If payroll fails to properly value a taxable benefit, it could mean big problems
When it comes to calculating taxable benefits, one of the most important issues payroll practitioners face is putting a value on the benefit. Mistakes can be costly.
"If the Canada Revenue Agency (CRA) reviews the amount that the employer has ascribed to a benefit in the T4 slip and determines that the amount is either too high or too low, it will not hesitate to challenge the employer’s decision. This will result in a tax assessment against the employer, the employees or both," says Adrienne Woodyard, a partner in the tax law group at the firm Davis in Toronto.
The CRA (and Revenu Québec) requires employers to assess taxable benefits based on fair market value minus any amounts the employee paid for them.
The CRA defines "fair market value" as "the highest price that can be obtained in an open market between two parties dealing at arm’s length." Payroll must value taxable benefits on this amount and not on how much it cost the employer to provide the benefit, says Woodyard.
"The employer may, for example, obtain a bunch of gift cards at a discount from one of its customers and distribute those gift cards to the employees. Even though the employer’s cost of the gift card was reduced, the amount to be included in the employee’s income for tax purposes is the face value on the card," she says.
"Even though it seems unfair that the employees will have ascribed to them a benefit that is greater than what it actually cost the employer, that won’t make any difference. The employee will pay full freight."
Woodyard adds that there can be serious consequences for under reporting a taxable benefit, starting with the Canada Pension Plan (CPP) and employment insurance (EI). "An employee’s annual CPP contributions and EI premiums are calculated on the basis of their earnings and an employer’s contributions and premiums are based on the employee amount. Therefore, if there is an underreporting of a taxable employment benefit, there may also be a shortfall in the CPP and EI paid by and on behalf of the employee."
"And if there is a shortfall, that’s the employer’s problem. The employer will be required to pay the shortfall on behalf of both the employer and the employee, plus interest, plus a penalty. The employer can sometimes recover the employee portion from the employee’s future paycheques, but this is by no means guaranteed, especially if the employee later resigns or is fired," she says.
"If the employee remains employed, the employer can recover those amounts, but the employer is tied to a very fixed recovery schedule and they can’t recover any CPP or EI that has been outstanding for more than one year, so if you have under reporting that goes back two or three years, then the employer will not be able to recover the full amount."
The problem for the employee can be even worse when it comes to income tax. "Depending on the amount of the benefit and the amount of the under reporting, this could mean the employee will have hundreds, if not thousands, of dollars in unexpected taxes to pay, plus interest and penalties," says Woodyard.
The fair market value of some taxable benefits can be easy to determine. For benefits such as gift cards, cell phone plans or subsidized meals, it can be as straightforward as looking at how much it would cost an employee to buy the item or service on the open market. It can be trickier for other benefits, such as employer-provided parking.
"The value of employer-provided parking is a significant source of controversy and there are a number of (court) cases on the subject, probably because we are talking fairly large numbers, particularly in urban areas where the cost of parking is very high," says Woodyard.
The value of the parking will depend on where the employer is located. If the employer operates in a shopping centre or industrial park where there is free parking for both employees and the public, there may not be a value for the parking and, therefore, no taxable benefit. There is also no benefit to include in income if there is "scramble parking," where there are significantly fewer parking spots than there are employees who use them.
If the employer has its own parking lot and it is near paid commercial parking lots, the fair market value of the benefit would be based on the rate charged in the nearby commercial lots, less any amounts the employee paid for the parking. If there are no commercial lots in the area, it can be more difficult to set a fair market value, says Woodyard.
"If the parking is in a location where it’s a little more remote, where there is no commercial parking available, the CRA might look at the cost of parking in nearby residential buildings. The CRA might tweak that value up or down based on the quality of the parking. Is it above ground or below ground? Is it tandem parking or not tandem? What sort of hours of access are provided?" she says.
A number of court cases in recent years have supported the CRA’s view that benefits must be valued based on their fair market value. In Schroter v. The Queen in 2010, the Federal Court of Appeal upheld a Tax Court of Canada ruling that a parking pass provided to an employee was a taxable benefit and the amount of the benefit should be calculated using fair market value.
The judge rejected the argument of Richard Schroter that the value of the benefit his employer provided to him be based on costs saved. Schroter had argued that when he received the parking pass, the only cost he saved was the price of a monthly transit pass and this cost was offset by the expense of driving to work.
The Federal Court of Appeal also supported fair market value in Spence v. The Queen in 2011. The case looked at whether a taxable benefit for reduced tuition fees for the children of employees at a Montessori school should be based on the fair market value of tuition at the school or the cost to the employer to provide the benefit.
The school gave the employees a 50 per cent discount on their tuition fees. The school calculated the amount of the taxable benefit as the difference between the reduced fees and the per student cost of providing education there. The CRA reassessed the employees and increased the taxable benefit to the full 50 per cent discount.
In ruling fair market value was the correct method to use, Justice Gilles Létourneau wrote, "What is in issue here is not the cost for the employer of granting the benefit to the employees. It is the value of the benefit received by the employees."
He added that "costs of the benefit to the employer is the wrong instrument to assess the value of the benefit." In making the ruling, Létourneau cited an article on taxable benefits by Kim Brooks called "Delimiting the Concept of Income: The Taxation of In-Kind Benefits," which appeared in the McGill Law Journal in 2004 (vol. 49, no. 2). In the article, she wrote that the cost to an employer to provide a benefit does not necessarily equal the value of the benefit to the employee.
"Employees may receive a huge personal benefit from employer-provided goods and services even though they cannot sell the goods and services, and there is no reason for supposing that the value of a benefit to an employee should be in any way related to its cost to the employer," Brooks wrote.
To make sure benefits are correctly valued, Woodyard recommends payroll departments do their homework on benefit value in advance and that they be thorough about it, paying attention to CRA policy.
"It’s much easier to put the policy in place at the beginning and to carry it through than to have to reverse course after a couple of years. Having to reverse course not only is disruptive to the payroll department, it’s very disruptive to the employees who are now paying tax on a benefit that they didn’t think was taxable or the value that is being attributed to the benefit is different than it used to be," she says.
Payroll should also keep good records on the benefit valuation in case of a CRA audit. "If you can demonstrate that practical efforts were made to ascertain the value of the benefit and that can be communicated clearly to an auditor, it’s less likely to become a point of controversy," Woodyard says.
"There’s no specific rule as to what form the documentation has to take, but in my view it should be a memo or a set of calculations demonstrating not only that you made an effort to value the item, but what the methodology was. Many audits go off the rails when no documentation at all is available," she adds.
"One of the added benefits of having a memo or other document is to preserve institutional memory in an employer’s organization. Employees may come and go and by the time the CRA gets around to examining it, many years may have passed since the benefits were actually put in place," Woodyard says.
"There may be no one left in the payroll department who remembers how the benefit was valued and memos like this are critical in those cases to be able to allow someone who wasn’t around when the policy was formed to understand how it was that the benefit was calculated."
Without documentation, payroll may be left scrambling to back up the valuation, say Woodyard. "The fact that there may not be a memo may not be your fault, but it’s going to be your problem."