© Copyright 2000 Rogers Media. The following article first appeared in the June 2001 edition of BENEFITS CANADA magazine.

A taxing affair

Healthcare spending accounts aren't the tax-free havens they're often made out to be.

By Marg French and Karen Millard

Healthcare spending accounts (HSAs) have been touted as the answer to cost shifting, inflation protection, employee flexibility and efficient healthcare spending. For many employers, however, the real juice in this carrot is tax planning.

HSA benefits are not subject to federal income tax. As for provincial income tax, only Quebec taxes HSA benefits. If, for example, an employee pays tax at a 40% rate, the employer paying $1,000 in cash compensation is generally providing that employee with $600 in after-tax value. Providing the same employee $1,000 in HSA credits gives a $1,000 value--assuming the employee is able to use all of the credits.

But, as with all tax planning, there are rules--some of which are complicated. Employers who are unaware or ill advised may find themselves at odds with the Canada Customs and Revenue Agency (CCRA). Because HSAs are regulated within a system of self-assessment, it's up to each employer to ensure that the design and the tax planning are legitimate.

Under the tax rules, qualified medical expenses do not need to be medically necessary. An eligible expense for an HSA is an expense that would qualify for the medical expense tax credit under the federal Income Tax Act. The CCRA has published a bulletin spelling out the general rules, but employers will not find a complete list of HSA eligible expenses on the CCRA Web site or in the federal Income Tax Act. What actually qualifies as an eligible expense has been a topic of hundreds of court cases and the CCRA has published many opinions on this topic.

Most employees will find ways to spend every dollar in their HSA. Why would a reasonable person allow HSA credits to fall off the table when they could be applied to a wide range of services, treatments and products? HSAs present a different situation than do conventional group insured medical/dental plans, where employers don't expect each and every employee to reach their annual limits every year. In finding ways to spend their credits, employees will want to push the boundaries on what qualifies and they will call their employer for confirmation.

Plan sponsors are routinely asked the following types of questions about HSAs:

• Can employees claim the cost of fitness therapists, fitness equipment and fitness memberships under their HSA?
• Can employees claim costs paid for homemakers, housekeepers and caregivers?
• Do over-the-counter drugs for which prescriptions are written qualify?
• How does an employee get a prescription for over-the-counter drugs or homeopathic agents?
• Only fees paid to provincially licensed and regulated medical practitioners qualify for coverage. Is a therapist, social worker or counsellor provincially regulated?

One possible solution to address these common queries is for an employer to develop and publish a limited set of expenses that qualify for the employer's specific HSA. This should reduce the flood of questions coming into the human resources office.

TAX IMPLICATIONS

Employees naturally want to maximize their tax savings and their flexibility. Employees, particularly highly paid employees, may ask for the opportunity to direct a portion of their before-tax income or annual bonus into an HSA on an as-needed basis. Then, if they do not spend all of their HSA credits, they may expect reimbursement in the form of cash or bonus.

If these arrangements sound too good to be true, it's because they are. In fact, they're contrary to general tax principles and to the published positions of the CCRA.

There are two fundamental rules in designing HSAs. First, an employee cannot trade accrued rights to cash compensation, bonus or other benefits for HSA credits without triggering immediate tax consequences. The idea is that you can only trade something you already have. If an employee has the power to trade earned compensation (bonus, salary or benefits) for HSA credits, the employee has received the compensation for tax purposes.

Second, an HSA must represent a plan in the nature of insurance. In other words, there must be an element of risk. This is the reason that an employee cannot cash out unused HSA credits.

When credits expire after the 24-month period, they must fall off the table. Similarly, employees must accept that their HSA credits may be insufficient to cover all of their qualified expenses. This is also the reason why an HSA cannot reimburse claims incurred prior to the date an individual first joins an HSA arrangement.

OPPORTUNITIES AWAIT

Employees can purchase more HSA credits during a plan year, but there is no tax advantage to doing so because these credits must be purchased from after-tax income (generally from payroll deduction). Employees cannot claim a tax deduction or exemption for purchasing HSA credits.

There are opportunities to provide employees with planning and flexibility regarding their future total compensation structure. For example, tax planning opportunities may be available on the valid renegotiation of an expiring term contract, the renegotiation of collective agreements and through regular benefits plans. Opportunities may also be available for employers to do long-term planning around their future compensation structures for employees.

Aside from the tax complications, changes to future base salary are harder to sell to employees than one might think. This is especially true for industries where employees have an expectation of minimum annual pay increases. Employees may be delighted to have an HSA but not at the expense of an expected increase to their base salary. Even financially sophisticated executives have been known to resist the introduction of an HSA if it in any way affects future salary increases.

The decision to introduce an HSA rather than a salary increase can also confuse compensation benchmarking down the road. Care must be taken to consider the total compensation package, rather than just base salary.

Less common, but potentially far more disastrous, is the offering of HSA benefits to non-employees or controlling- shareholder-employees.

Non-employees include anyone who does not qualify as an employee for federal tax purposes (practically, those people to whom an employer does not issue a T4 slip). These can include self-employed contractors, consultants, commissioned salespeople and brokers. Non-employees also include participants in some professional associations and partnerships. Controlling-shareholder-employees are individuals who are both employees and shareholders of an organization and who, because of their shareholdings, exert influence over the organization. They often include owners and managers of corporate businesses, dealerships and franchises.

COMPLEXITIES

Someone who is not an employee for tax purposes cannot take advantage of the general tax exemption for employer-paid medical/dental coverage. For example, if a self-employed individual is provided with medical/dental coverage as part of the compensation for providing services, the cost of this coverage is generally part of the individual's business income. There is a complex series of rules that provide some self-employed individuals participating in qualified arrangements with a limited tax deduction.

Two basic points are worth mentioning:

• Qualifying group plans are generally limited to tax- exempt business or professional association plans.
• Personal HSAs are generally not tax effective unless the self-employed individual has at least one arm's length employee and pays for that employee to have the same HSA benefits.

The situation for controlling-shareholder-employees is similarly complex. These individuals are subject to special shareholder benefit rules that can make an HSA plan tax-inefficient or even trigger tax penalties. The tax effectiveness of HSA benefits provided by a corporation to its owner or manager generally depends on such factors as whether the corporation operates an active business, and whether it has regular employees (i.e., non-controlling employees) who enjoy HSA benefits similar to the owner's or manager's.

COST CONSIDERATIONS

Employers may believe that the costs of operating an HSA are nominal. As with any medical/dental plan, there are administrative costs associated with establishing and running these accounts. Employers who use an insurer or third-party administrator to adjudicate HSA claims and administer payments can expect the carrier to charge a fee based on a percentage of claims paid. Depending on the funding arrangements and the jurisdiction, an employer may also have to pay goods and services tax, provincial sales tax and premium tax.

It's true that HSA reimbursements do not trigger employment insurance premium or Canada Pension Plan (CPP) contribution obligations, but for groups of employees who already pay maximum employment insurance premiums and CPP contributions, offering an HSA will not reduce these costs to the organization.

In light of the administrative and communication costs associated with an HSA, employers should consider whether these plans really provide any value, when compared to paying straight salary or wages. An employer thinking of administering the HSA in-house to avoid administrative fees should be aware that new federal privacy legislation will place heavy obligations on in-house staff to keep all health information private and confidential.

The tax planning challenges of establishing and operating HSAs are significant. On the other hand, well-designed HSAs can offer tax advantages, more flexibility in health spending and more control in health spending costs­­and may help plan sponsors sleep better at night. BC

Marg French is a senior consultant and Karen Millard is a tax lawyer and consultant. Both are with the healthcare and group benefits practice of William M. Mercer Ltd. in Toronto.

HSAs at a glance

A healthcare spending account is a notional account into which an employer deposits notional dollars. Employees are reimbursed from their individual notional accounts for all qualified medical and dental expenses. Unused credits or non-reimbursed expenses may be rolled forward for up to 24 months from the month they are awarded or incurred. One plan cannot allow, however, for both credit and expense roll-forwards.

HSA accounts are rarely set up to reimburse any and all eligible expenses without limit. In fact, the costs of an unlimited HSA may not be deductible because they would likely be viewed by the Canada Customs and Revenue Agency as an unreasonable business expense.

The Romanow Commission has released its final report on the future of healthcare in Canada.

For Commissioner Romanow's recommendations, click here.

Click here for Senator Michael Kirby's report, "The Health of Canadians – The Federal Role: Recommendations for Reform."