Small Business, Private Health Services Plans and the Tax Man

The purpose of a Private Health Service Plan (PHSP) is to enable an employer to provide health benefits to their employees on a tax-free basis and deduct the costs from the income of the business.

Many small businesses establish PHSPs as a benefit for owners. The Canada Revenue Agency (CRA) is reviewing plans that have been set up to benefit one or a few of a company’s shareholders. In some cases, they have reassessed both the owner and the company and have had these reassessments upheld in Tax Court. If you want to set up a PHSP for your company be aware of what they will be looking for.

In general, the Income Tax Act defines PHSPs as insurance contracts for medical expenses between employers and employees. This type of benefit is exempt from tax to the employee. However, the plan must be an employment benefit, not a shareholder benefit to allow for this tax treatment since shareholder benefits have different rules for taxation.

There are two common types of PHSPs. The first is a traditional health and dental plan in which a premium is paid to an insurance company in return for a package of benefits.

The second type is a cost-plus plan. In this situation, an employer contracts with a trustee to cover defined risks or claims of an employee and their dependents. The employer reimburses the cost of such claims plus an administration fee. When a shareholder is a member of a cost-plus plan by virtue of employment, the company can cover his medical expenses and deduct the amounts paid. A taxable benefit doesn’t arise for the shareholder personally. The tax treatment associated with a PHSP is clearly advantageous to both the company and employee.

In a case that went to Tax Court, the owner of an incorporated company established a cost plus plan for himself only – no only employees were provided this option. Additionally, the plan was set up shortly before the owner underwent expensive medical treatments.

The CRA reassessed the business owner on the basis of receiving a benefit as a shareholder and they also disallowed the business expense claimed by the company. This resulted in the payment being taxed twice.

The Tax Court ruled that the owner received a shareholder benefit. It decided that the plan would never have been entered into had the owner not been a shareholder. Since there was no evidence that other employees were covered and given the amount involved, the judge concluded that it would be very unlikely that such a plan would be set up for the employees.

In disallowing the business expense, the Court determined that the purpose of paying for the medical costs was for the benefit of the owner and not for the purposes of the business to earn income.

Clearly, the CRA will challenge a PHSP when it believes that the plan has been set up primarily for the benefit of shareholders. So remember to get advice before setting up a cost-plus private health services plan so that you don’t end up paying tax twice.