17 July 1995 External T.I. 9501435 - VACATION TRADING IN A FLEX PLAN -3RD ALTERNATIVE

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues: tax implications to a health care spending account

Position TAKEN: general comments

Reasons FOR POSITION TAKEN:

A. Humenuk
XXXXXXXXXX 950143

Attention: XXXXXXXXXX

July 17, 1995

Dear Sirs:

Re: Health Care Spending Accounts and Flexible Benefits Plans

XXXXXXXXXX

XXXXXXXXXX

The term "health care spending account" is not defined in the Act and could be used to describe any arrangement between an employer and employee.

XXXXXXXXXX

We have often been asked whether such an arrangement would qualify as a "private health services plan" (PHSP) as defined in the Act.

As stated in paragraph 7 of the enclosed Interpretation Bulletin IT-339R2 "Meaning of "Private Health Services Plan", an arrangement where an employer is obligated to reimburse its employees for medical or hospital expenses may come within the definition of a PHSP where the employer is obligated by the employment contract to pay for such expenses. However, in order for a particular plan or arrangement to qualify as a PHSP, it must involve a reasonable element of risk which is assumed by the employer. If the plan or arrangement is such that there is little risk that the employee will not eventually be reimbursed for the full amount allocated to that employee annually, then the arrangement is not a plan of insurance and therefore, not a PHSP. While a carry forward period undoubtedly reduces the risk of loss to the employee, it is our view that a plan which permits the carry forward of either the unused allocation or eligible medical expenses (but not both) up to a maximum of 12 months will not be disqualified as a PHSP solely by reason of the carry forward provision in the plan.

Another question we are often asked is whether a plan can permit some employees to carry forward credits while others carry forward expenses and also whether it is permissible for an employee to carry forward expenses in one year and credits in the following year. As stated above, it is our view that a plan which permits the rollover of unused expenses as well as credits does not have a sufficient degree of risk to qualify as a PHSP. Thus, a plan which permits some employees to carry forward credits and others to carry forward expenses would not qualify as a PHSP.

In order for an arrangement to qualify as a PHSP, coverage must be limited to medical expenses as defined in subsection 118.2(2) of the Act. Where a plan or arrangement provides a benefit other than the reimbursement of medical expenses

XXXXXXXXXX

the plan will not qualify as a PHSP but instead may be treated as an employee benefit plan or, if administered directly by the employer, the reimbursement would be treated as a taxable benefit to the employee.

Even if XXXXXXXXXX was using the term "health care spending account" to refer to an arrangement commonly referred to as a "flexible benefit plan", the entire plan may be treated as an employee benefit plan. While it is possible to design a flexible benefit plan so that the taxability of a benefit is not altered by the fact that it is provided under the umbrella of the plan, all amounts received by an employee out of a plan which meets the definition of "employee benefit plan" (other than a return of employee contributions) will be taxable as employment income in the year of receipt.

An employee benefit plan is defined in subsection 248(1) of the Act and occurs where there is:

- an arrangement,
- a custodian,
- an employer,
- an employee, and
- a payment made to the custodian by the employer for the benefit of the employee.

It can readily be seen that virtually all funded plans to provide employees with benefits (including payments by an employer under an insurance policy) could meet these tests. Hence it is important that each plan or arrangement under a flexible benefit plan or a cafeteria plan fit squarely within one of the statutory exclusions contained in the definition of employee benefit plan found in subsection 248(1) of the Act if the employee benefit plan rules are to be avoided. The exclusions which are common to flexible benefit plans are:

1.private health services plans,

2.group term life insurance policies and,

3.group sickness or accident insurance plans,

Failure to be excluded from the employee benefit plan rules can result in adverse tax consequences where the intention is to provide non-taxable benefits to employees. For example, if payments are made to a funded, health care spending account or plan that does not squarely fit the definition of a "private health services plan", not only is the timing of the deduction to the employer affected, but all payments to the employees out of the fund become taxable.

XXXXXXXXXX

If a flexible benefit plan permits withdrawals or transfers between plans the employee will be required to include in income the value of all benefit credits allocated in the year. This is because the plans which are excluded from the employee benefit plan rules are all plans of insurance. A flexible benefit plan can incorporate the principles of insurance and maintain its flexibility in providing a variety of benefits by requiring the employee to allocate the flex credits prior to the beginning of the plan year. However, if a change in the employee's family circumstances occurs during the plan year (e.g. he or she marries or has a child) it is permissable for the employee to adjust his or her coverage by re-allocating credits accordingly.

In addition, XXXXXXXXXX any amount transferred to the employee's health spending account by reason of the sale or forfeiture of vacation will be included in the employee's income under subsection 5(1) of the Act. In our opinion, the fact that an employee trades vacation entitlement for health related coverage, which would have been non-taxable to the employee by virtue of subparagraph 6(1)(a)(i) of the Act if his or her employer had made the contribution, does not render the trading of vacation entitlement non-taxable. It is the trading of vacation entitlement by the employee that triggers a taxable event and not the use of the flexible credits obtained. The specific exemption from employment income in subparagraph 6(1)(a)(i) of the Act is intended to apply in respect of benefits received or enjoyed by an employee from his employer's contribution to the plans listed in that subparagraph and therefore does not apply in a situation where an employee purchases coverage under a plan mentioned in subparagraph 6(1)(a)(i) of the Act, through the use of vacation trading since the contribution in such a situation is not made by the employer.

For your reference we have also enclosed a copy of Interpretation Bulletin IT-502 "Employee Benefit Plans and Employee Trusts".

We trust our comments will be of assistance to you.

Yours truly,

P.D. Fuoco
for Director
Business and General Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
Enclosure