Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.
Principal Issues:
Whether amount under incentive plan is taxable in year bonus determined or in year amount received; whether it is employment income or disposition of capital property.
Position:
The plan may be an SDA and taxable in year bonus awarded. If it is an SDA, a bonus paid within 3 years is exempted. Whether taxable in year right arose or as bonus when paid within 3 years it is employment income, not capital property.
Reasons:
Amount determined by reference to past services (i.e. by bonus awarded); future amount linked to performance of shares does not cause right to amount to be a capital property.
July 19, 1996
TORONTO EAST TAX SERVICES OFFICE HEADQUARTERS
D. Graham P. Spice
Interim Director (613) 957-8953
Attention: Ms Lois Sellers
Client Assistance Division
961913
XXXXXXXXXX
This is in reply to your facsimile transmission of May 23, 1996, enclosing a copy of the above-noted plan (the "Plan"), and requesting our views on the taxation of amounts received by the employee under the Plan. A summary of the relevant facts and our views follow.
FACTS
1.Employee is designated by employer in first quarter of fiscal year 1 to participate in plan and agrees in writing to be bound by plan. Participants will have a portion of their bonus awarded during fiscal year 1 converted to units in lieu of cash based on the selected portion of the bonus for that fiscal year divided by the average share price in that fiscal year.
Example:
AMOUNT AVERAGE PRICE
YEAR BONUSCASH CONVERTED PER SHARE UNITS
1 $200 $100 $100 $1 100.
2.Employee may be designated to participate in any subsequent fiscal year and must agree to be bound in each such fiscal year. He will receive units based on bonus for that fiscal year divided by the average share price in that fiscal year.
Example:
AMOUNT AVERAGE PRICE
YEAR BONUSCASH CONVERTED PER SHARE UNITS
2 $400 $200 $200 $2.00 100
3 600 300 300 2.50 120
4 800 400 400 4.00 100
TOTAL UNITS TO EMPLOYEE'S CREDIT AT END OF FISCAL YEAR 4: 420
3.Units start to be converted at a rate of 20% of the units to employee's credit at end of fiscal year 4, paid in cash in January of the calendar year following the end of fiscal year 4 (i.e. in fiscal year 5).
4. Conversion calculated in January of the calendar year following the end of fiscal year 4 in an amount equal to:
number of units x greater of
average book value of shares during the 12 months immediately prior to month in which units are converted
and
average daily closing price of shares (Plan does not specify but we assume the average closing price for fiscal year 4)
Example: Assuming average daily closing price is greater than average book value, employee will be entitled in January of calendar year following end of fiscal year 4 to cash of $336.00 (420 units x $4.00 = $1680 x 20%)
The balance of the units relating to the bonuses from fiscal years 1 through 4 will continue to be paid in each January following the end of fiscal years 5 through 8 at a rate of 20% of 420 units multiplied by the greater of the average book value and the closing price for the fiscal year or 12 months immediately preceding each such January.
5.Where an employee has not participated in consecutive fiscal years but is still an employee, 20% of the units to the employee's credit prior to non-participation are converted each January after the first fiscal year in which employee did not participate and in each January of the following four calendar years, provided that the conversion does not start until the fifth fiscal year following the fiscal year in which the employee was first designated to participate.
6.If the employee has fewer than 25 units at the end of the previous fiscal year, all units are converted and paid out in cash in the following January.
7.Retired employee may elect within two months of retirement to convert all or some of the units and to spread out the conversion over 5 successive calendar years starting after the fiscal year in which he retires, with a minimum 10% conversion in any one year.
8.Units of employee who dies are converted immediately to cash and paid to estate.
9.An employee who terminates employment loses all units.
ANALYSIS
This is a phantom stock plan as described in question 26 of the 1988 CTF. Our general position is that such a plan is a salary deferral arrangement ("SDA"), and the employee is taxable in the year the right to the amount arose (in this case, the calendar year in which the bonus was awarded). In order to be considered an SDA, however, one of the main purposes for agreeing to receive the amount in a later year must be to defer tax and there must be no substantial risk that the right to the amount will be forfeited.
Whether one of the main purposes of the Plan is to defer tax can only be determined after a review of all the circumstances surrounding the establishment of the plan and the awarding of the rights. Therefore, in any discussions with the client we suggest that he be advised of the Department's general position and asked to establish the facts which would evidence that the main purpose of the plan was not to defer tax for the participants. Please note that although the definition of "salary deferral arrangement" in subsection 248(1) of the Act refers to a plan "in respect of a taxpayer", greater weight should be given to the motivations of the employer and the executives as a group at the time the Plan was established or materially altered rather than to the individual client's intent. It will, of course, be true that the individual had little choice in agreeing to participate in the Plan but this is true of any compensation package and would not alter the fact that "one" of the main purposes of the individual (in accepting employment under these conditions or later becoming a participant under the Plan) was to defer receipt of 50% of the bonus in order to defer taxes.
With respect to the "substantial risk" of forfeiture, we do not find any of the conditions of the Plan lead to a conclusion that an employee is very likely to forfeit the deferred bonus. However, the client could be asked to provide proof in this regard also.
The following discusses the tax consequences should the plan be found to be an SDA.
Certain arrangements are grandfathered from the SDA rules. If the agreement to defer receipt of the amount was made in writing before February 26, 1986, by the taxpayer and the employer in respect of services rendered before July 1986.
Example: Assuming the agreement in writing under the plan in issue relates to a bonus for a fiscal year that ends before July 1986, January 90 would be the first time at which 20% of such grandfathered units would be converted and January 94 would be the last time for all grandfathered units.
Alternatively, if the agreement to defer receipt of the amount was made in writing before February 26, 1986, by the taxpayer and the employer in respect of services rendered after June 1986 the arrangement is grandfathered where the taxpayer is obliged to defer receipt of the amount and cannot cancel or otherwise avoid the obligation.
Example: In this case the employee must agree in writing to be bound by the plan each year he is designated to participate. So the agreement in writing before Feb. 26, 1986 could only relate to the 1986 or 1987 fiscal year, which at the latest would bring us to the last 20% being converted in January 95.
If the arrangement with respect to any particular fiscal year is not grandfathered, the amount of bonus deferred may be excepted from the SDA definition if it is payable within 3 years of the end of the calendar year in which the services relating to the bonus were rendered (paragraph (k) in the definition of "salary deferral arrangement" in subsection 248(1) of the Income Tax Act (the "Act"). This exception will apply to some of the units being converted but it would be necessary to know the fiscal year of the employer to determine to which calendar year the bonus relates in whole or in part and whether the amounts are being paid out within the requisite period of time. Note that in our view services rendered in a fiscal year are in respect of the calendar year which contains the fiscal year end (see document #E55767).
Example: Assuming XXXXXXXXXX fiscal year end is October 31, amounts paid in January of fiscal year 5 which relate to bonuses awarded in fiscal years 2, 3 and 4 will be paid within 3 years of the calendar year to which the services relate. However, bonuses awarded with respect to fiscal year 1 will relate to services rendered in a calendar year more than 3 years before the payment date.
Deferred amounts (the amount of the bonus which has been converted into units in any particular year unless they will be paid within 3 years) are deemed, by subsection 6(11) of the Act, and for the purposes of paragraph 6(1)(a) only, to have been received by the taxpayer as a benefit in the year. Note that if not included in income and taxed in the year the right arose, the amounts are taxable in subsequent years so long as the employee still has the right to receive the amount in future. Where the amount of the bonus which has been converted to units in fiscal year 1 is greater than the total amount received over the five calendar years in increments of 20% (i.e. there has been a forfeiture), there is a deduction available under paragraph 8(1)(o) of the Act to the extent of the difference.
We have located a technical interpretation that was provided to XXXXXXXXXX (document # EC0285) with respect to a predecessor plan which seems to contain many if not all of the same terms and conditions of the current Plan. A copy is enclosed for your information. This technical interpretation related to the law before the addition of the SDA rules and is no longer valid.
Should the client be able to establish that one of the main purposes of the Plan was not to defer taxes, amounts received would be taxable as employment income under subsection 5(1) of the Act.
In our telephone conversations (Spice/Sellers) you indicated that it was the employee's view that the amount should be treated as a capital property, the realization of which would give rise to a capital gain or loss. The amount is a bonus and the fact that the performance of the shares affects the ultimate amount received by the employee is irrelevant. It retains its character as employment income.
for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch
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