CHAPTER FOUR • Income from Employment • I. Scope and Structure of Employment Income • II. Cash Basis • III. Employee Benefits • IV. Allowances • V. Deductions from Employment Income • VI. Employment Income and the GST/PST/HST
I. Scope and Structure of Employment Income • An individual’s income from providing service can be regarded as income from employment only if that individual is considered to be employed by another party. • The definition of employed is not specifically established within the Act. • Normally, people are considered employed when they agree to provide their services, at the full direction and control of the employer, in return for a specific salary or wage.
In some cases an individual may provide services to another party as an independent contractor. • The individual is not subject to the same direction and control described previously and is paid in the form of a fee for the specifically contracted activities. • The individual is considered to be self-employed rather than employed, and earning business income rather than employment income.
When it is not clear whether a person is an employee or an independent contractor, the courts consider four primary tests: • Control test • Ownership of tools test • Chance of profit or loss test • Integration test
Control Test • Who determines what is done, where, when, and how? • Generally, in an employer-employee relationship, the employer controls the way the work is done and the work methods used.
Ownership of Tools Test • In an employer-employee relationship, the employer generally supplies the equipment and tools required by the employee. In addition, the employer covers the following costs related to their use: repairs, insurance, rental and operations. • An independent contractor normally supplies the tools required to do a job.
Chance of Profit or Loss Test • An independent contractor normally has a chance to earn a profit on a job, but also bears the risk of realizing a loss on the job. • Generally, in an employer-employee relationship, the employer alone assumes the risk of loss. The employee does not assume any financial risk, and is entitled to his/her full salary or wages regardless of the financial health of the business.
Integration Test • A worker whose work is an integral part of the business is probably an employee. • If the worker is an accessory to the business, he/she is probably an independent contractor.
In many cases these tests will provide conflicting indicators. • When that occurs, all four tests are considered and weighed against each other.
Fundamental Rules and Basic Formula • The formula for arriving at net income from employment for tax purposes can be expressed as: Employment income = (A + B + C) – D Where: A = the salary, wages, commissions, gratuities, and other forms of remuneration received B = the sum of the benefits received or enjoyed C = the sum of the allowance received D = deductions that are specifically permitted as exceptions to the general rule
The aggregate of this formula is the net income from employment which is included in the overall formula for determining a taxpayer’s total net income (Chapter 3).
II. Cash Basis • The first fundamental rule for determining employment income concerns the inclusion of the formal compensation arrangements such as: • Salary and wages • Commissions • Gratuities • Bonuses • Honoraria • Director’s fees
This rule is very broad and requires that all items of remuneration earned as a result of a position as an employee or an officer be included. • It further requires that an employee include amounts in income for tax purposes in the year they are received, which is not necessarily the year they are earned.
Salary Deferrals • Any gap between the time that employment income is earned and the time that it is received can influence the rate of tax payable. • A remuneration delay may be beneficial to the employee if the tax rate in the future will be lower.
Anti-avoidance rules • Significant abuses of salary deferral programs have led to the development of two anti-avoidance rules that limit the extent to which employers and employees can defer employment benefits: • Accrued bonuses must be paid within 180 days of the fiscal year end in which the expense was incurred. • When an employer and an employee enter into an arrangement the main purpose of which is to defer the receipt of remuneration that would otherwise have been paid, the employee is deemed to have received it in the year that it was earned.
III. Employee Benefits • Include: • Employee pension plans • Insurance programs • Stock options • Automobile benefits • For employees, some fringe benefits are taxable in the year in which they are received; others are taxable at some future time or are not taxable at all. • However, most forms of compensation are deductible for the employer.
Taxable Benefits • The value of all benefits of any kind whatever (subject to specific exceptions), if received or enjoyed in respect of, in the course of, or by virtue of an office or employment, must be included in the taxpayer’s income. • The scope of the general rule is extremely broad. • A reasonable starting point is to assume that all benefits are taxable unless a search of the limited list of specific exceptions discloses that the benefit is not taxable.
IT-470R reviews the topic of employee fringe benefits. • Taxable benefits include: • Rent-free or low-rent housing. • Gifts from the employer to the employee, that are in cash or near cash, including wedding and Christmas gifts. • Frequent flyer programs for personal travel from credits accumulated during business-related travel. • Club dues when membership in the club provides little or no advantage to the employer’s business.
The amount of the benefit that must be included in the income of the employee is usually determined as either the cost to the employer of supplying the benefit or the fair market value of the benefit, whichever is lower. • Special benefit calculations apply to loans from employers, stock option benefits, the reimbursement of specific relocation expenses, and the use of employer automobiles.
Automobiles • It is not uncommon for an employer to provide an employee with an automobile for business and personal use. • To the extent that an automobile is for personal use, a taxable benefit results. • There are two components to the benefit: • Standby charge • Operating cost benefit
Standby Charge • The employer – either by purchase or lease – has paid for the vehicle and in doing so has relieved the employee of the need to acquire a personal car. • The standby charge is normally based on the time period that the automobile was available to the employee for personal use.
If the employer owns the automobile, standby charge = Original Cost Number Of the x 2% x Of Months Automobile Available
If the employer leases the automobile, standby charge = Monthly Number Lease x 2/3 x Of Months Cost Available
Reduced Standby Charge • In some cases the standby charge can be reduced to reflect a low amount of personal use. • The reduction occurs only when the distance travelled is primarily (defined as 50% or more) for employment duties • In order to qualify for the reduced standby charge, total non-employment use of the automobile must be less than 20,000 kilometres for the year.
The reduced amount is determined by multiplying the basic standby charge for either an owned or a leased vehicle by the following fraction: Non-Employment Kilometres 1,667 Kilometres/Month of Availability
Operating Cost Benefit • The operating cost benefit is determined by multiplying a prescribed rate by the number of personal kilometres driven by the employee in the year. • For 2005, the prescribed rate is $0.20. • For purposes of the above calculation, driving between home and the employer’s place of business is considered personal use.
Operating Cost Benefit – Alternative Calculation • Employees who use an employer provided automobile primarily (defined as more than 50%) for employment purposes can elect to have the operating cost benefit calculated as one-half of the standby charge. • This alternative calculation does not have to be used and, in most practical situations, it will not be a desirable alternative as it will produce a higher figure for the operating cost benefit.
Employee Loans • If an employer extends a loan to an employee and the interest rate is below the going market rate, the employee is receiving a benefit that will be taxed. • A prescribed formula is used to determine the value of the benefit to the employee. • The taxable benefit to an employee on a loan made from an employer is the difference between CRA’s prescribed interest rate at the time and the actual interest paid.
A loan may be made to an employee for the purpose of investing in assets that produce business or property income. • Any taxable benefit is treated as interest paid by the employee; this means that the employee can deduct the deemed interest when determining investment income for tax purposes.
Usually, the prescribed interest rate will change every quarter of the year for purposes of calculating the benefit. • When the purpose of the loan is to assist an employee with a home purchase or home relocation, the taxable benefit can be determined using the prescribed interest rate that was in force at the time the loan was made. • If the prescribed rate declines, the lower rate can be used. • This ceiling on the benefit is only available for the first five years such loans are outstanding.
Relocation Expenses • The reimbursement of two specific types of relocation expenses is taxable to the employee: • The full amount of any reimbursement of costs to finance the use of a residence is taxable. • The first $15,000 of a reimbursement of a loss suffered by the employee from the decrease in value or impairment of proceeds of disposition of the employee’s residence is not taxable, but one-half of any amount above $15,000 is taxable.
Stock Options • A stock option is a contractual arrangement that allows the holder to acquire a specified number of shares, for a specified period of time, at a specified price. • Benefits arise under stock option programs when an employee is given the opportunity to acquire shares in the employer corporation at a price lower than the fair market value of the shares at the time of the purchase.
Categories of Stock Option Plans • Stock options of public companies with a designated option price below fair market value at the date the option is granted by the employer. • Stock options of public companies with a designated option price equal to or greater than the fair market value at the date the option is granted by the employer. • Stock options of a CCPC.
1. Public Company, In-the-money Option • A taxable benefit must be included as employment income at the time the option is exercised. • Benefit is calculated as the difference between the FMV of shares at the purchase date and the option price. • To the extent that the shares change in value after the purchase date, the value change is considered to be a capital gain or loss.
2. Public Company, Option Not In-the-money • When the option is not in-the-money, the tax treatment differs as follows: • The normal employment gain calculated when the shares are purchased is reduced by one-half in determining taxable income. • On the first $100,000 of stock option value offered to the employee in any year (referred to as the specified value), the stock option benefit from employment can be deferred and included in the employee’s employment income in the year the stock is sold rather than in the year it was purchased.
3. CCPC • Category relates only to options granted to employees of CCPCs. • Provided that the employee holds such shares for two years after acquisition, the employment benefit is reduced by one-half in determining taxable income, and the benefit, rather than being taxable at the time of purchase, is not taxable until the shares are sold.
Non-Taxable and Tax-Deferred Benefits • The Act specifically allows certain tangible benefits from employment to be excluded from taxable income • Some of the benefits are taxable at a later time, which means their exclusion is actually a deferral. • Other benefits are permanently excluded from taxable income.
The following specific benefits are excluded from income on a deferred or permanent basis: • Employer contributions for an employee to a registered pension plan (RPP). • Employer contributions on behalf of an employee to a deferred profit sharing plan (DPSP). • Insurance premiums – group sickness or accident plans. • Premiums for private health service plans that provide extended medical coverage beyond public plans. • The payment by an employer, on an employee’s behalf, of premiums for supplementary unemployment insurance plans. • Counselling services relating to the mental or physical health or to the re-employment or retirement of the employee.
Tax-exempt Benefits • CRA has, for administrative purposes, chosen to arbitrarily consider certain benefits to be non-taxable. • Some of these benefits are as follows: • Discounts on merchandise • Subsidized meals • Uniforms and special clothing • Recreational facilities • Club dues, which it is clearly to the employer’s advantage to be a member of the club
IV. Allowances • All allowances of any kind whatever, including personal and living allowances, are taxable, subject to specific exceptions. • The term allowance refers to a fixed, specified amount that is paid to an employee on a regular basis, over and above a normal salary, to cover certain expenses incurred by the employee. • The unique aspect of an allowance is that the employee does not have to account for the allowance or provide details of how the money has been spent.
Exceptions • Nine specific allowances are excepted from the general rule and considered not taxable. • Only two of the exceptions have broad application: • Employees selling property or negotiating contracts • Employees other than salespeople
Employees Selling Property or Negotiating Contracts • Employees engaged in the selling of property (salespeople) or in negotiating contracts for an employer are entitled to a non-taxable allowance for travel expenses provided that the allowance is reasonable. • Travel expenses include transportation, meals, lodging, and other incidental costs. • The allowance must be reasonable; if it is unreasonably high or low in relation to the actual costs incurred, the allowance is taxable.
This tax-free allowance is not always beneficial, as its receipt usually eliminates the right to claim expenses that would otherwise be permitted. • An allowance, if less than the expenses incurred, may be considered unreasonably low and thus be included in taxable income, in which case expenses can be deducted.
Employees Other Than Salespeople • Employees who are not salespeople are also entitled to receive a tax-free allowance for travel expenses. • However, a non-salesperson’s travel allowance that does not relate to the use of an automobile is considered tax-free only if: • The allowance is a reasonable amount; and, • The employee travels outside the municipality or metropolitan area in which the employer is located.
Automobile allowances paid to employees who are not salespeople are considered tax-free if: • The allowance is for the purpose of travelling in the performance of their duties as employees; and, • The allowance is reasonable and is based solely on the number of kilometres used to conduct employment duties.
V. Deductions from Employment Income • The fourth and last rule for determining net income from employment states that no deductions are permitted except those specifically provided for in the Act. • If an item in question is not on the list, it is not deductible when calculating employment income.
The major items that can be deducted as employment deductions are as follows: • Expenses incurred by employees selling property or negotiating contracts. • Travelling expenses, including motor vehicle expenses. • Professional membership dues. • The cost of supplies consumed directly in the performance of employment duties. • Annual dues paid to a trade union. • Contributions to an employer’s registered pension plan. • Office rent or work-space-in-the-home expenses in certain circumstances.
Travel Expenses • An employee can deduct travel expenses incurred in the course of work-related duties provided that the following circumstances exist: • The employee is ordinarily required to carry on the duties of employment away from the employer’s place of business. • Under the employment contract, the employee is required to pay the travel costs incurred in the performance of duties. • The employee has not received a non-taxable allowance designed to cover such costs.
Travel expenses include the costs of all forms of transportation (incl. automobile costs), meals, lodging, and all other expenses created by the travel activity. • The costs associated with employee use of a personal vehicle for business travel include gas, oil, general repairs, insurance, financing costs (interest), and amortization of the automobile from its use. • An acceptable method for determining automobile costs is to total the full costs for the year and prorate the total on the basis of the number of kilometres driven for employment purposes as opposed to personal use.
Certain of the above travel expenses are subject to an arbitrary reasonableness test which limits the amount that can be deducted against employment income. • The maximum cost of an automobile available for CCA is $30,000. • The maximum deduction for a leased automobile is $800/month. • The deduction for interest paid on a loan to finance the acquisition of an automobile is limited to an average of $300/month. • The deduction for meals incurred during travel is limited to 50% of the actual costs incurred.