In our competitive and fast-moving labour market employers are grappling with the significant cost and operational burden of employee turnover. Strategies for addressing that turn-over, in particular in key managerial employee positions, has become a topic relevant across industries. Many employers are exploring their options for looping employees into corporate ownership or implementing delayed profit-sharing structures outside the typical annual bonus program as a mechanism for encouraging long term organizational commitment from their valued team members.
At the same time, many employers are recognizing the costly administrative burden and tax issues associated with traditional employee share ownership plans. While useful in certain circumstances and an integral compensation component in some sectors (such as the tech industry), many employers are turning away from these equity structures to explore the benefits of “phantom” plans; profit sharing plans that provide employees with a stake in corporate performance without wading into employee ownership waters.
The formal options for implementing delayed employee profit sharing are an Employee Profit Sharing Plan (“EPSP”) pursuant to Section 144 of the Income Tax Act and a Deferred Profit Sharing Plan (“DPSP”) pursuant to Section 147 of the Income Tax Act. The key difference between the two is tax treatment both at the employer and employee levels, with cascading implications in terms of the degree of regulation imposed on each by the Canada Revenue Agency (“CRA”) as a result of that tax treatment.
Both EPSPs and DPSPs require the creation of a trust with corporate representatives acting as trustees responsible for administering trust funds on behalf of designated beneficiary employees. A share of a corporation’s profits are paid to the trust (“Plan Funds”) and allocated among participating employees on an annual basis. Allocations of Plan Funds among beneficiary employees may be based on an employee’s earnings, length of service, or another formula and subject to a delayed vesting schedule at the discretion of the employer.
Generally, an employee’s allocated portion of Plan Funds, along with their proportionate share of an accumulated interest earned on those Plan Funds, remains in the trust until the employee is terminated, resigns, dies or retires. At the end of the employment relationship an employee will be entitled to receive all vested funds. Any unvested funds are forfeited back to the employer corporation responsible for the initial contribution. Both EPSP and DPSP Plan Funds are recognized as employment income by the CRA and employer contributions are deducted from a corporation’s annual corporate profit calculation at the end of the tax year.
While similar in their basic structure, EPSPs and EPSPs vary in terms of registration requirements, vesting schedule limitations, contribution ceilings and employee tax treatment. A summary of these differences is as follows:
- An employee’s entitlement to Plan Funds may vest on any timeline imposed by the employer.
- There is no cap on the amount an employer may allocate to an employee in EPSP.
- An EPSP does not need to be registered with the CRA.
- Employees are not able to defer the income tax liability associated with the amounts allocated to them under the plan. While an employee does not receive the allocated Plan Funds annually, they are required to report their allocated amount on their annual tax return and pay tax on that allocation as they would on any other income.
- When employment is concluded an employee will be entitled to receive only that portion of their allocated Plan Funds that have vested as of the date of resignation, death or retirement or as of the end of the notice period when they are terminated on a without cause basis.
- An employee will be eligible for a tax refund for any annual income tax paid on the unvested Plan Funds that are forfeited back to the employer on the conclusion the employment relationship.
- Unlike an EPSP, an employee’s allocated portion of Plan Funds held in a DPSP are not subject to annual income tax. Because DPSP plans allow for income tax deferral they must be registered with the CRA and are subject to greater regulation and control than EPSP’s.
- The Income Tax Act stipulates that:
The creation of a DPSP trust requires the appointment of three trustees with control and knowledge of the corporate employer in question. The DPSP Trust Deed and plan documents must be provided to the CRA for review and approval prior to registration. The maximum vesting period under a DPSP is 2 years. DPSPs are subject to contribution limits equal to the lessor of 18% of an employee’s salary and 1/2 of the money purchase limit for the year. An employer is subject to reporting obligations related to any amounts paid out to employees or any amount forfeited by a former employee who has left the organization prior to his/her allocated amounts vesting. Vested Plan Funds must be paid out to an employee the earlier of 90 days from the date the employee turns 71, resigns, is terminated, dies or retires. An employee has the option of transferring vested DPSP Plan Funds to another registered tax deferral instrument (RRSP, etc.) on leaving the plan.
Both EPSPs and DPSPs have benefits and drawbacks. While an EPSP affords an employer more flexibility in that it does not require registration with the CRA and allows for longer besting periods, the up-front tax burden on employees impacts the value of the retention incentive those plans offer. Similarly, while DPSPs allow employees to defer the tax burden associated with their allocated amounts, the registration requirements and strict regulation of those plans places a ceiling on employer contributions, imposes shorter duration vesting periods that hamper long term retention incentives and are often associated with burdensome administrative costs. What structure works for an organization will depend on a number of factors including its current ownership structure, future growth plans, number of employees and current compensation structure.
For a discussion of how these options or another form of employee share ownership plan that might be a fit for your organization, please contact Aly L. Fry. Click here to learn more about Swainson Miki Peskett LLP’s Corporate-Commercial Team. To read more of our Labour & Employment articles, click here.
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