My name is Mark Goodfield. Welcome to The Blunt Bean Counter ™, a blog that shares my thoughts on income taxes, finance and the psychology of money. I am a Chartered Professional Accountant and a partner with a National Accounting Firm in Toronto. This blog is meant for everyone, but in particular for high net worth individuals and owners of private corporations. The views and opinions expressed in this blog are written solely in my personal capacity and cannot be attributed to the accounting firm with which I am affiliated. My posts are blunt, opinionated and even have a twist of humor/sarcasm. You've been warned.

Monday, February 20, 2012

Employment Insurance Refund Claims- The Unexpected Income Tax Implications

You have probably heard one of the radio advertisements from companies asserting that they can get your business or company a refund if you have paid Employment Insurance (EI) premiums on behalf of your family members. These advertisements can be misleading and they have led some people to believe that EI premiums are not required when remuneration is paid to a spouse, siblings, children or parents employed in a family controlled business. This assumption is incorrect, and in some cases, companies that have not remitted EI have been subject to interest and penalties upon a reassessment.

As if the criteria to determine whether EI must be submitted in the first place on behalf of family members are not confusing enough, there is an insidious income tax issue associated with requesting an EI refund. If you make a claim, you are in many cases essentially telling the Canada Revenue Agency (“CRA”) that the wages you paid to your family are unreasonable.

So let’s try to deconstruct this issue.

The CRA’s position is that EI premiums are required on salaries paid to family members unless the conditions of employment are not similar to conditions that would be enjoyed by an arm’s length individual in similar circumstances (EI is not applicable in the first place if the family member owns more than 40% of the corporations voting shares). This position means for example, that if a family member employee is paid a higher salary or wage than the employer would normally pay to an arm’s length person who had the same or similar responsibilities, EI premiums may not be required. It would also apply to situations where the family member employee is required to work fewer hours or is entitled to more vacation time than what would be offered to an arm’s length employee in a similar position. As the above criteria are somewhat subjective, the answer to whether a company should be paying EI on behalf of family members is not necessarily clear cut. A company can request an EI ruling from the government to determine whether the family member's employment is considered "non-arm's length" and therefore can stop deducting and remitting EI premiums and possibly receive a refund of premiums paid in the current and three prior years.

Various EI refund companies have stepped into this void and may charge a fee of up to 30% for any EI they recover on your behalf. As one can fairly easily file an EI ruling and make their own refund claim, it is a question or your time and sophistication as to whether to hire an EI refund company to make your company's/business's claim.

While there is no doubt that a refund of EI premiums is available in some circumstances, you must be understand that when you claim a refund for EI, you are admitting to the CRA that a salary paid to a family member may have not been what you would have paid to a non-related employee, and, as such, was not reasonable. The Income Tax Act specifically prohibits a deduction for unreasonable salaries. Thus, you may accidentally be providing the CRA a trail to unreasonable salary paid in the past that could be denied by CRA for corporate or self-employment business tax purposes. This has been confirmed by the CRA in a past tax pronouncement I note below: (Since it is not my intention to cause my readers unnecessary audit anxiety, I must note that I have not seen the CRA aggressively use EI refund and ruling information in assessing taxpayers. I am just pointing out a risk associated with ruling requests and refund claims.)


“(the Income Tax Act) will operate to disallow any portion of the salary which is not reasonable in the circumstances…. the conditions of employment being enjoyed by the employee are dissimilar to the conditions which would be enjoyed by an arm’s length employee suggests that some portion of the salary being paid to the employed (family member) may be in excess of a reasonable amount. To what extent the salary is in excess of a reasonable amount can only be determined after a review of all of the facts of the case.”

A simple example illustrates the potential costs if a family member’s salary is denied as a tax deductible expense. Say a small business owner pays his or her spouse $50,000 for administrative services he or she performs in the office. In 2012, the combined employer and employee EI premiums that could be saved or recovered would be approximately $2,000. The additional corporate income taxes that would result if $30,000 of the $50,000 salary expense is denied because it is deemed to be unreasonable would be approximately $4,700 plus potential penalties (unlikely in this situation) and interest. If the entire salary was disallowed, the income tax cost would be approximately $7,800, plus potential penalties and interest. This is a current cost analysis, however, once on CRA's radar, it would be prudent to restrict the future salary to family members, thereby costing you future income splitting income tax savings.

One should also bear in mind that EI protection will cease for family members if EI premiums are recovered or simply not remitted. This should be of particular concern for anyone counting on EI benefits in the future, especially during a parental leave. However, we have seen the government deny EI benefits even when EI premiums have been deducted and made consistently in respect of salary paid to a family member. Thus, if you employ family members you may want to request a ruling from the CRA to determine whether or not the salary paid to a family member is insurable in the first place, however, that then brings the reasonable salary issue back into play.

Although it is true that a refund of EI premiums may be available under certain circumstances, in some cases the potential risk for the non-deductibility of the salary may outweigh the potential recovery, especially where very unreasonable salaries have been paid to family members. I would suggest before moving forward with an EI claim, you discuss the issue with your accountant to best quantify the risk if any.

The blogs posted on The Blunt Bean Counter provide information of a general nature. These posts should not be considered specific advice; as each reader's personal financial situation is unique and fact specific. Please contact a professional advisor prior to implementing or acting upon any of the information contained in one of the blogs.