As the cost of medical expenditures is continuously on the rise, employers are looking for ways to manage the cost for themselves as well as for their employees. The Income Tax Act (“ITA”) provides for non-taxable benefits to their employees (including their dependents) provided they are offered as group benefits.
PHSPs offered by insurance carriers require premiums payable by employers which is based on risk for the particular group based on actuarial information. Generally speaking, the larger the group, the lower the premiums should be because the risk is spread over a larger group. However in some arrangements, renewals without beneficial negotiation between the employer and the carrier may result in higher premium costs, especially where the claims experience has increased.
The key requirement of a PHSP is that the plan must be in the nature of insurance (i.e. an undertaking by the employer to indemnify an employee for agreed consideration from loss or liability in respect of an event the happening which is uncertain.) Termination of the plan without notice at the employer’s sole discretion indicates doubt as to the level of risk.
For example, if a plan states that an employer will cover 75% of eligible costs to a cap of $1,500, the uncertainty is inherent in the fact that the employer could be liable to pay $100 or $1,100. If the plan allows a refund for unused annual limit, or the plan covers medical expenses that are not otherwise eligible for the medical expense refundable tax credit, then the plan will be considered an employee benefit plan, with the employee becoming taxable on the value of benefits he or she became entitled to.
As an alternative to plans offered by insurance carriers, employers may offer a health services plan that is self-funded either directly by the employer or funded through what is called a health & welfare trust.
A self-funded plan may be a cost or cost-plus plan. A cost plan is self- administrative by the employer or the HR department. A cost-plus plan is one in which the employer submits actual employee medical expenses to third party administrator. The cost to the employer is the actual medical receipt (within plan limits) plus a 10% mark-up for administration costs. Payments made by the employer are tax deductible, while the reimbursements are non-taxable to the employee.
A health & welfare trust is a formal trust arrangement in which an employer contributes involuntary and non-refundable funds to a trust that can not be used for any other purpose other than providing health and welfare benefits. Trustees act independently of the employer and they enforce contributions payable by employer. The employer may have representation as a trustee.
Regardless of the type of funding arrangement, a PHSP is a viable mechanism for a high-rate owner-manager to use cheaper pre-tax corporate dollars to fund medical expenses that would otherwise be acceptable for the personal refundable medical expense tax credit yielding a much lower tax benefit.
CRA has accepted the extension of a PHSP to particular employee groups (ie., management group) as the only staff covered by a plan. However the key here is that the recipient of the benefits must be by virtue of employment and not by virtue of being a shareholder. An operating company with shareholders who are employees and there are no other arm’s length employees, there still may be a PHSP provided the shareholders are active employees.
In 2004, the Informal Tax Court found against the taxpayer because the plan was only available to employees who were shareholders. Shortly after the plan was established, the majority shareholder was reimbursed in excess of $35,000 for a knee operation. The company had over 30 employees. The final determination was that the payment was made to the shareholder by virtue of being a shareholder and not by virtue of being an employee. The burden on the taxpayer is to prove that the benefit is received by virtue of employment or more specifically, would have the PHSP been created had not the individual been a shareholder?
If the shareholder is actively engaged as an employee and the benefits under the PHSP are reasonable, it is CRA’s view that the benefits would be derived by virtue of employment and exempt from tax under subparagraph 6(1)(a)(i) of the ITA. Likewise, the employer would be entitled to a deduction for reasonable contributions.
In the case of a self-employed proprietorship, the PHSP must be a third party trustee or an insurance company. Their deductible premium limits are $1,500 per adult and $750 per dependent child. The limit may only increase if there are arm’s length employees comprising more than 50% or more of total insured persons. If a proprietor pays 90% of the premium for an arm’s length employee, then 90% of the premium for the proprietor, his spouse and dependent child are deductible.
To avoid the limitations of the PHSP for a self-employed proprietorship, it is advisable to incorporate the business to allow for flexibility.
Provided the plan extends to individuals by virtue of employment and the caps are reasonable in light of current market conditions, the PHSP is a viable mechanism for a high-rate owner manager to use cheaper pre-tax corporate dollars to fund medical expenses.
Caution should be exercised in establishing the reimbursement limits and identifying individuals entitled to reimbursement under the PHSP. CRA’s acceptance of certain conditions, are administrative and have been evolving over recent years to meet the needs of current owner managers. The final determination is based on the facts.
Contact your professional advisor prior to implementing any of the outlined strategies