le revenu necontient aucune mention explicite aux régimes d’avantages sociauxadaptés aux besoins des employés et, jusqu’à récemment, Revenu Canadan’en traitait que par le biais d’interprétations techniques. De plus, lesrégimes d’avantages sociaux adaptés aux besoins des employés n’ont pasfait l’objet d’examens détaillés de la part des commentateurs canadiens.

En février 1998, Revenu Canada a publié un bulletin d’interprétationsur l’imposition des régimes d’avantages sociaux adaptés aux besoinsdes employés. Les auteurs examinent ce bulletin, ainsi que l’élaborationde régimes d’avantages sociaux adaptés aux besoins des employés auCanada, le traitement fiscal de régimes similaires aux États-Unis etdiverses questions de politiques découlant de l’octroi d’avantages sociauxadaptés aux besoins des employés. Les auteurs concluent que le nouveaubulletin d’interprétation de Revenu Canada est utile en ce sens qu’ilfournit une certitude accrue quant au traitement fiscal des régimesd’avantages sociaux adaptés aux besoins des employés. Toutefois, ilsconcluent également que de nombreuses questions de politiques reliéesà ces régimes ne peuvent pas être réglées efficacement au moyen demesures administratives, mais qu’elles doivent plutôt l’être grâce à unemodification des dispositions législatives.

ABSTRACTOver the past several decades, flexible benefit plans have becomecommonplace in Canada. Despite the increasing popularity of such plans,their tax treatment has been far from clear. Flexible benefit plans are notreferred to explicitly in the Income Tax Act and, until recently, wereaddressed by Revenue Canada only by way of technical interpretation.

* Lara Friedlander is of Stikeman Elliott, Toronto and Jana Steele is of GoodmanPhillips & Vineberg, Toronto. The authors would like to thank Marivic Bernal, JulieMuirhead, Gary Nachshen, Donna Shepherd, Hemant Tilak, and the editors of the Cana-dian Tax Journal.

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Additionally, the income taxation of flexible benefit plans has not beendiscussed by Canadian commentators in any significant detail.

In February 1998, Revenue Canada published an interpretation bulletinon the income taxation of flexible benefit plans. The authors examine thisbulletin, as well as the development of flexible benefit plans in Canada,the income tax treatment of similar plans in the United States, and aselection of policy issues arising in connection with the delivery offlexible benefits. The authors conclude that Revenue Canada’s newinterpretation bulletin is helpful in that it provides increased certainty withrespect to the income tax treatment of flexible benefit plans. However,they also conclude that many of the policy issues associated with theseplans cannot be addressed effectively by administrative measures, butrather must be dealt with by legislative change.

INTRODUCTIONA “flexible benefit plan,” sometimes referred to as a “cafeteria plan,”1 isa plan or arrangement established by an employer for the purpose ofdelivering employee benefits, under which an employee may choose amongtwo or more classes and/or levels of benefit options. Under the classicflexible benefit plan, the employee typically selects types and levels ofbenefits up to a prescribed maximum for a given period of time. Benefitchoices may be denominated in terms of “credits”2 or monetary amountsand are often limited to a specified number of credits or a specifiedmonetary amount for each employee. Under an alternative form of flex-ible benefit plan, known as a “modular” or “core-plus” plan, an employerprovides a basic bundle of benefits with an option to increase benefitspartially or wholly at the employee’s expense.

Approximately 100 large Canadian corporations are known to have orhave had flexible benefit plans in place, including Warner-Lambert, Ameri-can Express, DuPont, McDonald’s Restaurants, Northern Telecom, CanadaTrust, Cominco, and Xerox.3 It is expected that the number of employers

1 As explained below, neither flexible benefit plans nor cafeteria plans are referred toexplicitly in the Income Tax Act, RSC 1985, c. 1 (5th Supp.), as amended (herein referredto as “the Act”). (Unless otherwise stated, statutory references in this article are to theAct.) In the United States, however, “cafeteria plans,” which are a subset of flexiblebenefit plans, are recognized by section 125 of the United States Internal Revenue Code of1986, as amended (herein referred to as “the Code”). In this article, we will use the term“flexible benefit plan” to refer to Canadian plans and reserve the term “cafeteria plan”exclusively for discussion of those plans recognized as such under US law.

2 These “credits” are typically called “flexible credits” or “flex credits.”3 These plans are a matter of public record. See Julie Charles, “Some Assembly Required”

(January 1995), 19 Benefits Canada 24-28, at 25 and 28; M. Gulens, “Lights! Cameras!Re-Action!” (November 1995), 19 Benefits Canada 89; and Jan Kauk, “The Stretch toFlex” (December 1996), 20 Benefits Canada 61-64.

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with flexible benefit plans will increase in the future.4 In early 1995, approx-imately half of the major employers in the United States had some formof flexible benefit plan,5 and interest in such plans is continuing to grow.6

This article will first provide some background on flexible benefitplans. Second, it will discuss the taxation of benefit plans generally, thenspecifically the taxation of private health services plans (PHSPs) and healthand welfare trusts (HWTs), and the current tax treatment of flexible ben-efit plans in Canada.7 Third, the article will review the taxation of flexiblebenefit plans (in particular, cafeteria plans) in the United States. Fourth,it will consider some important policy issues associated with flexiblebenefit plans. Finally, the article offers a critique of the current Canadianincome tax regime as it applies to flexible benefit plans, together withsome suggestions for reform.

BACKGROUNDFlexible benefit plans came into vogue in the United States in the late1960s and early 1970s, when the influx of women into the workplacebegan to result in a duplication of employment benefits at the householdlevel.8 As the 1970s progressed, employers became increasingly inter-ested in flexible benefit plans to provide employees with an opportunityto avoid such duplication. Benefit “menus” were seen as a means ofattracting skilled employees.9

Today, two considerations underlie most decisions to establish flexiblebenefit plans. First, such plans are viewed by employers as a means ofcontrolling costs.10 They allow employers to offer benefit coverage at alower cost but with a higher value as perceived by the employee. Rather

4 Kristine Gordon, “The Flexed Generation” (March 1995), 19 Benefits Canada 21-24;and Victor Pywowarczuk, “School’s in on Flex Plans” (September 1994), 18 BenefitsCanada 47-49. Since these articles appeared, employer response to flexible benefit plansmay not have been as great as the authors anticipated, perhaps because changes to benefitplans can be difficult to market to employees in a unionized environment. (Kauk, suprafootnote 3.)

5 Charles, supra footnote 3, at 25.6 M.O. Howard, “Serving Up Benefits: Although Cafeteria Plans Don’t Work for Every

Company, They’ve Become Popular due to Their Flexibility,” Richmond Times Dispatch,February 1, 1997.

7 This article will consider only the income tax treatment of flexible benefit plansunder the Act. Provincial and other tax considerations are not discussed.

8 For example, each spouse might have a dental plan that covered all members of theemployee’s immediate family.

9 Daniel C. Schaffer and Daniel M. Fox, “Tax Law as Health Policy: A History ofCafeteria Plans, 1978-1985” (Spring 1989), 8 American Journal of Tax Policy 1-67, at 9.

10 For example, Montreal’s École des Hautes Études Commerciales introduced a flexiblebenefit plan to help offset rising costs of health care and dental benefits. (Pywowarczuk,supra footnote 4, at 47.)


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than offering the same benefit package to everyone, which can be ex-tremely costly if the package in question is comprehensive, an employercan offer employees a choice of benefits, thereby delivering benefits at alower cost by eliminating the delivery of unwanted or undervalued ben-efits, yet still fulfilling employee demand. Employees generally find thatsuch cost-cutting works to their advantage: although the benefits offeredunder a flexible benefit plan are less comprehensive, individual employeescan allocate their flexible credits or amounts to the benefits they value most.11

Second, flexible benefit plans are perceived as an effective means ofmeeting employees’ varied needs, particularly in view of the increasingdiversity of the workforce (such as the increase in single-parent families).12

Flexible benefit plans may also be established to increase employees’understanding of their benefits and to allocate benefit dollars in a tax-effective manner (for example, educating employees as to the types ofbenefits that can be received without tax).13

Flexible benefit plans take a number of different forms. One populartype of plan is the account structure (often labelled a “benefit bank” or a“flexible spending account”).14 Under this kind of plan, funds are credited(perhaps only notionally) to each employee’s flexible spending account.15

When the employee incurs an expense covered by the plan, the employeefiles a claim with the employer and is reimbursed out of the balanceremaining in the account. The accounts can be unfunded and may existsolely as bookkeeping entries.16 Some plans may require or permit em-ployee contributions, which are also credited to the employee’s flexiblespending account.

11 Gordon, supra footnote 4, at 22. See also Arthur F. Woodward, “Cafeteria Plans,” inProceedings of the New York University Forty-Fifth Annual Institute on Federal Taxation,vol. 1 (New York: Matthew Bender, 1987), chapter 15, at section 15.02.

12 Gordon, supra footnote 4, at 21; and Pywowarczuk, supra footnote 4, at 49. In theUnited States, cafeteria plans are the most common method by which employers offerdependant care assistance programs. (Giselle Sered, “Day Care and Tax Policy” (Spring1995), 12 American Journal of Tax Policy 159-206, at 193.)

13 Gordon, supra footnote 4, at 21.14 This type of plan is similar in concept to the “medical savings account” that was

discussed so frequently during the 1996 US presidential election, although the medicalsavings account was to be offered directly to individuals rather than through employers.(For a description, see William V. Roth, “Legislative Commentary: Medical SavingsAccounts” (Fall 1994), 11 Journal of Contemporary Health Law and Policy 149-64.) InCanada, these accounts are sometimes called “health care spending accounts” or “healthcare expense accounts.” A national survey conducted by Hewitt Associates in 1995 indi-cated that 75 percent of employers with flexible benefit plans used health care spendingaccounts, compared to 50 percent in 1992. (Gordon, supra footnote 4, at 21.)

15 For a detailed discussion of the flexible spending account structure, see Hewitt Asso-ciates, Canadian Handbook of Flexible Benefits (Toronto: Wiley, 1996), chapter 7.

16 Woodward, supra footnote 11, at section 15.02.


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A typical flexible benefit plan in Canada might take the followingform. Employees receive a basic level of benefits with respect to accidentaldeath and dismemberment, salary continuance, short-term disability, lifeinsurance, long-term disability, and health care. Each employee is thencredited with flex dollars to upgrade coverage with respect to one orseveral of the benefits already offered. The number of flex dollars allo-cated to each employee will be determined by his or her salary. Eachemployee selects his or her allocation of flex dollars annually, before thebeginning of the plan year.

Flexible benefit plans have become increasingly common in Canadaduring the past 20 years, yet relatively little information regarding thetaxation of such plans has been published.17 Revenue Canada did notpublish its position on flexible benefit plans until 199118 and did not issuean interpretation bulletin addressing the tax treatment of such plans untilthe publication of Interpretation Bulletin IT-529 on February 20, 1998. Itis the dearth of literature concerning the taxation of flexible benefit plansand the publication of IT-529 that has prompted this article.

THE INCOME TAX TREATMENT OF FLEXIBLE BENEFITPLANS IN CANADAThe Existing Statutory Regime for the Taxation of EmployeeBenefits and Benefit PlansThere are four basic questions regarding the tax treatment of flexiblebenefit plans:19

1) If an employer contributes to a plan, is the employee taxed on thiscontribution and, if so, does taxation occur when the funds are contrib-uted to the plan or when the funds are eventually paid to the employeeout of the plan in the form of benefits?

17 There have been only a few articles published in Canada that have considered thetaxation of flexible benefit plans in any detail. See Elizabeth M. Brown and ChristopherM. Newton, “Tax Considerations in the Design of a Flexible Benefits Plan” (September1995), 7 Taxation of Executive Compensation and Retirement 22-29; and Claude Boulanger,“Administrative Guidelines for ‘Cafeteria’ Style Benefit Arrangements Are Published atTax Conference” (July/August 1991), 3 Taxation of Executive Compensation and Retire-ment 477-80. The leading book on flexible benefit plans, Canadian Handbook of FlexibleBenefits, supra footnote 15, contains a chapter dealing with the taxation of flexible benefitplans. See also, generally, James A. Norton, “Flex—A Strategic Benefit—A Real WorldSolution” (September 1995), 7 Taxation of Executive Compensation and Retirement 19-22;and Jo-Anne Billinger, “Flexible Benefits a Practical Approach for Employers and Em-ployees in the Cost-Conscious ’90s” (April 1993), 4 Taxation of Executive Compensationand Retirement 747-51.

18 Bryan W. Dath and Paul D. Fuoco, “Flexible Employee Benefit Arrangements,” inIncome Tax and Goods and Services Tax Planning for Executive and Employee Compensa-tion and Retirement, 1991 Corporate Management Tax Conference (Toronto: Canadian TaxFoundation, 1992), 6:1-27.

19 There are, of course, a variety of other issues relating to the tax treatment of benefitplans, including the treatment of plan trusts. For the sake of simplicity, this article willfocus on the four key questions listed above.


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2) If an employer contributes to a plan on behalf of an employee, canthe employer deduct the contribution and, if so, is the deduction availablewhen the funds are contributed to the plan or when the funds are eventu-ally paid to the employee out of the plan in the form of benefits?

3) If an employee contributes to a plan, does the employee receive adeduction for that amount?

4) Is the employee taxed on the benefits received and, if so, whendoes this taxation occur?

The Act does not address any of these questions directly. In fact, unlikethe US Code,20 the Act does not specifically address the taxation of flex-ible benefit plans at all. Accordingly, the Canadian tax treatment of suchplans must be determined by trying to fit each flexible benefit plan intoone or more of the various provisions and defined terms in the Act relat-ing to benefit plans generally.

Typically, any benefit received by an individual in the course of employ-ment will be included in that individual’s income in the year of receipt.Paragraph 6(1)(a) provides that an employee must include in computinghis or her taxable income the value of all benefits received in the yearfrom an office or employment.21 In this context, the term “benefits” encom-passes “benefits of any kind whatever” that are received by the taxpayer“in respect of, in the course of, or by virtue of an office or employment,”subject to certain specified exceptions. Thus, this provision is the startingpoint for any analysis of employee benefits. Any benefit received by anemployee in the course of his or her employment will either be includedin income by virtue of paragraph 6(1)(a) or fit within one of the exceptionsto this general rule.

Generally, any payment made by an employer to or for the benefit ofan employee will be deductible to the employer in the year of payment.22

Employee expenses are generally not deductible by the employee.23 Over-laying these general rules are provisions applicable to various categoriesof benefit plans, each of which is taxed in a specific manner. Each cat-egory is mutually exclusive as defined in the Act; a plan cannot fit intotwo categories. Several categories of plans referred to in the Act arerelevant to this article: employee benefit plans (EBPs), employee trusts (ETs),

20 As noted earlier, the Code addresses one particular type of flexible benefit plan,referred to as a “cafeteria plan” and defined in section 125(d).

21 “Employment” is defined in subsection 248(1) to mean “the position of an individualin the service of some other person . . . and ‘servant’ or ‘employee’ means a person hold-ing such a position.” Subsection 248(1) defines “employee” to include an officer.

22 Payments to employees are deductible under section 9 because they are made for thepurpose of gaining or producing income from a business.

23 Subsection 8(2).


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and salary deferral arrangements (SDAs).24 Each category is described inturn below.

Employee Benefit PlansAn EBP is a funded arrangement under which contributions are made byan employer or by a person dealing not at arm’s length with the employer,and payments under such arrangements are made to or for the benefit ofemployees.25

Under an EBP, an employer ordinarily may not deduct its contributionuntil the employee actually receives a corresponding benefit out of theplan.26 Employee contributions are not deductible to the employee but arenot taxed upon return to the employee.27 Employees must include in incomefrom office or employment plan benefits in the taxation year in which thebenefits are received (except to the extent that these benefits constitute areturn of the employee’s contribution to the EBP).28

Employee TrustsAn ET is a funded arrangement under which an employer makes pay-ments to a trustee for the benefit of employees. The right to benefitsunder an ET vests at the time each payment is made, and the amount ofthe benefit does not depend on the individual’s position, performance, orcompensation as an employee.29

The trustee of an ET is obligated to allocate funds annually to allemployees who are beneficiaries of the trust. The employee’s right to thecontributions allocated to him or her vests in the employee immediatelyupon contribution.30 Employer contributions to the trust are included inthe employee’s income in the year in which the contribution is made and

24 See also the discussion of PHSPs and HWTs below. The rules in the Act relating toretirement compensation arrangements (defined in subsection 248(1)) also may be relevantwhere a flexible benefit plan provides for a payment to be made to an employee upontermination of employment; however, discussion of this type of arrangement is beyond thescope of this article.

25 Subsection 248(1), definition of “employee benefit plan.” See Interpretation BulletinIT-502, “Employee Benefit Plans and Employee Trusts,” March 28, 1985, as amended by aspecial release dated May 31, 1991; Julie Y. Lee, “Deferred Compensation in the Wake ofthe 1986 Federal Budget,” Personal Tax Planning feature (1986), vol. 34, no. 2 CanadianTax Journal 429-45; and John M. Solursh and Jeff Sommers, “Employee Benefit Plans,” inDeferred Income Arrangements: A Practitioners Guide to Proper Tax Planning (Toronto:Canadian Tax Foundation, 1997), tab 6.

26 Paragraph 18(1)(o) and section 32.1.27 Subsection 8(2) and paragraph 6(1)(g).28 Paragraph 6(1)(g).29 Subsection 248(1), definition of “employee trust.” See IT-502, supra footnote 25.30 Subsection 248(1), definition of “employee trust.”


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are deductible to the employer upon contribution to the plan.31 Employeecontributions are not deductible to the employee.32

Salary Deferral ArrangementsAn SDA is a plan or arrangement that satisfies all of the following criteria:

1) any person has a right in a taxation year to receive an amount afterthe year;

2) it is reasonable to consider that one of the main purposes for theexistence of the right to receive an amount after the year is to postponetax payable under the Act by the taxpayer; and

3) the amount is on account or in lieu of salary or wages of the tax-payer for services rendered by the taxpayer.33

An SDA may be funded or unfunded.

If a plan is an SDA, any amounts to which the employee has a right ina given taxation year are included in the employee’s income for thattaxation year under subsection 6(11) and are deductible by the employerunder paragraph 20(1)(oo). The amount to be included or deducted is the“deferred amount,” defined in subsection 248(1) as “any amount that aperson has a right under the arrangement [SDA] at the end of the year toreceive after the end of the year . . . unless there is a substantial risk thatany one of those conditions will not be satisfied.”

Revenue Canada’s Administrative Position Regardingthe Treatment of Flexible Benefit Plans Under the ActAs stated above, the tax treatment of a flexible benefit plan depends onthe application of current provisions of the Act to the particular plan.

Revenue Canada takes the position that so long as an employer prop-erly segregates contributions to and distributions from a flexible benefitplan, for tax purposes each benefit offered under the plan will be consid-ered on a stand-alone basis; that is, Revenue Canada will ignore the factthat the benefit was delivered as a component of a flexible benefit plan.However, if contributions and distributions are not properly segregated,Revenue Canada will characterize the entire flexible benefit plan as asingle plan (such as an EBP). As Revenue Canada states in InterpretationBulletin IT-85R2 in the context of HWTs for employees:

Where part of a single plan could be regarded as a plan described in 1(a) to(d) above [a group sickness or accident insurance plan, a PHSP, a group

31 Paragraph 6(1)(h) (inclusion), section 9, and paragraph 18(1)(a) (deduction).32 Subsection 8(2).33 Subsection 248(1), definition of “salary deferral arrangement.” For a detailed discus-

sion of the mechanics of the SDA rules, see Hugh A. Gordon, “Deferred Compensation,”in Report of Proceedings of the Thirty-Eighth Tax Conference, 1986 Conference Report(Toronto: Canadian Tax Foundation, 1987), 34:1-30.


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term life insurance policy, or any combination thereof ] and another part asan employee benefit plan or an employee trust, the combined plan will begiven employee benefit plan or employee trust treatment in respect of thetiming and amounts of both the employer’s expense deductions and theemployees’ receipt of benefits under the plan. However, if contributions,income and disbursements of the part of the plan that is described in 1(a) to(d) above are separately identified and accounted for, the tax treatmentoutlined in this bulletin will apply to that part of the plan.34

Again, in its discussion of EBPs in Interpretation Bulletin IT-502, RevenueCanada states:

Where an employer makes contributions to a custodian which are then usedto fund several types of benefit plans, some of which are excluded from thedefinition of an employee benefit plan, it is necessary for the employer toidentify the portion of each contribution that relates to each separate plan.If the custodian of such an omnibus arrangement does not account sepa-rately for the income and disbursements of the component plans, it may benecessary to regard the total arrangement as an employee benefit plan andtreat it accordingly in respect of the timing and amounts of both the em-ployer’s expense deductions and the EBP beneficiaries’ receipt of benefitsor income under the arrangement.35

Suppose, for example, that an employer offers a benefit plan that al-lows employees to choose among benefits under a PHSP, contributions toa pension plan, child care, and cash. If each one of those four benefits isaccounted for separately, the tax treatment of each will be determinedseparately, as if the others did not exist. However, if the benefits are notaccounted for separately and, for example, Revenue Canada takes theposition that the entire plan is an EBP, then each benefit will be taxed asan EBP benefit.36 The fact that benefits under a PHSP might have receivedmore favourable treatment had they been offered on a stand-alone basis isirrelevant.37 Taxable benefits provided under the flexible benefit plan willbe taxed upon receipt by the employee (and will simultaneously becomedeductible to the employer) regardless of the other elements of the plan,38

and taxation of the non-taxable benefits will depend on the characteriza-tion of the plan as a whole.

34 Interpretation Bulletin IT-85R2, “Health and Welfare Trusts for Employees,” July31, 1986, paragraph 4.

35 IT-502, supra footnote 25, at paragraph 4.36 For a discussion of the effect of the EBP rules on flexible benefit plans, see Solursh

and Sommers, supra footnote 25.37 IT-502, supra footnote 25, at paragraph 4; and Interpretation Bulletin IT-529, “Flexible

Employee Benefit Programs,” February 20, 1998, paragraph 5.38 See Dath and Fuoco, supra footnote 18; and “Flexible Benefit Plans, Health Care

Expense Accounts,” Revenue Canada document no. 9304605, July 14, 1993. Note RevenueCanada’s position with respect to vacation selling. If an employee chooses to exchangevacation days for other benefits, Revenue Canada considers the exchange to be a “sale” ofvacation days and takes the position that the value of the benefits received in the exchange

(The footnote is continued on the next page.)


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Most likely, a flexible benefit plan that is not properly segregated willbe treated as either an EBP or an SDA, depending on a number of factors(such as whether the plan is funded by contributions to a third party).39 Aflexible benefit plan could receive SDA treatment if it were being usedfor the purpose of deferring compensation. For example, a plan mightallow an employee to choose to take vacation days rather than other typesof benefits. Revenue Canada has indicated that a plan that permitted therollover or cashing out of purchased vacation might be considered anSDA.40 Alternatively, if the employer were to make payments to a trustee,the plan might be characterized as an ET; for example, under a plan thatfailed to constitute an HWT because it offered a cash option (as discussedbelow), an employee would have to include in income amounts allocatedto him or her by the trustee rather than including benefits on actual receipt.

When is a flexible benefit plan “properly segregated” such that RevenueCanada will look through the plan and tax the benefits on a stand-alonebasis? In a technical interpretation, Revenue Canada stated:

While separate employer records and separate insurance policies are notrequired in order to consider the plans as separate, there must not be anycross-subsidization between the plans and the level of benefits, the pre-mium rates, the qualifications for membership and other terms and conditionsof each of the plans must not be dependent upon the existence of the otherplan or plans. If the policy is experience-rated, separate experience ratingsmust be established for each plan.41

should be included in the employee’s income under subsection 5(1) or paragraph 6(1)(a).(“Taxation of Flexible Benefit Plans,” Revenue Canada document no. June 1991-196, June10, 1991.) Revenue Canada justifies its position on the ground that “an employee’s entitle-ment to vacation each year is a right which has value to that employee. . . . We can see nodifference, from an income tax perspective, between ‘cashing out’ vacation entitlement to[sic] trading it for something of value to the employee such as credits in a flexible benefitplan.” Revenue Canada takes the same position even where the employee must forfeitvacation days because the annual vacation allotment has expired. (“Vacation Trading inFlexible Benefit Plans,” Revenue Canada document no. August 1991-5, August 30, 1991;and Dath and Fuoco, supra footnote 18, at 6:11.) Revenue Canada maintains this positioneven where the employee trades vacation entitlement for flexible credits used to purchasehealth-related coverage that would have been exempt. It is Revenue Canada’s position that“it is the trading of vacation entitlement by the employee that triggers the taxable eventand not the use of the flexible credits obtained.” (“Flexible Benefits Plan—Vacation Trad-ing,” Revenue Canada document no. 9128165, January 14, 1992; “Trading Vacation orBonus for Health Care,” Revenue Canada document no. 9531035, January 17, 1996.) If theemployee trades the vacation for medical benefits, the employee may still be entitled to amedical expense credit. (Ibid.)

39 “Carryforward of Health Care Expense Account Credits in a Private Health ServicesPlan,” Revenue Canada document no. 9309625, October 6, 1993.

40 Revenue Canada document no. June 1991-196, supra footnote 38.41 See “Disability Plans with Employee Pay Option,” Revenue Canada document no.

9507035, July 5, 1995.

38 Continued . . .


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Additionally, Revenue Canada requires each employee to make an irrevo-cable42 selection of benefits with respect to a particular plan year beforethe beginning of the plan year. In Revenue Canada’s view, if a flexiblebenefit plan permits an employee to exchange unallocated or newly allo-cated credits for cash, to transfer credits between benefit options, or toselect benefits after the beginning of the plan year, the lookthroughapproach will not apply.43

It is not entirely clear how Revenue Canada’s approach applies to aplan that offers employees a choice among benefits not included in in-come under paragraph 6(1)(a) when the plan does not segregatecontributions and distributions relating to different benefits. For example,employer contributions to a supplementary unemployment benefit plan,44

a deferred profit-sharing plan,45 a registered pension plan,46 or a retire-ment compensation arrangement47 should not be included in income underparagraph 6(1)(a) and should be immediately deductible to the employerif the benefits are offered individually. However, a plan that offers em-ployees a choice among these benefits but does not account for themseparately might, technically, trigger EBP treatment (and thus deferreddeductibility to the employer). Where the benefits are combined in asingle plan, the plan will presumably fall outside the definitions of supple-mentary unemployment benefit plan, deferred profit-sharing plan, etc.,which are mutually exclusive plan categories.48

Revenue Canada’s administrative position and the existing statutoryregime are significantly affected by the concepts of constructive receiptand indirect receipt.49 Constructive receipt is a common law concept thathas been explained as follows: where an amount of income is readilyavailable to a cash basis (as opposed to an accrual basis) taxpayer, it willbe considered to have been received by the taxpayer whether or not he orshe chooses to take possession of it. Indirect receipt is a related (although

42 Revenue Canada makes two exceptions for changes in an employee’s selection ofbenefits: (1) the occurrence of a “life event,” such as the birth or death of a dependant ora change in marital status; and (2) a change in employment status. See IT-529, suprafootnote 37, at paragraph 6.

43 Ibid., at paragraph 8.44 Paragraph 18(1)(i) and subsection 145(5).45 Paragraph 18(1)( j) and subsection 147(8).46 Paragraph 20(1)(q) and subsection 147.2(1).47 Paragraph 18(1)(o.2) and paragraph 20(1)(r).48 See “Flexible Benefit Plan,” Revenue Canada document no. 9632073, February 21,

1997. Here Revenue Canada ruled on a flexible benefit plan that included the use of flexdollars for contributions to a group registered retirement savings plan (RRSP). It is unclearwhether the plan provided for true segregation of contributions and benefits.

49 B.J. Arnold, Timing and Income Taxation: The Principles of Income Measurementfor Tax Purposes, Canadian Tax Paper no. 71 (Toronto: Canadian Tax Foundation, 1983), 91.See also Patricia A. Metzer, “Constructive Receipt, Economic Benefit and Assignment ofIncome: A Case Study in Deferred Compensation” (Spring 1974), 29 Tax Law Review 525-87.


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not identical) concept50 found in subsection 56(2) of the Act. Under sub-section 56(2), an amount will be included in a taxpayer’s income if apayment or transfer of property

• was made to a person other than the taxpayer;

• was made at the direction or with the concurrence of the taxpayer;

• was for the taxpayer’s own benefit or for the benefit of some otherperson on whom the taxpayer desired to have the benefit conferred; and

• would have been included in computing the taxpayer’s income if ithad been received by the taxpayer instead of the other person.51

The doctrines of constructive receipt and indirect receipt are both rele-vant to flexible benefit plans because they frequently serve as the basesupon which Revenue Canada claims that benefits or credits under suchplans are immediately taxable to the employee. For example, IT-502 states:

10. The Department considers an amount to have been paid by an EBPbeneficiary out of the plan upon the earlier of the date upon which paymentis made and the date upon which the EBP beneficiary has constructivelyreceived a payment. Constructive receipt is considered to apply in situa-tions where an amount is credited to an EBP beneficiary’s debt or account,set apart for the EBP beneficiary or otherwise made available to the EBPbeneficiary without being subject to any restriction concerning its use.Consideration will be given to the application of subsection 56(2) (indirectpayments) where payments are made to persons other than the employee orformer employee while living.

11. Where the terms of an employee benefit plan provide that an em-ployee entitled to benefits thereunder may elect to defer the receipt of alump-sum amount payable on death, retirement or other termination ofemployment, it is the Department’s view that the amount so deferred wouldnormally be taxed in the year of actual receipt provided the election todefer is made prior to the termination of employment.

50 The concepts of constructive receipt and indirect receipt are sometimes confused.For example, in Fraser Companies Ltd. v. The Queen, [1981] CTC 61, at 70 (FCTD), Mr.Justice Cattanach stated, “[t]he often repeated statement is that the subsection (both 16(1)and 56(2)) embodies a portion of the general concept of constructive receipt. The generalrule is that a taxpayer is only taxed upon the receipt of income or when it becomesreceivable by him in the legal sense. There are certain circumstances where income receiv-able may be caused not to be received by him and by that device he achieves benefits thatamount to income. In those circumstances as set forth in subsection 56(2) that is incomeconstructively received by the taxpayer. If the taxpayer had actually received the money ormoneys worth and passes it on he would have been taxable on that amount. Therefore heshould not be permitted to avoid tax liability by the simple expedient of directing paymentto a third party without having actually received the money himself.” Subsection 56(2)does not seem to codify the concept of constructive receipt since it is difficult to find inthe language of the provision support for the view that subsection 56(2) applies only whenthe taxpayer would have received the amounts in question but for the redirection of thoseamounts to someone else. However, see the decision of the Supreme Court of Canada inNeuman v. The Queen, 98 DTC 6297.

51 Fraser Companies, supra footnote 50, at 71; aff ’d. in Neuman, supra footnote 50, at 6301.


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Revenue Canada takes the position that the doctrine of constructiveand/or indirect receipt allows the imposition of tax when an employeechooses to “cash out” vacation pay or give up other taxable benefits inexchange for non-taxable benefits.52 Constructive receipt may also allowRevenue Canada to impose tax when an employee redirects benefits fromone plan to another. Revenue Canada has taken that position in respect ofa redirection by an employee of benefits from an EBP to a retirementcompensation arrangement even though the employee would not havebeen taxed on EBP benefits until the benefits were actually received.53

To the extent that subsection 56(2) is not applicable, Revenue Cana-da’s position regarding constructive receipt may be overstated. First, thecase law that refers to constructive receipt is sufficiently confused as toprevent certainty that such a doctrine actually exists in Canada. Second,Revenue Canada has not always applied the doctrine with consistency;contrast paragraph 10 of IT-502 above with paragraph 8 of IT-529, whichstates that certain amounts (such as redirected benefits) will cause “theemployee [to] be considered to have constructively received employmentincome equal to the value of the allocated credits (unless the entire FlexProgram is considered to be an employee benefit plan.)” However, theseambiguities may be of little relevance if Revenue Canada can claim thatthe flexible benefit plan is designed to defer tax and is therefore an SDA.

Note also that it is Revenue Canada’s view that, generally, where salaryor benefits under an existing contract (including bonuses, vacation, orsalary increases) are converted to flex credits, the employee will have ataxable benefit under subsection 5(1), subsection 56(2), or paragraph6(1)(a).54 This result arises whether or not the acquired credits are used to

52 See supra footnote 37. See also “Qualifying Stock Option Agreement,” RevenueCanada document no. 5-9559, April 9, 1990, in the context of an agreement to purchaseshares in lieu of compensation, and “Mandatory Conversion of Salary to Flex Credits,”Revenue Canada document no. 9606655, April 18, 1996, in the context of a redirection ofbenefits on the implementation of a new flexible benefit plan. The latter technical inter-pretation suggests that Revenue Canada takes a strict stance on constructive receipt.Conversion of benefits to a flexible benefit plan was considered constructive receipt eventhough the conversion was mandatory; the technical interpretation states, “While youstressed the fact that the initial redirection of salary is mandatory and that the employeehas no choice as to the amount of salary redirected to the flexible benefit credit pool, anemployee typically has a degree of control over the amount of salary redirected by meansof the choices made by the employee under the flexible benefit plan.”

53 IT-529, supra footnote 37, at paragraph 8; and “Employee Benefit Plan Conversionto Retirement Compensation Arrangement,” Revenue Canada document no. 9632316,October 8, 1996: “[t]he fact that . . . it is the employee who causes the amendment mayindicate that the employee has control over the disposition of the funds in the plan and thatthere is no trust arrangement at this point. This could indicate that the employee hadconstructive receipt of the amounts and should be taxed in accordance with paragraph6(1)(g) of the Act.”

54 “Mandatory Conversion of Salary to Flexible Benefits,” in Window on Canadian Tax(Toronto: CCH Canadian) (looseleaf ), paragraph 4171; “Salary Rollbacks and IncreasedBenefits,” Revenue Canada document no. 9633255, November 13, 1996; and RevenueCanada document no. 9606655, supra footnote 52.


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obtain non-taxable benefits, on the ground that where an employee con-verts salary or benefits to flex credits, it cannot be said that the employerhas contributed to the plan or provided a benefit. Here, the conversion ofsalary or benefits will be considered tantamount to the purchase of ben-efits with after-tax dollars. The immediacy of the income inclusion isbased (at least in part) on the application of the doctrines of constructiveand/or indirect receipt.55 However, if the employee does not yet have alegal right to salary (for example, where an employment contract is rene-gotiated upon expiry), a reduction in salary in exchange for an increase inbenefits exempt under subparagraph 6(1)(a)(i) should not be taxable.56

To summarize, a Canadian employer that wishes to offer a flexiblebenefit plan should be aware that establishing such a plan may give riseto three problems:

1) additional costs incurred to ensure that contributions to and dis-bursements from different plans under the flexible benefits plan umbrellaare sufficiently segregated;

2) deferred deductions for the employer; and/or

3) accelerated inclusions for the employee.

ExamplesConsider the following examples where Xco, a Canadian company, offersits employees a flexible benefit plan containing these elements:

• plan #1: group term life insurance policy,• plan #2: PHSP,57

• plan #3: group short-term and long-term disability coverage,• plan #4: dependant care plan,• plan #5: dental plan,• plan #6: RRSP contributions, and• plan #7: fitness club membership.

In order to ensure that preferred tax treatment is maintained for the non-taxable options, such as employer contributions to a PHSP, Xco mustcarefully segregate contributions to and distributions from each of thebenefit plans.

If Xco grants every employee the same number of flex credits—forexample, 3,000—to allocate among the above choices, the tax treatment

55 “Flex Plans and Conversion of Salary to Credits,” Revenue Canada document no.9505455, June 29, 1995. Recall that tax-free treatment of benefits arises under paragraph6(1)(a) only when the employer contributes to the plan or provides the benefit.

56 “Conversion of Salary to Non-Taxable Benefits,” in Window on Canadian Tax, suprafootnote 54, at paragraph 4419; “Conversion of Salary to Non-Taxable Benefits,” ibid., atparagraph 4232; and Revenue Canada document no. 9633255, supra footnote 54.

57 PHSPs are discussed below.


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of each employee will differ depending on his or her selections. As notedabove, it is critical that individuals allocate their flex credits before thestart of the plan year. Once the plan year has commenced, employeescannot reallocate their flex credits, except where there is a change in theemployee’s family circumstances in the year (for example, marriage orchildbirth) or a change in employment status.

Example 1Employee A is a young, single woman with no dependants. She allocatesher flex credits to the following plans:

• plan #2: PHSP,

• plan #6: RRSP contributions, and

• plan #7: fitness club membership.

A will not receive a taxable benefit where Xco reimburses her foreligible claims under the PHSP, up to the amount of credits in her healthcare spending account. A PHSP is a plan of insurance. Accordingly, theemployer is obligated to reimburse A for eligible expenses incurred up tothe amount of credits allocated to the account.

The RRSP contributions made by Xco on behalf of A will be includedin A’s income as salary or wages under subsection 5(1). However, A willstill be entitled to claim any deduction permitted under the RRSP rules.

Whether A is taxed on the fitness club membership depends on whetherthe membership is primarily for the benefit of A or of Xco. Provided thatthe fitness club membership is primarily for the benefit of Xco, A will notbe taxed on the value of the benefit.58

Example 2Employee B is a middle-aged, married woman with two children. Sheallocates her flex credits to the following plans:

• plan #3: group short-term and long-term disability coverage, and

• plan #4: dependant care plan.

B’s husband has an extensive benefits package through his job. Conse-quently, B wants to participate in only the two indicated plans. She alsowants to take a portion of her flex credits in cash. The amount receivedby B in cash will be included in her income as income from employment.

The value of the benefit of contributions made by an employer to a groupdisability insurance plan is generally not included in the employee’s incomeby virtue of subparagraph 6(1)(a)(i). Further, under paragraph 6(1)(f ),amounts received by an employee pursuant to a disability insurance plan

58 Interpretation Bulletin IT-470R, “Employees’ Fringe Benefits,” April 8, 1988. Whethera fitness membership is primarily for the benefit of the employer is a question of fact to bedetermined on the basis of the individual circumstances.


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are not taxable where the employee has made all the contributions to theplan. However, where the employer has contributed to the disability plan,benefits received by the employee under the plan are taxable.59 Since Bhas opted to use her flex credits to obtain disability coverage—that is, thecontributions are being made by Xco—any resulting benefit will be tax-able to her under paragraph 6(1)(f ).

Contributions to dependant care expenses are not exempt from taxunder paragraph 6(1)(a).60 Therefore, B will be taxable on the value of thebenefits she receives for dependant care. For the purposes of the section63 deduction, B is considered to have paid these expenses and can claimthe deduction if she otherwise qualifies.61

THE USE OF PRIVATE HEALTH SERVICES PLANS AND HEALTHAND WELFARE TRUSTS TO PROVIDE CHOICE TO EMPLOYEESIn this section, two particular types of plans are described—PHSPs andHWTs. These plans are frequently offered as components of flexible benefitplans. They may be viewed as “mini” flexible benefit plans, in that theyoffer employees a degree of choice with respect to benefits received. Anexamination of these two types of plans demonstrates the difficulty inadapting the concept of employee choice to the current taxation of benefitplans under the Act.

PHSPsThe Act specifically refers to the type of benefit plan known as a “privatehealth services plan.” Subsection 248(1) defines a PHSP as a contract ofinsurance in respect of hospital or medical expenses (or any combinationof such expenses), or a medical or hospital care insurance plan (or anycombination of such plans), subject to two exceptions.62

The plan must include an insurance element to qualify as a PHSP.Therefore, in Revenue Canada’s view, it must contain an undertaking by

59 Paragraph 6(1)(f ) provides for a reduction of tax with respect to any premiums paidby the employee. See K.M Dagenais et al. v. The Queen, [1995] 2 CTC 100 (FCTD); and“Employee-Pay-All-Plans,” Revenue Canada document no. 9705555, May 17, 1997.

60 In “Child Care Fund—Taxable Benefits,” Revenue Canada document no. 9519423,October 12, 1995, the department comments, “Generally, where an employer reimbursesan employee or provides for the payment of all or a portion of an employee’s child careexpenses, the employee is considered to be in receipt of a taxable benefit pursuant toparagraph 6(1)(a) of the Income Tax Act.”

61 See Interpretation Bulletin IT-495R2, “Child Care Expenses,” January 13, 1997; andDath and Fuoco, supra footnote 18.

62 The two exceptions are contracts or plans established pursuant to (1) a provinciallaw that establishes a health care insurance plan where the province receives contributionsfrom Canada for insured health services provided under a plan pursuant to the Federal-Provincial Fiscal Arrangements Act, or (2) an act of Parliament that authorizes the provisionof a medical or hospital care insurance plan for employees of Canada and their dependantsand for RCMP force members and their dependants where such employees were appointedin Canada and are serving outside Canada.


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one person to indemnify another person for an agreed consideration froma loss or liability in respect of an event the happening of which is uncer-tain.63 Revenue Canada considers a “cost-plus” plan to be one that satisfiesthese requirements.64

As contemplated in the Act, a PHSP is not a true flexible benefit planbut rather a single benefit.65 However, to the extent that an employee maychoose which expenses to claim, the plan resembles a flexible benefitplan. For example, under a PHSP, an employee may be eligible for reimburse-ment of $1,000 worth of medical expenses. If she actually incurs $3,000worth of medical expenses, she can choose which expenses to claim. Theability to choose expenses becomes particularly valuable if the employeeenjoys insurance coverage from other sources, such as a spouse’s benefit plan.

Employer contributions to a PHSP are not included in the employee’sincome under subparagraph 6(1)(a)(i), and they are deductible to the em-ployer under section 9. This tax treatment should encourage employers toprovide such plans. The employer will not forgo the immediate deductionfor salary paid directly to an employee because the employer receives animmediate deduction for contributions to a PHSP. At the same time, theemployee is not taxed on either the employer contributions or the benefitspaid under the plan. Employee contributions to a PHSP are not deductiblefrom the employee’s income, but they do generate a “medical expensecredit” to the employee,66 presumably because the employee would havereceived a medical expense credit even if she had spent her after-taxdollars directly on the expenses.

A plan that falls outside the definition of a PHSP will generally beconsidered by Revenue Canada to constitute an EBP.67 There are a numberof ways in which a plan may fail to qualify as a PHSP. The plan maycover expenses other than medical expenses. Alternatively, the plan may allowfor an indefinite carryforward of unused credits or the transfer of unusedcredits to other plans that are not PHSPs.68 Revenue Canada does notallow an unlimited carryforward of unused credits or expenses on the ground

63 Interpretation Bulletin IT-339R2, “Meaning of ‘Private Health Services Plan’,” August8, 1989, paragraph 3.

64 Under a “cost-plus” plan, an employer contracts with a trustee or insurance companyto indemnify employees for named risks. The employer reimburses the trustee or insurancecompany and pays an administration fee.

65 An employer may offer a single plan that qualifies as a PHSP under the Act. Alterna-tively, an employer may offer a flexible benefit plan that includes qualifying PHSPcontributions as one of the options. In the latter case, the PHSP must satisfy the definitionin the Act, and (as discussed above) contributions to and distributions from the PHSP mustbe segregated from those relating to the other benefit options. See the text accompanyingfootnote 34 and following.

66 Paragraph 118.2(2)(q).67 Dath and Fuoco, supra footnote 18, at 6:6.68 Ibid., at 6:10.


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that the employer does not retain a reasonable element of risk and thereforethe plan ceases to be a “plan of insurance.”69 A plan that allows an em-ployee to “cash out” unused credits also will not qualify because cash isnot one of the benefits that may be offered to an employee under a PHSP.70

The number of flex credits allocated to an employee must be fixed atthe beginning of the plan year.71 The amount of predetermined flex creditsallocated to each employee may be varied annually (before the beginningof the plan year) according to the employer’s ability to pay.72 RevenueCanada allows an employee to depart from his or her annual allocation offlex credits only to “accommodate a life event such as marriage, birth ofa child or the loss of a dependant” so long as the changes are internal tothe PHSP; reallocation between a PHSP and another benefit plan is notpossible without incurring adverse tax consequences except in very lim-ited circumstances.73 Revenue Canada has also indicated that flex creditsmay be reallocated where there is a change in the employment status ofan employee (for example, a part-time employee becomes full-time).74

In Income Tax Ruling ATR-23, dated July 14, 1987, an employer estab-lished a plan whereby employees were allocated an annual amount of“spending account dollars” to be used for health-related benefits such asdental benefits, prescription drugs, and vision care. The employees wererequired to submit claims to the employer, which would reimburse 80percent of the eligible expenses to a maximum of $500 per year (thus, amaximum reimbursement of $400). If an employee incurred more than$500 of eligible expenses, the plan permitted a carryforward of the addi-tional expenses to the next year. At the end of the year, unused creditswere forfeited. Revenue Canada ruled that the plan was a valid PHSPeven though there was a one-year carryforward of excess expenses. Rev-enue Canada has since clarified its position, stating that eligible medical

69 Revenue Canada document no. June 1991-196, supra footnote 38; Revenue Canadadocument no. 9304605, supra footnote 38; and “Health Spending Account with VaryingPlan Years and Amount of Credit,” Revenue Canada document no. 9522905, October 24, 1995.

70 Revenue Canada document no. 9309625, supra footnote 39; and Revenue Canadadocument no. 9505455, supra footnote 55. Presumably such a plan would not satisfy therequirement that there be an element of insurance present.

71 A plan that calculates credits as a percentage of an employee’s salary might falloutside the definition of a PHSP because the number of credits allocated to the employeecould, depending on the particular plan, change over the plan year as the employee’ssalary changes over the plan year. (Revenue Canada document no. 9522905, supra foot-note 69.)

72 “Variations in the Annual Flex Credits Allocated,” Revenue Canada document no.9623445, October 11, 1996. However, as discussed elsewhere, if an employee converts anexisting right to salary or benefits to more flexible credits, the employee will incur ataxable benefit, whether the flex credits are used to obtain non-taxable or taxable benefits.See the text accompanying footnote 43.

73 Reallocation among different plans may be possible if the credits accrue to theemployee on a periodic basis. (Revenue Canada document no. 9522905, supra footnote 69.)

74 IT-529, supra footnote 37, at paragraph 6.


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expenses or flex credits (but not both) may be carried forward for amaximum of one year.75 It is Revenue Canada’s position that a plan thatallows a carryforward of expenses or credits in excess of one year is morein the nature of a savings plan than a plan of insurance and, as such, doesnot qualify as a PHSP.76

HWTsA second type of benefit plan that resembles, to a limited degree, a flex-ible benefit plan, is not defined in the Act but rather has been created byRevenue Canada. As defined in IT-85R2, a “health and welfare trust” is aplan that is “administered by an employer through a trust arrangementand which is restricted to (a) a group sickness or accident insuranceplan. . . , (b) a private health services plan, (c) a group term life insurancepolicy, or (d) any combination of (a) to (c).”77

IT-85R2 imposes further requirements on an HWT:

• “the funds of the trust cannot revert to the employer or be used forany purpose other than providing health and welfare benefits for whichthe contributions are made”;78

• the funds contributed must not exceed the level required to fund thebenefits;79

• the employer must have a legal obligation to make contributions tothe plan;80 and

• two or more employees must be covered by the plan (unless it is aPHSP).81

If these criteria are met, certain tax consequences arise. First, the em-ployer may deduct contributions to the trust in the year of contribution.Second, neither the employer’s contributions nor the premiums paid bythe trustees to the insurer or the PHSP will be included in the employee’sincome at the time such payments are made. Benefits eventually enjoyedby the employee may or may not be included in the employee’s income,

75 Ibid., at paragraph 16.76 “Carryforward of Credits and Expenses in a Health Spending Account—Flex Plan,”

Revenue Canada document no. 9311525, August 9, 1993; and Revenue Canada documentno. 9309625, supra footnote 39.

77 Supra footnote 34, at paragraph 1. Revenue Canada takes the position that a “groupsickness or accident insurance plan” includes a “sickness or accident insurance plan,” a“disability insurance plan,” and an “income maintenance insurance plan” as found inparagraph 6(1)(f ) of the Act. (IT-85R2, supra footnote 34, at paragraph 2.) The rulespertaining to HWTs were originally published in 1966 in Information Bulletin no. 31,“Health and Welfare Trusts for Employees,” August 4, 1966.

78 IT-85R2, supra footnote 34, at paragraph 6.79 Ibid.80 Ibid.81 Ibid., at paragraph 7.


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depending on the type of benefit involved.82 Employees do not receivedeductions for employee contributions to the trust and are not taxed onthe proportion of their benefits that corresponds to those contributions.83

The trust will be taxed on any funds that it retains after premiums, ben-efits, and certain expenses are paid out.84 If an employee purchasesinsurance or contributes to plans other than a PHSP, a sickness or acci-dent insurance plan, or a group term life insurance plan, the entire trustloses its characterization as an HWT and will likely be considered an EBPor perhaps an ET.85

An HWT under IT-85R2 is generally not considered to be a flexiblebenefit plan. IT-85R2 was introduced in response to industry practice ofcombining all three benefits within one plan, rather than offering employ-ees a choice among benefits.86 The effect of IT-85R2 is that a plan thatcombines all three benefits will preserve the same tax treatment for eachbenefit. In other words, premiums paid by employers for group sicknessor accident insurance plans and PHSPs are excluded from an employee’sincome under paragraph 6(1)(a) and are immediately deductible to em-ployers under paragraph 18(1)(a). It appears that an HWT will not receiveEBP treatment even if the three components of the plan are offered on anon-segregated basis.87

TAXATION OF FLEXIBLE BENEFIT PLANS INTHE UNITED STATESAs noted earlier, the US tax system provides a specific taxation regimefor cafeteria plans, in section 125 of the Code.88 A product of a series oflegislative and regulatory changes made primarily in the mid-1980s, sec-tion 125 was enacted to prevent employees from being caught byconstructive receipt rules.89

82 Benefits provided to an employee under a PHSP are not subject to tax. (Ibid., atparagraph 9.) Benefits under a group term life insurance plan are normally subject to taxunder subsection 6(4) of the Act. Full taxability of group term life insurance was added tothe Act in 1994. IT-85R2 has not yet been revised to reflect this change. If the benefit isfunded by a combination of employer and employee contributions, the portion of thebenefit that can be attributed to the employee contributions will not be included in theemployee’s taxable income for the year. (IT-85R2, supra footnote 34, at paragraph 9.)

83 Subsection 8(2); IT-85R2, supra footnote 34, at paragraph 10.84 IT-85R2, supra footnote 34, at paragraphs 11 and 12.85 Ibid., at paragraph 3.86 The term “health and welfare trust” was originally introduced by construction un-

ions, which developed these combined benefit plans for workers in the construction industry.IT-85R2 reflects the format typically used for these plans.

87 A group sickness or accident insurance plan, a PHSP, and a group term life insuranceplan all fall outside the definition of “employee benefit plan.”

88 For a more detailed review, see Woodward, supra footnote 11; Schaffer and Fox,supra footnote 9; and M.J. Canan and W.D. Mitchell, Employee Fringe and Welfare BenefitPlans (St. Paul, Minn.: West, 1996), chapter 15.

89 See Wiedenbeck, infra footnote 97.


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Cafeteria plans and flexible benefit plans are different concepts in theUnited States. Cafeteria plans are those plans that qualify under section125; they are funded by pre-tax dollars and may provide tax advantagesto both employers and employees. In contrast, a flexible benefit plan isany benefit plan that provides an employee with choice. The US cafeteriaplan regime is carefully crafted to ensure favourable income tax treat-ment only for specific types of flexible benefit plans.

Section 125(d) of the Code defines a “cafeteria plan” as

a written plan under which—

(A) all participants are employees, and

(B) the participants may choose among 2 or more benefits consisting ofcash and qualified benefits.

The Code defines a “qualified benefit” as any benefit that “is not includible inthe gross income of the employee by reason of an express provision of thischapter [excluding certain sections]”90 as well as other specified benefits.91

In contrast to Canadian PHSPs and HWTs, US cafeteria plans requireemployers to offer a combination of taxable benefits and cash. A cafeteriaplan may offer employees taxable benefits, including property or anyother benefit that would be taxable to the employee, without endangeringthe characterization of the plan as a cafeteria plan.92 A plan may alsoprovide that employees can purchase certain benefits with after-tax dollars;these benefits will not be taxed again merely because they are offered ina cafeteria plan.93 However, if a benefit is generally to be included in anemployee’s income, the employee cannot escape taxation by opting forthe benefit within a cafeteria plan.

A cafeteria plan may be funded by a salary reduction agreement betweenthe employee and the employer.94 A salary reduction agreement is anagreement under which an employee agrees to forgo salary increases or to

90 With the exception of certain benefits such as scholarships and tuition programs,certain fringe benefits, and employer education assistance programs. See section 125(f ) ofthe Code.

91 These specified benefits include group term life insurance up to $50,000, certainaccident or health plan benefits, some medical expense reimbursements, some dependantcare assistance benefits, and participation in certain cash or deferred arrangement plans.(Section 125(f ) of the Code and temp. Treas. reg. section 1.125-2T, A-1.) Vacation daysare taxable benefits under the Code that can be purchased under a cafeteria plan withoutjeopardizing the validity of the plan. However, the validity of the cafeteria plan will bejeopardized if the employee is permitted to use or “cash out” the vacation days in asubsequent plan year. (Temp. Treas. reg. section 1.125-2T, A-1.)

92 Prop. Treas. reg. section 1.125-1, A-2 provides that a plan is not a cafeteria planunless it offers at least one taxable benefit and at least one non-taxable benefit. A non-taxable benefit that is not a “qualified benefit” will be considered a taxable benefit if it isoffered within a cafeteria plan. (Prop. Treas. reg. section 1.125-1.)

93 Prop. Treas. reg. section 1.125-1, A-5.94 Prop. Treas. reg. section 1.125-1, A-6.


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decrease salary in exchange for contributions by the employer to thecafeteria plan of the amounts forgone or subtracted. The employee willnot be liable for tax on those amounts to the extent that they were notcurrently available to the employee.

A plan does not qualify as a cafeteria plan if it discriminates in favourof “highly compensated individuals or participants” with respect to eligi-bility to participate in the plan or with respect to contributions or benefits.95

A “highly compensated individual or participant” is defined in section125(e) as an officer, a shareholder owning more than 5 percent of thevoting power or value of all classes of stock of the employer, a personwho is highly compensated, or a spouse or dependant of any of the above.In addition, non-taxable benefits provided to “key employees”96 may notexceed 25 percent of the total non-taxable benefits offered to all planparticipants.

A plan is not a cafeteria plan if it provides for deferred compensa-tion.97 For example, proposed regulations suggest that an arrangementwhereby unused credits from a given plan year could be retrieved in cashin a subsequent plan year would constitute deferred compensation andthus would disqualify the plan from section 125 treatment.98 In addition,the proposed regulations state that a plan that allows an employee topurchase vacation days will not qualify as a cafeteria plan if the em-ployee has the opportunity to use those vacation days in the next planyear;99 the inability of the employee to convert the purchased vacationdays into other benefits is irrelevant. The proposed regulations also statethat an employee may not purchase benefits in the current year for con-sumption in subsequent years.100

Elections among benefits made by an employee must be irrevocablewithin the coverage period, subject to certain exceptions.101 Although the

95 Section 124(b)(1) of the Code.96 Defined in section 416(i)(1) of the Code to include certain officers of the employer,

the 10 employees who own the largest interests in the employer, employees who own morethan 5 percent of the employer, and employees who own more than 1 percent of theemployer and earn more than $150,000 annually.

97 Section 125(d)(2)(A) of the Code. Some exceptions to this general rule are found inthe remaining provisions of section 125(d)(2) of the Code. An example of deferred com-pensation that would be prohibited by the section might be the US equivalent of an SDA.The Code contains a number of anti-discrimination provisions in the area of deferredcompensation. The purpose of these provisions is twofold: first, to encourage employers toprovide benefits to a wider range of employees; and second, to ensure that benefits areallocated fairly. See Peter J. Wiedenbeck, “Nondiscrimination in Employee Benefits: FalseStarts and Future Trends” (Winter 1985), 52 Tennesee Law Review 167-267, at 170 and 175.

98 Prop. Treas. reg. section 1.125-1, A-7.99 Ibid.100 Ibid.101 These exceptions include marriage or divorce of the employee, birth or adoption of

a child, and death of a covered family member. (Temp. Treas. reg. section 1.125-4T.)


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Code does not specify the length of a coverage period, it may be assumedthat the period will generally be a plan year. Therefore, for example, if anemployee has the right to change an election from a particular benefit tocash midway through the plan year, the employee will have to include theamount of cash in taxable income for the current taxation year whether ornot he or she has actually received the cash.102 Thus, section 125 of theCode provides an exception to the constructive receipt rules, but only tothe extent that the employee makes choices among benefits before thosebenefits become currently available.103

A popular type of cafeteria plan in the United States is the flexiblespending account. This kind of plan can be funded by both employer andemployee contributions. A cafeteria plan can be funded solely by em-ployee contributions. Benefits may also be uninsured and delivered on a“pay-as-you-go” basis. However, in the case of health care benefits,amounts contributed by the employer to reimburse the employee’s medi-cal expenses must relate to expenses incurred within the coverage period.If a plan provides for reimbursement of the employee for a specific amount(say, $1,000) but allows the employee to “cash out” the unused portion ofthe amount, the benefit is not a “qualified benefit.”104 The total payroll ofan employer administering a flexible spending account will be reduced bythe amount of money put into that account. The employer will thereforeenjoy a tax advantage, since its social security and unemployment taxeswill be reduced.105

Once a plan meets the definition of a cafeteria plan in section 125 ofthe Code, employer contributions are not taxable to the employee at thetime of contribution, whether or not the employee could have elected(before the beginning of the plan year) to receive that contribution incash.106 Once an employee receives cash, the cash is taxed in the employ-ee’s hands as compensation. A plan that fails to meet the definition of acafeteria plan results in taxation of the employee on all benefits thatcould have been received in cash or in the form of taxable benefits.

102 Prop. Treas. reg. section 1.125-1, A-15.103 Prop. Treas. reg. section 1.125-1, A-9. A benefit is currently available to an em-

ployee “if the participant is free to receive the benefit currently at his discretion or theparticipant could receive the benefit currently if an election or notice of an intent toreceive the benefit were given.” A benefit will not be considered currently available merelybecause the employee must give notice if he or she wishes to receive the benefit, nor willit be considered currently available if the employee is ineligible to receive the benefit untilsome time in the future and “there is a substantial risk that, if the participant does notfulfil specified conditions during the period preceding this time, the participant will notreceive the benefit.” (Prop. Treas. reg. section 1.125-1, A-14.)

104 Prop. Treas. reg. section 1.125-1, A-17; sections 106 and 105(b) of the Code.105 R. McCarthy, “Do-It-Yourself Flexible Benefits: Tips To Enable a Benefits Manager

To Help Employees Navigate Through Choices” (1996), 14 Business and Health 63.106 Section 125(a) of the Code.


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The US cafeteria plan regime attempts to resolve many of the problemsfaced in Canada in connection with flexible benefit plans (for example,the use of options to defer compensation). There is, however, a key con-ceptual difference between the US and Canadian regimes, other than theirtreatment of cash benefits: the United States has chosen to implement alegislative regime, while Canada has (thus far) opted for an administra-tive regime. The importance of this distinction is addressed in the nextsection.

IS THERE A NEED FOR LEGISLATIVE CHANGE?Although flexible benefit plans have existed in Canada for well over adecade, Revenue Canada has only recently begun to provide guidancewith respect to their tax treatment. Until this year, the regulatory responseto flexible benefit plans has been piecemeal, consisting largely of Rev-enue Canada opinions relating to specific factual situations. IT-529 is thefirst attempt by Revenue Canada to provide a comprehensive guide to thetax treatment of such plans. However, the bulletin generally represents acollection of Revenue Canada’s views already published in the area. Thereis no specific tax legislation in Canada pertaining to flexible benefit plans,and the Department of Finance has not indicated any intention of amend-ing the Act in this regard in the near future.

The lack of legislative activity in this area is not surprising. The provi-sions in the Act dealing with employee benefits have been primarilyreactive and have seemingly responded to the changing demographics ofthe Canadian workforce over the past few decades.107 There are now morewomen in the workforce and many families in which both partners work.108

These changes have led to innovative approaches to work and compensa-tion, and flexible benefit plans are one measure that has become widelyaccepted by both employers and employees. Perhaps the government hasbeen reluctant to recognize such plans through legislative amendmentsbecause it is concerned about loss of tax revenues. As will be discussedbelow, an increase in the use of flexible benefit plans would arguablyresult in an increase in the absolute dollar value of non-taxable benefitsbeing consumed. Nevertheless, given that many plans are already in placeand interest in them is still growing, it is timely now to consider theintroduction of legislation clearly specifying the tax treatment to employ-ers and employees who participate in these plans. The remainder of thisarticle presents arguments in support of a legislative framework for thetaxation of flexible benefit plans.

107 Canadian Handbook of Flexible Benefits, supra footnote 15, at 443.108 Statistics Canada, Labour Force, Employed and Unemployed, Numbers and Rates

by Sex, 1995, catalogue no. 71F-004-XCB.


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Flexible Benefit Plans GenerallyThe absence of legislation governing flexible benefit plans may indicateneutrality toward or even discouragement of such plans by Parliament.On the other hand, Revenue Canada has provided limited administrativeguidance regarding their tax treatment and thereby seems to have encour-aged the use of such plans. If parliamentary inactivity indicates an intentionto discourage flexible benefit plans, arguably tax legislative policy andtax administration are at odds with each other. The first question to beaddressed, then, is whether the Canadian taxation system ought to en-courage flexible benefit plans.

Arguments in Support of Flexible Benefit PlansThere are two basic arguments in favour of flexible benefit plans.

First, flexible benefit plans respect and enhance individual choice.109 Aflexible benefit plan allows each employee to select a benefit packagethat best represents his or her preferences.110 Moreover, a flexible benefitplan accommodates changes in the requirements of employees. Factorssuch as wage increases, fluctuations in family size, and age of plan parti-cipants all affect employee preferences. An individual employed by afirm with a flexible benefit plan is not bound by the benefit packagechosen at the beginning of his or her career.

Second, flexible benefit plans allow for efficient allocation of re-sources.111 Flexible benefit plans transfer decisions regarding benefit

109 It could also be argued that enhancement of individual choice of benefits allowsCanadian firms to compete better in international labour markets. Given the range of othervariables that determine where individuals choose to work, this argument may not carrymuch weight; however, it may be more persuasive in the case of markets suffering fromlabour shortages.

110 With the dramatic changes that have taken place in the demographics of theworkforce, employers have generally had to reassess their benefit packages. Similarly,employers have taken a closer look at the pension plans they offer to employees and havebeen exploring the possible uses of flexible pension plans. Revenue Canada has recentlypublished its position on flexible pension plans (Revenue Canada, Registered Plans Divi-sion, Newsletter, no. 96-3, November 25, 1996), approving of their use. Revenue Canadahas clearly established that flexible pension plans (as approved in the newsletter) can beregistered under the pension rules in the Act. Contrast the department’s approach to flex-ible benefit plans, for which there is no formal registration procedure and no requirementfor the plan documents to be approved by Revenue Canada before implementation. Forfurther discussion of flexible pension plans, see Sheldon Wayne, “Switch Hitting” (April1995), 19 Benefits Canada 23-25.

111 Consider the following example offered by Julie A. Roin, “United They Stand,Divided They Fall: Public Choice Theory and the Tax Code” (November 1988), 74 CornellLaw Review 62-134. An employer with three employees decides to raise wages in order toprovide its employees with additional non-taxable benefits. The employer is willing toraise wages only to the level required to fund one type of benefit for each person. How-ever, each employee would like to receive a different benefit. Each employee could simplytake the wage raise and buy the benefit herself, but she would receive less of a benefit

(The footnote is continued on the next page.)


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allocation from employers to employees. Employees are most familiarwith their own requirements and therefore are in the best position tomake appropriate allocation decisions. For example, it is the employeewho will know whether benefits will be duplicated within her family ifher partner participates in a similar plan. Furthermore, requiring employ-ees to make choices regarding the allocation of their benefit dollars forcesthem to measure the value of one benefit against others. This more effi-cient allocation of resources means that the costs of providing benefitsshould be set at the correct level. It is likely that an employee will useonly benefits that she believes she requires, since under a flexible benefitplan an employee generally must sacrifice one benefit in order to obtainanother. Accordingly, the overuse of benefits should not be a problem.

These arguments, of course, do not take tax into account, but a reviewof the efficiency of flexible benefit plans under various tax regimes isbeyond the scope of this article. These arguments do support the positionthat attempts to design a tax regime governing flexible benefit plans shouldbegin with the premise that such a tax regime should encourage (throughneutrality or even, perhaps, preferences) the efficiency of flexible benefitplans that would exist in a tax-free world.112

Arguments Against Flexible Benefit PlansThere are at least four arguments against the encouragement of flexiblebenefit plans.

First, policy makers may be concerned that if employees are permittedto choose their benefits, they may opt out of those benefits that legisla-tors deem important. Such a rationale may explain why currently the only

because the benefit would be purchased with after-tax dollars. The employee could partici-pate in the plan offered by the employer, but she might not receive her preferred benefit.Many employees may choose this option because it is less expensive, and because they donot have the knowledge to purchase other benefits. Continued receipt of less desirablebenefits could eventually lead to the termination of the benefit plan owing to decreasedemployee participation and increased expense to employers. (Ibid., at 97.) Under a flexiblebenefit plan, the employer in this example can offer each employee the benefit she prefersfor the same cost. Employee choice is enhanced, and resources are allocated more effi-ciently because the employee receives the benefits she most desires, rather than incurringcosts for unwanted benefits. Roin argues that even if the three employees are allowed tovote on the benefit to be offered, the “impossibility theorem” of public choice theorydictates that a majority of employees will be dissatisfied with the outcome in that theywould have preferred a different benefit. (Ibid., at 65.) Hence, argues Roin, “the Codeoperated to minimize revenue loss by exploiting the effects of the impossibility theorem.”(Ibid., at 66.)

112 We recognize, of course, that designing such a tax regime may cause unintendeddistortions and is thus fraught with difficulty. (See, for example, Boris I. Bittker, “A‘Comprehensive Tax Base’ as a Goal of Income Tax Reform” (March 1967), 80 HarvardLaw Review 925-85.) However, this article does not argue for a specific tax regime;instead, it argues that an attempt to design a specific regime ought to be made because thecurrent tax regime appears to undermine non-tax efficiencies.

111 Continued . . .


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plans referred to in the Act that offer individual choice are those provid-ing health benefits (under PHSPs).113 Arguably, policy makers havedetermined that such benefits are important and should be encouraged.Some may immediately dismiss this argument as paternalistic; however,given that the benefits are subsidized by taxpayers, it may be appropriatefor the federal government to curtail individual choice in favour of thepursuit of specific national policies.

A second concern is that although flexible benefit plans result in amore efficient allocation of resources generally, they may have an adverseeffect on tax revenues. While non-taxable benefits may be allocated moreefficiently among employees, the absolute dollar value of non-taxablebenefits being consumed will likely increase for two reasons: first, it islikely that more employees will choose to participate in flexible benefitplans; and second, it is more likely that employees will consume thebenefits actually offered. Thus, an increase in the use of flexible benefitplans may result in decreased revenues. Accordingly, Parliament may hesi-tate to encourage the use of such plans.

Third, some may argue that the introduction of legislation would need-lessly complicate an area that is already adequately regulated. Perhaps alegislative regime would only cause new problems and raise compliancecosts.

Finally, it has been suggested that flexible benefit plans may not ulti-mately benefit employees, since they may make the valuation of taxablebenefits easier for Revenue Canada.114 For example, where an employeeelects to forgo salary in exchange for a package of benefits, it is easier toplace a monetary value on that package of benefits. Similarly, if flexcredits are used, where each credit has a specific value, it may be easierfor Revenue Canada to place a value on the taxable benefits selected bythe employee. However, as increased transparency is always beneficial tothe functioning of the tax system and therefore to taxpayers generally,this argument lacks persuasiveness and, in fact, likely provides supportfor the encouragement of flexible benefit plans.

ConclusionFlexible benefit plans are desirable because they enhance employee choice,because they permit employers to provide benefits at equal or reducedcost, and because they encourage a more efficient allocation of resources.

113 Many employers that offer flexible benefit plans do not allow employees to opt out ofmedical coverage. According to the 1995 survey by Hewitt Associates, referred to in Gordon,supra footnote 4, at 22, 31 percent of employers surveyed did not allow opting out, while21 percent of employers allowed opting out with proof of coverage elsewhere. In 1992, 56percent of employers surveyed allowed employees to opt out of medical coverage.

114 Barrie M. Philp, “Executive and Employee Compensation After Tax Reform,” inReport of Proceedings of the Fortieth Tax Conference, 1988 Conference Report (Toronto:Canadian Tax Foundation, 1989), 28:1-56.


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The arguments against encouraging flexible benefit plans can largely beresolved satisfactorily. Legislative adjustments can be made to respond tothe concern that choice may undermine national policy objectives. Forexample, if policy makers want to encourage the receipt of medical ben-efits (such as PHSPs) by employees, the Act can be amended to providefor minimum coverage requirements for those employees who participatein a flexible benefit plan.115 Arguments raising the spectre of legislativecomplexity can be countered by reference to the US example, which,setting aside complexities made necessary by the uniqueness of the UStax system, is not significantly more complicated than the current Cana-dian system. Concerns regarding the valuation of benefits are easily setaside since the efficient and equitable functioning of the current taxationsystem requires the accurate valuation of benefits. Perhaps the most power-ful argument against the encouragement of flexible benefit plans is thepossibility of forgone revenue by the national treasury. This questioncannot be resolved from the viewpoint of tax policy alone but ratherdemands a much broader analysis.

It appears, then, that there are sound non-tax arguments that may bemarshalled in favour of flexible benefit plans. Nevertheless, as explainedabove, the Canadian tax system is not neutral toward these plans; indeed,employers may have to incur additional costs to ensure that their planadheres to Revenue Canada’s guidelines, or risk deferred deductions oraccelerated inclusions for their employees. Accordingly, this article ar-gues that legislation is needed to ensure that, at least, neutrality towardflexible benefit plans is achieved. The remainder of this article will ad-dress several specific aspects of the taxation of flexible benefit plans andwill suggest that the tax system should provide outright encouragementrather than mere neutrality.

Specific IssuesThe Cash OptionWhen the Canadian and US approaches are compared, the most strikingdifference is the tax treatment of a “cash option” under a flexible benefitor cafeteria plan. In the United States, a cash option is a required compo-nent of a cafeteria plan, subject to certain restrictions.116 In Canada, acash option is not directly addressed and may, depending on the structure

115 For example, the Act could specify that any employee participating in a flexiblebenefit plan must use a given percentage or amount of credits for the reimbursement ofmedical expenses.

116 Section 125(d)(B) of the Code. Cash is not a valid option of a cafeteria plan if it isoffered in the form of “deferred compensation” (section 125(d)(2)(A) of the Code). Pro-posed regulations may substantially alter the cash option. Under prop. Treas. reg. section1.125-2, an arrangement that allowed an employee to cash out unused benefits in subse-quent years would be considered “deferred compensation.” Note, however, that althoughthe Canadian and US systems appear to treat the cash option in radically different ways,the US proposed regulations resemble the current Canadian administrative position.


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of the plan, result in the current taxation of benefits that would otherwisebe either non-taxable or taxable only at a later date.117

A cash option does not render all allocated credits immediately taxable,so long as the employee makes an irrevocable election at the beginning of theplan year. However, if an employee can change the election in the middleof a plan year and withdraw cash, Revenue Canada considers all creditsor benefits offered by the plan to be immediately taxable to the employeewhether or not the credits or benefits were actually withdrawn in cash.118

The problem with providing a cash option is that a flexible benefitplan could be used as a tool to defer compensation. For example, if a planallows an employee to roll over unused benefits from one year to thenext, and then cash out those unused benefits at a later time, the result isa deferral of compensation.119 If a plan spans a year other than a calendaryear and the employee elects to cash out at the end of the plan year,compensation may be deferred from one calendar year to the next.

Another argument against the allowance of a cash option is that lower-paid workers will always choose cash instead of benefits. Consequently,only higher-paid employees will participate in the plan. Schaffer and Foxexplain that plans that “discriminate” in favour of highly paid employeesdefeat the justification for preferred tax treatment for certain benefits,such as health and disability insurance, and pension schemes:

The only justification for leaving employer-provided benefits untaxed wasthat it encouraged the use of health insurance, disability insurance, andpension schemes “so that individuals, particularly lower income employ-ees, will be assured of protection against certain contingencies—sickness,disability, retirement—which are particularly difficult to plan for at lowincome levels.” This justification failed if employers provided tax-free ben-efits only to their more highly paid employees.120

117 Yet the cash option remains popular in Canada. According to the 1995 survey con-ducted by Hewitt Associates (Gordon, supra footnote 4, at 22), 58 percent of employerssurveyed allowed employees to cash out unused benefits, and 58 percent allowed employ-ees to deposit unused benefit dollars into RRSPs.

118 Dath and Fuoco, supra footnote 18, at 6:2-3; and IT-529, supra footnote 37, atparagraph 8. See also “Treatment of a Flexible Benefit Plan,” Revenue Canada documentno. June 1991-161, June 13, 1991; and Revenue Canada document no. June 1991-196,supra footnote 38.

119 In “Vacation Buying and Selling in a Flex Plan,” Revenue Canada document no.9500075, July 17, 1995, the department notes that “a plan which permits the rollover orcash out of purchased vacation leave may be a salary deferral arrangement.” It is clear thatthe rollover of vacation entitlement to a future year postpones the tax payable. Such anarrangement would likely fall within the definition of an SDA in subsection 248(1) if “thedeferment of tax is one of the main purposes of the arrangement.”

120 Schaffer and Fox, supra footnote 9, at 12, citing United States, Department of theTreasury, The President’s 1978 Tax Program: Detailed Descriptions and Supporting Analysisof the Proposals (Washington, DC: US Government Printing Office, January 30, 1978), 145.


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From a social policy standpoint, favourable tax treatment is given to cer-tain benefit plans because policy makers want all employees to participate;allowing some employees to escape from participation defeats the policy.

On the other hand, employees may not participate if there is no cashoption:

Flexible spending accounts that are forfeitable may at first seem to beunattractive to employees. An employee can choose to reduce his taxablesalary by $1,000 in return for his employer’s promise to reimburse him(without tax) for up to $1,000 in, say, uninsured medical expenses and daycare. But what if he should have the misfortune of good health? Then hehas lost $1,000 of salary and gotten nothing for it. . . . At the end of theyear he would have been better off with taxable cash instead.121

The employees for whom such a situation creates the most concern arelow income earners. For them, the risk that reductions in salary will neverpay off is greater than the risk that any of the situations insured against(such as disability) will occur. Therefore, particularly for low-incomeemployees, non-participation is likely.

Most arguments in favour of providing a cash option can be addressedby allowing employers to provide employees with unlimited opportunityto roll over unused credits into future years. Although lower-paid employ-ees will still choose cash over benefits in kind, they will likely do so to alesser extent because they will pay less tax and will be assured of beingable to use the benefits at some point in the future. Participation of em-ployees in benefit plans will increase for the same reasons. Under thecurrent system, benefits cannot always be rolled over to subsequent planyears. This issue is addressed below.

Rolling Over Benefits Through TimeThe concept of rolling over credits from one year to the next within aflexible benefit plan means that an employee who allocates credits to aplan for a given plan year is not required to consume the benefits associ-ated with those credits in that year.122 The ability of employees to rollover credits in this fashion is determined by the particular plan or benefitin issue.

Under the current regime, the rolling over of credits is limited withrespect to certain benefit plans. The most clear limitation is specific toPHSPs, and it follows from the requirement that a PHSP contain an insur-ance element. It is questionable whether the requirement that PHSPs containan insurance element continues to be a reasonable one, since these planshave moved away from being a form of “insurance.” The concept of

121 Schaffer and Fox, ibid., at 44-45.122 This concept is analogous to the provisions in the Act that currently permit the

rolling over of unused RRSP contribution room from one year to the next, to a maximumof seven years.


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insurance has been described as involving four general characteristics (atleast from the point of view of the insured): low incidence of claims, highamounts, unpredictability, and uncontrollability.123 Arguably, PHSPs donot satisfy these criteria. PHSPs are extremely common, and generallythere is a high incidence of claims under them, for relatively low amounts.In addition, many of the service claims under these plans are predictable(for example, regular dental or visual checkups).124 The insurance re-quirement dates back to 1983125 (or perhaps earlier) and has not beenrevised despite the increased use of PHSPs in Canada, particularly withinflexible benefit plans. One of the consequences of this requirement is thatemployees can roll over unused eligible medical expenses or flex creditsin a PHSP only for a maximum of one year; they cannot roll such ex-penses or credits forward to fund claims in subsequent years.

The inability of employees to roll over credits indefinitely within aPHSP or other insurance plan presents a serious problem in the context offlexible benefit plans. For example, it has already been argued that flex-ible benefit plans encourage the efficient allocation of resources byemployees. Requiring employees to estimate the monetary value of theirmedical claims on a year-by-year basis does not entirely undermine thisadvantage, but it does decrease efficiency to a significant extent, espe-cially if the result is that employees deliberately under- or overestimatefuture medical claims. In addition, if employees perceive credit rolloversto be extremely limited, the discrimination or non-participation problemsdescribed above may arise in connection with lower-paid employees.

On the other hand, allowing employees an indefinite rollover of unusedcredits could result in long-term benefits from a social cost standpoint.Although these credits will escape immediate taxation, they will be avail-able to fund future needs such as increased health care costs associatedwith age, which are not covered by the public health care system. So longas the funds accumulated must be used for designated non-taxable ben-efits, employees will be encouraged to “save” for future contingencies.

It is also apparent that the policy decision to provide for a deductionupon taxation for some benefits, rather than labelling the benefit “non-taxable” under paragraph 6(1)(a), has an impact with respect to the designof flexible benefit plans. For instance, section 63 provides a deduction inrespect of certain child care expenses. If instead such child care expenseswere non-taxable benefits under paragraph 6(1)(a), it might be appropri-ate to allow these benefits to be included under an HWT.126 Under both

123 Melvin J. Norton, “Taxation of Benefit Plans,” paper presented at the Infonex Semi-nar on Employee Compensation and Benefits Taxation, June 24-25, 1997.

124 Ibid., at 5.125 Interpretation Bulletin IT-339R, “Meaning of ‘Private Health Services Plan’,” June 1, 1983.126 However, given the current governmental trend toward greater fiscal responsibility,

it is unlikely that the federal government would be willing to expand the categories ofbenefits eligible to receive preferred non-taxable treatment.


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this suggested plan and the current legislation, the employer would receivea deduction for the amount paid (either as salary or as a payment to anHWT), and in both cases the employee would pay less tax (either as anon-taxable benefit or as a deduction). Arguably, the reason for providinga deduction instead of making such expenses non-taxable is that the de-duction is limited to a specific amount based on a carefully crafted for-mula; total non-taxability under paragraph 6(1)(a) would presumablyundermine this deliberate policy choice. It is questionable, however,whether it would be possible to limit non-taxability under paragraph 6(1)(a)to a monetary amount equivalent to the current section 63 deduction. Ifthis limitation were possible, child care expenses could be included in anHWT without endangering the tax treatment of the other benefits in theplan.127 Alternatively, Revenue Canada could simply take the position thattaxable benefits that are wholly or partially deductible to employees shouldbe includible in an HWT to the extent of the deduction, without endangeringthe status of the HWT. Such a change would not provide employees withan opportunity to defer taxation of compensation because the benefits (at leastto the extent of the deduction) would not have been taxed in any event.

Transfer of Credits Among PlansA third issue surrounding the treatment of flexible benefit plans under thecurrent Act is the ability—or inability—of employees to transfer creditsfrom one plan or benefit to another within a given plan year. As discussedabove, to avoid treatment of a flexible benefit plan as an EBP (or possiblyan SDA), an employer must segregate contributions and distributions re-lating to each plan or benefit at the beginning of each plan year.128

Accordingly (subject to limited exceptions), an employee may not alterthe allocation of credits in the middle of a plan year. For example, con-sider a flexible benefit plan whose plan year corresponds to the calendaryear. An employee realizes in November that she will not use all of thecredits that she has allocated to her PHSP, and she would like to transferany unused credits to her RRSP. If she does, she will have to include inincome the value of all the benefits received under the entire flexiblebenefit plan, whether or not the benefits would have been otherwise tax-able.129 As discussed above, the reason for this limitation on interplanrollovers is that such rollovers would constitute constructive receipt or“indirect payments” under subsection 56(2).130

It is unclear whether this effective prohibition on interplan creditrollovers is desirable, or even sensible, if credits are being rolled over

127 Recall that currently, if an employer offers a taxable benefit within an HWT withoutadequately segregating the valid HWT benefits and the taxable benefits, the plan loses itsstatus as an HWT.

128 See the text accompanying footnote 34.129 IT-529, supra footnote 37, at paragraph 8.130 See the text accompanying footnote 54.


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from one non-taxable benefit to another. This article has already exam-ined the problems associated with “cashing out” unused credits at the endof a plan year; the same arguments can be made in relation to the rollingover of credits from non-taxable benefits to taxable benefits such as vaca-tion days. However, if credits are being rolled over from one non-taxablebenefit to another (for example, from a PHSP to an RRSP), there is nopolicy rationale for the imposition of adverse tax consequences to theemployee. In fact, in view of the arguments presented above regardingthe efficient allocation of resources and the enhancement of employeechoice, such interplan transfers ought to be encouraged. Under the cur-rent system, adverse consequences do occur (at least in Revenue Canada’sview) under subsection 56(2) when such interplan transfers take place.

THE NEED FOR CHANGEFlexible benefit plans are now in wide use in Canada. Nevertheless, theyare not recognized in the Act, and administrative guidance with respect totheir tax treatment has been primarily reactive. As a result, taxpayers arefaced with considerable uncertainty in determining the tax treatment ofbenefits provided under a flexible benefit plan. At least until the issuanceof IT-529, taxpayers frequently needed to submit requests to RevenueCanada for rulings or technical interpretations regarding these plans. Fur-ther complications have arisen with respect to plan design, since employershave had to take great care to ensure that their plans do not inadvertentlyfall into categories of plans or arrangements defined in the Act (EBPs,ETs, SDAs, etc.) and thereby attract adverse tax consequences. To avoidthis risk, employers have incurred additional costs in segregating contri-butions and distributions on a plan-by-plan basis.

Revenue Canada has recently attempted to clarify the treatment offlexible benefit plans by issuing a number of new technical interpreta-tions as well as IT-529. However, the department can only provide guidancewithin the parameters of the legislation, and in this area the legislation issilent. Many of the specific problems addressed above, such as intra- andinterplan credit rollovers, require legislative solutions. Furthermore, tax-payer uncertainty is increased by the possibility of conflict between thepolicy goals of the Department of Finance and the administration of theAct by Revenue Canada. In our view, it is time for Parliament to turn itsattention to the governance of flexible benefit plans.

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