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A salary deferral arrangement is an anti-avoidance rule in Canadian tax law, designed to prevent employees from deferring tax on income that has already been earned. The rules governing SDAs are complex and have significant implications for both employers and employees who wish to structure compensation in a tax-efficient manner.
What is a Salary Deferral Arrangement?
Under subsection 248(1) of the Income Tax Act (ITA), a salary deferral arrangement (SDA) is broadly defined as any plan or arrangement—formal or informal, funded or unfunded—between an employer and an employee that gives the employee a right in a taxation year to receive an amount after that year.
The key element is that one of the main purposes of the arrangement is to postpone tax payable by the employee on salary or wages for services rendered in the year or a preceding year. The rules apply even if the right to the deferred amount is conditional, unless there is a substantial risk that the condition will not be satisfied.
Tax Consequences of SDAs
If an arrangement is classified as an SDA, the deferred salary or wages are included in the employee's income in the year they are earned, not when they are received. This is enforced by subsection 6(11) of the ITA, which deems the deferred amount to be a benefit received in the year the right exists. Employers are required to report the deferred amount on the employee's T4 slip for the year in which the services were rendered.
Exceptions: Three-Year Bonus Rule
There are certain exceptions from the broad application of the SDA rules. Specifically for bonuses: if an employee has a right to receive a bonus or similar payment for services rendered in a year, and the bonus is paid within three years after the end of that year (i.e. paid by December 31 of the third year from the taxation year the services were rendered), the arrangement is not considered an SDA, meaning the bonus is to be included in employee's income when it is received. If the bonus is not paid within this three-year period, the SDA rules apply and the amount is taxed when awarded.
Prescribed Plans
Certain plans are also specifically excluded from being SDAs. The most notable exception is the prescribed salary deferral plan under paragraph (l) of the SDA definition in subsection 248(1) of the ITA and paragraph 6801(a) of the Income Tax Regulations (ITR). The most common example is the Deferred Salary Leave Plan (DSLP), which allows employees to defer a portion of their salary to fund a future leave of absence, such as for sabbatical or for educational or training purposes.
To qualify as a prescribed plan, the arrangement must meet strict requirements:
- The plan must be established to permit a leave of absence, not to provide benefits on or after retirement.
- The leave must generally be at least six consecutive months (or three months for full-time attendance at a designated educational institution).
- The deferral period cannot exceed six years.
- The employee cannot receive salary or wages from the employer (other than the deferred amounts and reasonable fringe benefits) during the leave.
- Deferred amounts must be held in trust or by a third party, not paid directly to the employee until the leave.
- Any interest earned on the deferred amounts must be paid to the employee annually and included in income for that year.
- All amounts must be paid out no later than the end of the first taxation year after the deferral period.
If a plan fails to meet these requirements at any time, it ceases to be a prescribed plan and becomes an SDA, with all deferred amounts becoming taxable in the year the plan fails.
Flexible Benefit Plans
Flexible employee benefit programs (flex plans) can also be caught by the SDA rules if they allow employees to defer salary or convert salary into benefits in a way that defers tax. If the benefits (i.e. flex credits) are notional and selections are made irrevocably before the plan year, the plan may avoid being an SDA. However, if employees can exchange credits for cash or make changes during the year, the plan may be considered an SDA and all benefits may become taxable.
Penalties for Non-Compliance
If an employer and employee knowingly enter into an arrangement that does not meet the requirements for a prescribed plan and treat it as such, they may be subject to gross negligence penalties under subsection 163(2) if a false statement is made on a T4 or tax return.
Pro Tax Tips – Exceptions to the SDA Rules are Subject to Strict Conditions
Salary deferral arrangements are subject to strict rules under Canadian tax law. While there are exceptions for prescribed plans and certain bonus arrangements, the exceptions are subject to strict rules and failed attempts to defer salary or wages will result in immediate taxation and potential penalties. Employers and employees should carefully review any proposed deferral arrangement with experienced tax lawyers in Canada to ensure compliance and avoid unexpected tax consequences.
FAQ
What happens if a bonus is not paid within the required three-year window?
If a bonus or similar payment for services rendered is not paid by December 31 of the third year following the year the services were performed, the arrangement is classified as a Salary Deferral Arrangement (SDA).
Consequently, the amount is no longer taxed when received; instead, it must be included in the employee's income for the year it was originally awarded. Employers are also required to report this deferred amount on the employee's T4 slip for the year the services were rendered.
Can an employee use a Deferred Salary Leave Plan (DSLP) to save for retirement?
No. To qualify as a prescribed plan and avoid being taxed as an SDA, a DSLP must be established specifically to permit a leave of absence for purposes such as sabbatical or educational. It cannot be designed to provide benefits on or after retirement. Additionally, the plan must meet strict requirements, such as ensuring the deferral period does not exceed six years and that the leave itself is generally at least six consecutive months or three months (in the case of full-time study).
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
