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Citation: 2005TCC149
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Date: 20050224
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Docket: 2003-748(IT)G
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BETWEEN:
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ALCATEL CANADA INC.,
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Appellant,
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and
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HER MAJESTY THE QUEEN,
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Respondent.
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REASONS FOR JUDGMENT
Bonner, J.
[1] This is an appeal from an
assessment of income tax for the Appellant's 1994 taxation year.
It raises the question whether the Appellant is entitled to an
investment tax credit in respect of the value of stock option
benefits conferred by it on certain of its employees who were
engaged in scientific research and experimental development
("SRED").
[2] The essential facts are not in
dispute. Many of the allegations set out in the Notice of Appeal
were admitted in the Amended Reply. Further facts were
established by the Agreed Statement of Facts filed. No witnesses
were called at the hearing.
[3] At all material times the
Appellant, a corporation formerly known as Newbridge Networks
Corporation, engaged in scientific research and experimental
development ("SRED") in Canada.
[4] The Appellant maintained an
employee stock option program. Under the program employees were
granted the right to purchase a specified number of the
Appellant's common shares at an exercise price not lower than the
market price of the shares on the Toronto Stock Exchange ("TSX")
at the time when the options were granted. The options were
exercisable in equal one-third instalments on each of the first,
second and third anniversaries of the date of the grant and
expired four years from the date of grant or following
termination of employment.
[5] The option plan permitted the
employees to exercise their options in one or the other of two
ways, the regular method and the cashless method. Under both the
cashless and regular methods, the employees derived a benefit
upon the exercise of their stock options equal to the excess of
the market value of the shares at the time the stock option was
exercised over exercise price. It was not suggested that the
method chosen by the employee for exercise of the option had any
bearing on the outcome of this appeal.
[6] The dispute over the investment
tax credit arose in the following way. In its 1994 income tax
return, the Appellant elected in accordance with
subsection 37(10) of the Income Tax Act (the
"Act") to use the proxy method, as set out in
clause 37(8)(a)(ii)(B) of the Act, to
calculate its SRED expenditures. In calculating its 1994 SRED
expenditures the Appellant included the value of stock option
benefits derived by those employees who were directly engaged in
the prosecution of SRED in the amount of $23,344,318 pursuant to
subclause 37(8)(a)(ii)(B)(IV). Accordingly, the
Appellant claimed an investment tax credit ("ITC") of $4,668,864
with respect to the stock option benefits for its 1994 taxation
year pursuant to section 127 of the Act.
[7] The Minister reassessed the
Appellant on November 27, 2002. He disallowed the ITC claim and
reduced the balance of the ITC pool on the basis that the stock
option benefits derived by the employees of the Appellant were
not "expenditures incurred" within the meaning of clause
37(8)(a)(ii)(B). The appeal is brought from that
reassessment.
[8] The main issue is whether the
benefits conferred on the employees by way of stock option
constituted "... expenditures made in respect of an expense
incurred in the year for salary or wages ..." within the
meaning of subclause 37(8)(a)(ii)(B)(IV) of the
Act. The position of the Appellant is that the benefits
did so qualify.
[9] The issue arises in the context of
a chain of statutory provisions intended to provide taxpayers
with an incentive to carry out SRED by providing investment tax
credits based on the taxpayer's expenditures for SRED. In
construing the statutory language the objective which the
legislature sought to attain in creating the incentive program
must be kept in mind.[1]
[10] It is convenient at this point to
review the chain of statutory provisions relied on by the
Appellant in support of its claim.
[11] The right to deduct an investment tax
credit from tax otherwise payable arises under
subparagraph 127(5)(a)(i) of the Act:
"(5) There may be deducted from
the tax otherwise payable by a taxpayer under this Part for a
taxation year an amount not exceeding the lesser of
(a) the total of
(i) the taxpayer's investment
tax credit at the end of the year in respect of property
acquired, or an expenditure made, before the end of the year,
and"
[12] The term "investment tax credit" is
defined in subsection 127(9) of the Act:
"127. In this section
(9)
"investment tax credit" of a taxpayer at the end of a taxation
year means the amount, if any, by which the total of
(a) the total of all amounts each of
which is the specified percentage of
...
(ii) a qualified expenditure made by the taxpayer in the year,
or,"
[13] The term "qualified expenditure" is
also defined in subsection 127(9):
""qualified expenditure" - "qualified expenditure"
means an expenditure in respect of scientific research and
experimental development incurred by a taxpayer that is ...
an expenditure described in paragraph 37(1)(a) or
subparagraph 37(1)(b)(i) and includes an amount that is a
prescribed proxy amount of a taxpayer, but does not include
..."
[14] Expenditures are "described" in
paragraph 37(1)(a) of the Act as follows:
"37.(1) Where a taxpayer carried on a business in Canada in a
taxation year and files with the taxpayer's return of income
under this Part for the year a prescribed form containing
prescribed information, there may be deducted in computing the
taxpayer's income from the business for the year such amount as
the taxpayer may claim not exceeding the amount, if any, by which
the total of
(a) the total of all amounts each of
which is an expenditure of a current nature made by the taxpayer
in the year or in a preceding taxation year ending after 1973
(i) on scientific research
and experimental development carried on in Canada, directly
undertaken by or on behalf of the taxpayer, and related to a
business of the taxpayer,"
I note in passing that the reference in paragraph
37(1)(a) to expenditure "of a current nature" is the
foundation of the second of the Respondent's two main
arguments.
[15] Subsection 37(8) of the Act
imposes limits on the ambit of references in section 37 to
expenditures on or in respect of SRED:
"(8) In this section,
(a) references to expenditures on or in
respect of scientific research and experimental development
...
(ii) where the
references occur other than in subsection (2), include only
...
(B) where a taxpayer has elected in prescribed form and in
accordance with subsection (10) for a taxation year, expenditures
incurred by the taxpayer in the year each of which is
...
(IV) that portion of an expenditure made in respect of an
expense incurred in the year for salary or wages of an employee
who is directly engaged in scientific research and experimental
development in Canada that can reasonably be considered to relate
to such work having regard to the time spent by the employee
thereon, and, for this purpose, where that portion is all or
substantially all of the expenditure, that portion shall be
deemed to be the amount of the expenditure."
[16] The Appellant did elect in accordance
with subsection (10) and thus it is necessary to consider whether
the benefits constitute expenditures incurred, each of which is a
portion of an expenditure made in respect of an expense incurred
for salary or wages of an employee within the meaning of the
statutory language set out immediately above. The term "salary"
or "wages" is so defined in section 248 of the Act as to
include the benefits in issue.
[17] The raising of capital was an
incidental result of the operation of the stock option program.
It was not, however, the objective. The goal was the securing of
the services of a contented and productive work force by
permitting employees to reap the benefit of increases in the
market value of the Appellant's shares.
[18] The goal is clear from a letter
delivered by management to an employee advising her of the grant
to her of options. It reads in part:
"I am pleased to advise you that you have been granted an
option by our Board of Directors to purchase 600 common shares of
Newbridge Networks Corporation. This stock option will allow you
to share in the success of the company. Your participation in
this round of options was determined by management review and is
based on your overall performance. This is an encouragement to
you to contribute good ideas, hard work and enthusiasm.
I would like to thank you for helping me to make our company
highly motivated and also for helping to maintain Newbridge at a
leadership position in our industry. I believe that Newbridge
will grow substantially over the next few years. It is in working
together as a team that we can gain business success. Success
that we can all share!"
I take the letter to be representative of communications from
management to all employees who benefited under the plan. It is
evident that the stock options were a form of benefit from
employment different in form but not in function from salary or
wages.
[19] As noted above, the employees derived a
benefit upon the exercise of their options equal to the
difference between the exercise price and the market value of the
shares at the time of exercise. The amount of the difference was
required to be included in the employee's income under section 7
of the Act. The amount now in issue is equal to the
aggregate of the option benefits.
[20] The advantage to the Appellant of the
stock option program generally was that it enabled the Appellant
to reward its employees without making any cash outlay.
[21] The Appellant did not record the amount
in issue as an expense on its income statement for the 1994
taxation year. The Appellant's financial statements for 1994
reflected only the increase in the number of shares and the
increase in share capital equal to the aggregate of the exercise
price of all the shares acquired under the program (plus the
corresponding increase in cash). No amount was recorded as an
expense on the income statement of the Appellant in years
preceding the 1994 taxation year at the time when the options
which were exercised in 1994 were granted to the Appellant's
employees.
[22] As I understand the Appellant's
position with regard to subsection 37(8), it is that:
a) the Appellant "incurred"
an expense in 1994 for salary and wages within subclause
37(8)(a)(ii)(B)(IV) when its employees exercised their
rights rendering it liable to issue the shares for a price less
than market value;
b) the Appellant made the
"expenditure" by issuing the shares at the option price.
[23] There was no dispute with regard to the
time when the expense was incurred and the expenditure, if any,
was made. The Respondent took the position in paragraph 11 of the
Amended Reply to the Notice of Appeal:
"The granting of an option under the terms of a stock
option program has no consequences until the option is
exercised and shares are acquired by the employee for less than
the fair market value prevailing at the time of exercise."
[24] The Respondent argued that the
Appellant, in allowing its employees to buy shares for less than
market value as contemplated by the option program, conferred a
benefit on them without making any outlay and therefore did so
without making any expenditure. The premise on which this
argument rests is that legislation which requires that an
expenditure be made can be satisfied only by making an outlay or
payment. Because the Appellant made no outlay it therefore made
no expenditure as required by subclause
37(8)(a)(ii)(B)(IV). Secondly, the Respondent argued, the
transactions whereby the Appellant's employees were permitted to
acquire shares at less than market value related not to the
Appellant's income earning process but rather to the Appellant's
share capital structure. The outlays, if any, were therefore not
"expenditures of a current nature made by the taxpayer" within
paragraph 37(1)(a) of the Act.
[25] In respect of both arguments, the
Respondent relied on the decision of the House of Lords in
Lowry v. Consolidated African Selection Trust, [1940]
A.C. 648. There, a corporate taxpayer, with a view to
expressing gratitude for services rendered by its employees,
granted to them the right to purchase its shares at par. At the
time the market value of the shares was in excess of par. The
taxpayer sought to deduct in computing its profit the premium
which it would have received if the shares allotted to the
employee had been issued in the open market. The House of Lords
rejected the taxpayer's claim by a majority of 3 to 2.
In doing so, it reversed the unanimous decision of the Court of
Appeal which, in turn, had reversed the decision at trial against
the taxpayer's claim. This decision, in which more judges found
in favour of the taxpayer's claim than against it was said to be
"the cornerstone of the Crown's case".
[26] The Respondent relied on Lowry
for the proposition that the word "expenditure" necessarily
involves outlay and, as well, for the proposition that any
outlays involved in the operation of the stock option program
were on capital account.
[27] In Lowry the majority of the Law
Lords held that the course of action adopted by the taxpayer did
not involve any expenditure of its money. That question is very
much at the centre of the present case. The following passages
from the speeches of the majority were among those relied on by
counsel for the Respondent in this case. At page 653
Viscount Caldecote noted that the taxpayer could have sold
its shares in the open market to raise funds necessary to pay to
the employees an amount equivalent to the benefit in cash. Had it
done so and paid cash to the employees the payment would have
been a deductible trading expense. He noted, however, that:
"...The company chose to take another course which did
not involve any expenditure of its money, or realization of any
of its assets."
After a review of the case law he continued at p. 656:
"...I come back to the facts of this case, and I ask
whether the issue of these shares in the manner adopted involved
the respondent in any "disbursements or expenses .... wholly
"and exclusively laid out or expended for the purposes of" its
trade. Its capital was intact after the issue of the shares : not
a penny was in fact disbursed or expended. Its trading receipts
were not diminished, nor do I think it is a right view of the
facts to say that the respondent gave away money's worth to its
own pecuniary detriment. The company was entitled to issue its
shares at par. It did so, and the company never received, and
never elected to receive, anything more than the par value of the
shares."
At p. 658 he concluded:
"...The plain fact as it appears to me is that the cost
to the company of earning its trading receipts was not increased
by the issue of these shares at less than their full market
value."
[28] Viscount Maugham also was influenced by
the view that (at p. 660): "We are invited to consider something
which did not take place; ...". On the facts, he
characterized the suggestion that conferring the right to buy at
par was a present of money or money's worth as a 'false view' of
the transaction. Moreover, he noted at page 661: "Indeed the
issue of shares by a limited company is not a trading transaction
at all." This analysis of the facts of the case led him to
conclude at page 662:
"...There is here in my opinion no transaction of trade
at all, nor an item of any kind that ought to be carried to
either side of the profit and loss account."
[29] Lord Russell was of like mind. At pp.
671-672, he stated:
"...I am of the opinion that the first basis of the
judgment of the Court of Appeal fails because the respondents
transferred neither money nor money's worth to their servants;
they merely elected not to obtain more than the nominal value of
the shares in order to induce the servants to become shareholders
in the company. I cannot hold (apart from compelling authority)
that such action by the respondents is, or may be treated as, a
disbursement or an expense ; or that the premium which the
servants could, if they wished, obtain from purchasers of their
shares, is or may be treated as money laid out or expended by the
respondents for the purposes of the respondents' trade."
[30] Obviously, the decision in
Lowry, although entitled to great respect, is not
binding on the courts in Canada. More importantly, it does not
involve the construction of the word "expenditure" in the context
of a statutory scheme intended to encourage, by the granting of a
tax credit, activity of the very sort in which the Appellant's
employees were engaged. Finally, it is distinguishable on the
basis that the facts in the present case cannot support a
conclusion that the costs of compensating the employees by the
stock option program was on capital account.
[31] Black's Law Dictionary, Eighth
Edition, defines "expenditure" as follows:
"1. The act of process of paying out; disbursement. 2. A sum
paid out."
I take that to be the ordinary meaning of the word.
Expenditure is not confined to outlays of cash. Nothing in the
definition excludes the disbursement of assets by mechanisms
adopted for that purpose which do not involve payouts of cash.
The Respondent's argument fails to recognize that a very real
expenditure is accomplished when shares having an established
market value are sold for less than that value in the context of
a scheme for the compensation of the employees who buy them. The
benefit realized by the employees is real. It is not conjured up
by magic. It flows from the Appellant to the employees by the
mechanism of the stock option. The expenditure consists of the
consideration which the Appellant foregoes when it issues its
shares for less than market value. The encouragement of
scientific research which is the object of the legislation would
be greatly diminished by the adoption of the narrow construction
for which the Respondent contends.
[32] The meaning of the word "expenditure"
which is implicit in the language used by the majority in
Lowry is not the same as the meaning of the word in
ordinary usage in Canada today. For example the word
"expenditure" is employed by the Department of Finance of the
Government of Canada in the term "tax expenditure". The term is
used, without in any way extending its ordinary meaning, to
describe tax revenues foregone due to exemptions, deductions,
rate reductions, rebates, etc. that reduce the amount of the tax
that would otherwise be payable.[2]
[33] Finally, I note that the stock option
benefits in issue fall within the meaning of salary or wages as
defined in section 248 of the Act. It is hard to see how
salary or wages can flow from employer to employee without
expenditure on the part of the employer. The section 248
definition forms part of the statutory context in which section
37 is found. Accordingly I reject the Respondent's first argument
for it imposes a constraint on the meaning of the word
'expenditure' which is not justified having regard to the purpose
of the legislation.
[34] I turn now to the Respondent's second
argument, namely, that the expenditure in issue is on capital
account. The argument rests on the proposition that consideration
received by the Appellant for the shares which it issued was an
addition to the capital of the company and not a trading receipt.
So far, I agree. The argument continued that the expenditure, if
any was made, arose from a distribution of shares which generated
capital and not from the conduct of the Appellant's ordinary
day-to-day revenue generating activities. Here, I disagree.
[35] As already noted, on the facts as I see
them, the primary purpose of the program was to compensate the
Appellant's employees for their services and to encourage future
effort. There was no suggestion that the work on which the
employees were engaged was aimed in any way at increasing or
otherwise altering the Appellant's capital structure. The mere
fact that a capital asset, in this case the share capital
generated by the issue of shares pursuant to the options, may be
the incidental result of activity undertaken with a different
objective in view does not warrant a conclusion that the cost of
the activity is on capital account.[3]
[36] The Respondent, in reliance on a
passage from the reasons of the Federal Court of Appeal in The
Queen v. Kaiser Petroleum Ltd. v., 90 DTC 6603 argued that
though employee compensation was a factor motivating the
Appellant the means adopted involved the reshaping of the capital
structure of the Appellant's organization. In my opinion there is
nothing in the evidence here which could conceivably justify an
assertion that the issuance of the shares pursuant to the options
could be described as a "reshaping" of the Appellant's capital
structure as was the case in Kaiser. Here, the options
were issued to satisfy a recurrent need to compensate employees
engaged in the day-to-day operations of the business. The cost of
the option program was an ordinary current expense.
[37] The Respondent also argued that
generally accepted accounting principles did not, at the time,
require that the Appellant's financial statements reflect any
expense in connection with the options. If non-cash expenditure
could be ignored in the preparation of a profit and loss
statement it might consistently be ignored in the computation of
a 'qualified expenditure'. That sort of accounting may well have
prevailed in 1994 but the argument raises the question whether
accounts which did not reflect the cost to the Appellant of the
options accurately disclosed the expenditures made to earn its
income. If the Appellant's accounts were up to current 1994
standards, then the standards required change (and, I note, they
have been changed). As I see it, disclosure of the expenditure is
necessary to reflect reality both for present purposes and for
domestic accounting purposes.
[38] Finally, the Respondent argues that
even if the amount in issue does satisfy the terms of subclause
37(8)(a)(ii)(B)(IV) it cannot be added to the expenditures
described in paragraph 37(1)(a) without contravening the
prohibition in paragraph 7(3)(b). The short answer to
this contention is that the deeming provision in paragraph
7(3)(b) by its clear language applies to the computation
of income only. It does not affect the computation of ITCs.
[39] The appeal will be allowed with costs
and the assessment referred to the Minister for reassessment to
allow the credit in issue.
Signed at Toronto, Ontario, this 24th day of February
2005.
Bonner, J.
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