ARCHIVED - Employees Profit Sharing Plans - Payments Computed by Reference to Profits
DATE: June 26, 1995
SUBJECT: INCOME TAX ACT
Employees Profit Sharing Plans - Payments Computed by Reference to Profits
REFERENCE: Section 144 (also section 147 of the Income Tax Act, and sections 212 and 1500 of the Income Tax Regulations)
This bulletin cancels and replaces Interpretation Bulletin IT-280, dated January 12, 1976. In addition, this bulletin incorporates many of the comments on employees profit sharing plans formerly contained in Part II of Information Circular 77-1R3, Profit Sharing Plans.
This bulletin deals with:
- contributions by an employer to an employees profit sharing plan (EPSP), particularly the requirement that these contributions be computed by reference to profits;
- the election that allows employer contributions to be paid "out of profits";
- the deductibility of contributions;
- certain reporting requirements for EPSPs; and
Discussion and Interpretation
1. An EPSP, as defined by subsection 144(1), is an arrangement that allows an employer to share business profits with all or a designated group of employees. Under an EPSP, amounts are paid to a trustee to be held and invested for the benefit of the employees who are members of the plan.
In each year, the following amounts must be allocated either contingently or absolutely among the EPSP members:
- the contributions received by the trust from the employer or a corporation with whom the employer does not deal at arm's length;
- the profits from the property of the trust (computed without reference to capital gains or capital losses);
- after 1971, the capital gains and losses of the trust;
- after 1971 and before 1993, a specified percentage of the total amount which is a payment of tax deemed to have been made by the employee under subsection 144(9) (Before 1993, subsection 144(9) provided that the employee was deemed to have made a payment of tax equal to 15 % of the forfeited amount with respect to an employee who ceased to be a beneficiary under the EPSP for the year.); and
- after 1991, the total amount an employee is entitled to deduct under subsection 144(9). (This relates to the amount forfeited by the member of the EPSP who ceased to be a beneficiary under the plan for the year.)
The allocations and reallocations must be made on an annual basis. The tax consequences to the participating employees are described in the current version of IT-379, Employees Profit Sharing Plans - Allocations to Beneficiaries. There are no requirements in the Act as to the form of the trust deed nor is it required that the plan be registered by or with Revenue Canada.
Meaning of "computed by reference to profits"
2. One of the essential requirements of an EPSP, contained in subsection 144(1), is that payments from the employer to the trust must be computed by reference to profits. This means that there has to be a binding obligation by the employer to make payments in accordance with a realistic formula in which profits are the principal variable and the employer has to make these payments in the event of profits. It is not enough that profits are used only as a means of calculating the employer's contribution; the amount so computed must also be paid under the plan when a profit is realized. Contributions computed by reference to profits have to be expressed as a percentage of profits for the year and the minimum contribution permitted cannot be less than 1% of profits.
3. Under subsection 144(1), the requirement that employer contributions be made cannot be dependent upon factors or conditions other than profits. See the decision of Lade v. MNR, (1964) CTC 305, 64 DTC 5189 (Ex. Ct.) affirmed by (1965) CTC 525, 65 DTC 5297 (SCC).
For example, a plan that provides that payments will be made by an employer only after contributions have been made by the employee members of the plan, or that provides that the employer's contribution will be based on a percentage of employee contributions, will not meet the requirements of subsection 144(1). However, as discussed in 6 to 11 below, such a plan may qualify as an EPSP if a valid election under subsection 144(10) has also been made.
4. Subject to the conditions discussed above, subsection 144(1) allows for considerable flexibility in determining the method and level of employer contributions to an EPSP. For 1992 and later years, subsection 144(1) provides that contributions determined by reference to profits may be based on the employer's own business profits for the year, the business profits for the year of a corporation with which the employer does not deal at arm's length, or any combination of these profits for the year.
5. Profits for the purpose of subsection 144(1) mean the net income after taxes of a business for a given year arrived at by following generally accepted accounting principles. It follows that contributions by the employer cannot be made in years in which the business incurs a net loss. While the contributions must be computed by reference to profits, there is no such restriction on the actual source of the funds contributed, which may be paid out of profits, retained earnings, capital surplus, or borrowings by the employer.
Election under subsection 144(10)
6. If there is a specific provision in the plan that the employer payments are to be made "out of profits" of a year or out of accumulated undistributed profits and the employer makes an election under subsection 144(10), the employer contributions are deemed to be payments computed by reference to profits. If the plan meets the other requirements of subsection 144(1), the plan will qualify as an EPSP. Included among those "other requirements" is the obligation upon the employer to actually make contributions in accordance with a realistic formula when such profits exist. This election allows a plan to qualify as an EPSP even though the payments are not computed by reference to profits, if the payments are limited by the level of profits. The formula may be expressed in various ways, and profits may be defined either as profits of the year or as undistributed profits of the year and previous years. However, profits of a non-arm's length corporation cannot enter into an "out of profit" formula unless that corporation is also an employer who participates in the EPSP (i.e., makes payments to the trustee of the EPSP), and has also made an election under subsection 144(10) with respect to making payments out of profits to the trustee of the EPSP. For example, a subsidiary which does not participate in the EPSP cannot elect under subsection 144(10) and its profits cannot enter into the calculation to determine the amount of contributions to the EPSP.
Examples of "out of profit" formulas are:
- a percentage of members' salaries or wages (subject to a minimum of 1%);
- an amount equal to members' contributions (subject to a minimum of 1% of each members' salary or wages); and
- a fixed dollar amount per member per year (subject to a minimum of $100 per member).
Accordingly, for a plan with an "out of profit" formula, the formula determining the employer's contributions must provide for a minimum contribution every year of the lesser of $100 per employee member and an amount calculated by, for example, reference to a percentage of the employees' annual contributions or salaries.
7. Other formulas will receive consideration, but a formula must not result in merely a nominal employer contribution so that the plan becomes primarily a savings plan for employees. The latter are generally considered "employee benefit plans" as discussed in the current version of IT-502, Employee Benefit Plans and Employee Trusts.
8. An employer's contributions in a year must be in accordance with the formula stated in the plan. The formula could provide for minimum contributions and, at the discretion of the employer, such additional amount (also out of profits) which, when added to that minimum, does not exceed the amount allowable as a deduction from income under subsection 144(5) and paragraph 20(1)(w). The minimum contributions cannot be less than a minimum described in 6 above.
9. A provision to suspend contributions or to reduce them below an acceptable minimum will not be permitted.
10. If more than one employer participates in a plan that refers to payments "out of profits," an election under subsection 144(10) must be made by each of the participating employers before such "an arrangement" may qualify under subsection 144(10) as an EPSP. Any subsequent addition of an employer to the plan would require an election by that employer under subsection 144(10). Failure to make an election may disqualify the plan as an EPSP retroactive to the effective date of the employer's participation in the plan.
11. Subsection 1500(3) of the Regulations specifies the way in which an election is to be made under subsection 144(10). The following documents must be submitted:
- a letter from the employer stating that the employer elects to have the arrangement qualify as an EPSP;
- if the employer is a corporation, and the directors are legally entitled to administer the corporation's affairs, a certified copy of the resolution of the directors authorizing the election to be made;
- if the employer is a corporation, and the directors are not legally entitled to administer the corporation's affairs, a certified copy of the authorization to have the election made by the persons legally entitled to administer the corporation's affairs; and
- a copy of the agreement and any supplementary agreement setting out the plan.
An election is made by sending these documents by registered mail to the Revenue Canada taxation services office serving the employer.
Deductibility of employer contributions
12. Subject to 13 below, subsection 144(5) provides that contributions to an EPSP made by an employer during a taxation year or within 120 days thereafter are a deductible expense of the employer to the extent that they were not deductible in the preceding year. As provided for in paragraph 20(1)(w), and as allowed by section 144, an employer may deduct amounts paid to the trustee of an EPSP for its employees or the employees of a corporation with whom the employer does not deal at arm's length.
If an employer pays the administration fees to the trustee relating to an EPSP, they will be considered to be contributions to an EPSP, which are required to be allocated to the members of the plan. Accordingly, such fees will be deductible to the employer as a contribution to the EPSP. However, certain expenses paid by the employer relating to capital property owned by the EPSP may not be expenses but have to be added to the capital cost of the property. For example, brokerage fees or commissions incurred to purchase securities are part of the cost of the security, and if incurred to sell the security, they may be deducted from the proceeds of disposition of the property when calculating the gain or loss.
13. If an EPSP is structured as a profit sharing plan but its purpose is the purchase or sale of treasury shares of the employer or of a corporation with which the employer does not deal at arm's length ("employer shares"), section 7 will apply to any of the employer's contributions to the plan that can reasonably be considered to have been used to purchase the treasury shares. Accordingly, the employer payments would not be considered contributions to an EPSP. In addition, the employer would be denied a deduction for these contributions under paragraph 7(3)(b). If, however, the employer contributions were used to purchase employer shares on the open market, paragraph 7(3)(b) will not apply to deny the employer a deduction.
Non-deductibility of employee contributions
14. An EPSP may permit employee contributions either as a requirement or on a voluntary basis. For income tax purposes, contributions made to the plan by employees are not deductible in computing income. However, any income earned by such contributions is taxable in the hands of the employee when allocated each year to the employee's account. Note that contributions made by the employee to the EPSP are not taxable when allocated.
Tax payable by an EPSP trust
15. For 1993 and later years, subsection 144(2) provides that, under Part I of the Act, no tax is payable by a trust governed by an EPSP, on the taxable income of the trust for a taxation year, when it is governed by the EPSP throughout the year.
Taxation year of an EPSP trust
16. Generally, the taxation year of a trust governed by an EPSP is the calendar year or such part of the calendar year while the trust was in existence. However, if an EPSP is accepted for registration as a deferred profit sharing plan (as described in section 147 and in the current version of Information Circular 77-1, Deferred Profit Sharing Plans), the taxation year of the EPSP trust shall be deemed by subsection 144(11) to have ended immediately before the plan is deemed to have been registered. All contributions and income received, all capital gains made and all capital losses sustained by the trust before the plan is registered must be allocated to employees and other beneficiaries by the trustee of the EPSP trust.
17. Every trustee of a trust governed by an EPSP, or the employer instead of such trustee, is required by section 212 of the Regulations to report on the T4PS Summary and Supplementary forms:
- amounts allocated, either contingently or absolutely, during the calendar year to members;
- amounts forfeited, that is, amounts previously contingently allocated to the account of members who, during the calendar year, ceased to be entitled to such amounts; and
- amounts paid to members during the calendar year, if part or all of such amounts are required by subsection 144(7) to be included in computing the income of the members.
The T4PS Summary and Supplementary forms must be filed with the appropriate Revenue Canada taxation services office by the last day of February following the end of the calendar year in which the amounts were allocated, forfeited or paid out.
Allocations, forfeitures and payments, to the extent they are required to be included in income of the members or beneficiaries, must be reported on the T4PS Summary and Supplementary forms. The manner in which such amounts are to be reported on these forms is explained on the T4PS Summary form.
18. Generally, subsection 144(3) provides that, with certain specific exceptions, amounts allocated to a member of an EPSP are required to be included in the member's income for the year of allocation regardless of whether the allocation was absolute or contingent. Therefore, if an amount, such as an employer's contribution, is allocated to a member contingent on a member continuing in employment for a period of years, the member has to include this amount in income. This is so even if employment is terminated before the number of years specified in the plan has expired and the member will not receive this amount. As provided under subsection 144(9), for 1992 and later years, an employee who ceases to be a beneficiary under an EPSP and forfeits an amount under an EPSP may be entitled to claim a deduction for the forfeited amount for the year he or she ceased to be a beneficiary if both of the following conditions are met:
- the beneficiary included in income, for the year or a previous year, any amounts allocated (other than any allocated capital gains and losses under subsection 144(4)) contingently to the beneficiary under the EPSP before ceasing to be a beneficiary; and
- the beneficiary could not have received or been entitled to receive any of the forfeited amount under the EPSP before ceasing to be a beneficiary.
The amount calculated using the formula in subsection 144(9) would be deducted by the beneficiary under paragraph 8(1)(o.1) in computing income from employment.
If you have any comments regarding the matters discussed in this bulletin, please send them to:
Director, Technical Publications Division
Policy and Legislation Branch
875 Heron Road
Ottawa ON K1A 0L8
Explanation of Changes for Interpretation Bulletin IT-280R Employees Profit Sharing Plans - Payments Computed by Reference to Profits
The purpose of the Explanation of Changes is to give the reasons for the revisions to an interpretation bulletin. It outlines revisions that we have made as a result of changes to the law, as well as changes reflecting new or revised departmental interpretations.
Interpretation bulletin IT-280R explains the rules in section 144 that apply to employees profit sharing plans (EPSPs). In particular, it explains the difference between contributions "computed by reference to profits" and contributions made "out of profits." We revised IT-280 to incorporate many of the comments on EPSPs contained in Information Circular 77-1R3 when it was cancelled and replaced by Information Circular 77-1R4 in 1992.
The revision to IT-280 was undertaken to reflect amendments to the Income Tax Act by S.C. 1994, c. 21 (former Bill C-27).
The comments in this bulletin are not affected by any draft legislation released before May 24, 1995.
Legislative and Other Changes
We have expanded No 1 to give a brief description of EPSPs. No 1 also reflects the Bill C-27 amendments to subsection 144(1).
We have expanded No 2 to include the 1% minimum contribution limit for contributions "computed by reference to profits." The Department's view regarding the 1% minimum contribution limit was formerly set out in Nos 19 and 56 of IC 77-1R3.
New No 4 reflects the comments formerly contained in Nos 21 and 56 of IC 77-1R3 and the Bill C-27 amendment to subsection 144(1) which allows the employer to base its contributions solely on the profits of a corporation with which the employer does not deal at arm's length.
New No 5 explains that when employer contributions are "computed by reference to profits," they cannot be made for a loss year. It also clarifies that there are no restrictions on the source of the funds contributed.
We have expanded new No 6 (former No 4), which discusses the subsection 144(10) election, to include examples of minimum contribution limits on contributions made "out of profits" that were formerly contained in Nos 19 and 56 of IC 77-1R3.
New Nos 7 to 10 reflect the comments formerly contained in Nos 20, 22, 23, and 60 of IC 77-1R3, respectively.
We have expanded new No 11 (former No 5) to incorporate the comments formerly contained in No 61 of IC 77-1R3. We have revised No 11 to indicate that subsection 144(10) elections have to be sent to the Revenue Canada taxation services office serving the employer rather than to the Pension and Profit Sharing Plans Section in Ottawa, Ontario.
New No 12 discusses the deductibility of employer contributions under subsection 144(5), formerly contained in No 21 and No 62 in IC 77-1R3. No 12 also explains that, under certain conditions, if an employer pays the administration fees to the trustee relating to an EPSP, they will be considered to be contributions to an EPSP, which are required to be allocated to the members of the plan.
New No 13 discusses the deductibility of employer contributions to an EPSP when an EPSP is structured as a profit sharing plan but its purpose is the purchase or sale of treasury shares of the employer or of a corporation with which the employer does not deal at arm's length.
New No 14 reflects the comments formerly contained in Nos 57 and 63 of IC 77-1R3.
New No 15 reflects the Bill C-27 amendment to subsection 144(2) and No 64 formerly in IC 77-1R3. Under this amendment, a trust governed by an EPSP will not be subject to tax on its taxable income only if the trust was governed by the EPSP throughout the year.
New No 16, concerning the taxation year of an EPSP trust, expands on the comments formerly in No 65 of IC 77-1R3.
New No 17, which relates to the reporting requirements of an EPSP, reflects the information previously contained in Nos 73, 74, and 75 of IC 77-1R3.
New No 18 deals with forfeitures under an EPSP and the Bill C-27 amendment to subsection 144(9). It discusses the deduction available to an employee who ceases to be a beneficiary under an EPSP and who forfeits an amount under an EPSP.
We have made a number of other changes to improve the overall clarity and readability of the bulletin.
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