Salary Deferral Arrangements: Key Risks and Mitigation Strategies

Canada’s salary deferral arrangement (SDA) rules present tax risks when structuring incentive and other deferred compensation. Under the Income Tax Act, an SDA may arise if an employee has a right at year-end to receive employment remuneration in a later year, and it is reasonable to consider that one of the main purposes of this right is to defer tax. The SDA rules equally apply to directors, who are treated as employees for Canadian tax purposes.

Employers and employees should consider these five key insights to minimize the risk of deferred amounts being characterized as an SDA:

1. Application of SDA Rules. An SDA can include absolute and conditional entitlements to employment remuneration payable in a future year, including bonuses or cash payable on the settlement of equity-based incentives, unless there is a substantial risk that any triggering conditions will not be met. Remaining employed until payment is not considered a sufficient risk.
2. Employer Consequences. If an arrangement is an SDA, employers must withhold income tax as of the year that the SDA arises, even if insufficient remuneration is available to withhold from. If an SDA is found to exist as of the end of an earlier year, the employer may face penalties and interest for failing to withhold as of this past date. Directors may be held personally liable, subject to due diligence defences.
3. Stock Options and Other Section 7 Awards. Awards subject to section 7 of the Income Tax Act are exempt from the SDA rules. To qualify, the award must be share-settled with no unilateral employer discretion to pay in cash. Most traditional stock options qualify for this exemption, as do share-settled restricted share units (RSUs).
4. Three-Year Bonuses. This exception permits bonuses to be paid by December 31 of the third year following the year in which an employee first performs the services for which the deferred amount is remuneration. Many cash-settled RSUs and performance share units are structured to fall within this exception. The Canada Revenue Agency may presume the first service year as the year before grant if the grant occurs early in a calendar year, making careful plan drafting essential.
5. Deferred Share Units (DSUs) and Share Appreciation Rights (SARs). DSUs, even if settled in cash, are exempt from the SDA rules if payment is based on the share’s fair market value and occurs only upon retirement, loss of office or death (and no later than December 31 of the following year). SARs with no intrinsic value at grant that track share appreciation may also avoid SDA treatment if certain conditions are met. Precise plan drafting is essential to ensure these arrangements qualify for an SDA exception.

Have more than five minutes? Watch our recent webinar on this topic or contact any Pensions, Benefits & Executive Compensation group member to learn more.