7 October 2016 APFF Roundtable Q. 21, 2016-0655901C6 F - Section 7 and bonus paid in share -- translation

Principal Issues: 1) Will section 7 and subsection 7(1.1) apply to the issuance of shares when those shares are issued as a payment of a bonus granted in accordance with an employment contract that provides for such a bonus when certain conditions are met?
2) If the employment contract provides the employee with the choice to receive the bonus in cash or in shares and the employee chooses to receive the bonus in shares, will our answer be the same?
3) A CCPC has issued shares of a particular class of its capital stock to its employee as payment of a bonus. What would be the amount added to the PUC of the particular class of shares?

Position: 1) Question of facts and law.
2) Yes.
3) Question of corporate law.

Reasons: 1) If an arrangement is fully discretionary, it will not be an agreement to issue shares for the purpose of section 7. To fall within the scope of section 7, an arrangement to issue or sell shares must be a legally binding agreement meaning that legal rights and enforceable obligations are created. This was confirmed in Transalta Corp. v. the Queen (2012 DTC 1106), where the Tax Court concluded that a discretionary arrangement was not an agreement for purposes of section 7.
2) The fact that the employee has the choice to receive the payment of the bonus in cash or in shares does not preclude the application of section 7 if the arrangement is a legally binding agreement to issue shares.
3) Paragraph 2 of IT 463R2: "Since subparagraph (b)(iii) of the definition of "paid-up capital" provides that the amount of the paid-up capital of a class of shares is initially determined without reference to the provisions of the Income Tax Act , the calculation is based on the relevant corporate law rather than tax law."

2016 APFF ROUNDTABLE

Question 21

Bonus payable in shares to an employee

A small business corporation ("SBC") agrees with one of its employees in its employment contract that he will be entitled under certain conditions to a bonus payable in shares. The maximum amount of the value of the shares agreed upon in the employment contract is $50,000. At the end of the year, if the conditions allowing the employee to earn the bonus are met, the corporation will assess the fair market value of its shares and determine the number of shares to be issued to the employee as a bonus.

As an example, assume that the employee would be issued shares with a fair market value of $50,000 for the year 2016.

Questions to the CRA

(a) Can you confirm that the issue of the shares will be governed by section 7 (and particularly subsection 7(1.1)) so that no taxable income will be included in the employee's income for the year of issue of the shares? The amount of income will be included under section 7 only in the year of the disposition of the shares.

(b) If the employment contract provides that the employee may elect to be paid $50,000 in cash or shares and the employee chooses payment in shares, can you confirm that your answer is the same as above?

(c) Can you confirm that the corporation will be able to add an amount of $50,000 to the paid-up capital of the shares it so issues without tax consequences to the employee (see Aylward v The Queen (footnote 1))?

CRA response to Q.21(a) and (b)

Section 7 of the Act applies where a corporation has agreed to sell or issue its shares or securities of a qualifying person with whom it does not deal at arm's length to an employee of the particular qualifying person or of a qualifying person with which the particular qualifying person does not deal at arm's length. Consequently, an agreement under which an employer undertakes to issue or sell securities must exist between the parties in order for section 7 to apply.

In the case of TransAlta Corporation v. The Queen, the Tax Court of Canada ("Court") concluded that section 7 did not apply to bonuses granted under a share purchase plan based on performance. Indeed, the Court found that the plan was not an agreement to sell or issue shares for the purposes of section 7 since the plan was expressly discretionary and no legal rights or obligations had been created. According to the Court, the words "agreed" and "agreement" in section 7 signify a legally binding agreement, that is to say, the granting of legal rights to employees and the creation of corresponding obligations of the employer. The CRA is of the view that this principle must be applied in analyzing whether or not an arrangement comes within section 7.

The question whether in a particular case an agreement is an agreement to issue shares for the purposes of section 7 is one of fact and law which cannot be resolved until consideration of all relevant facts and documents. Consequently, it is not possible for us to determine whether or not section 7 is applicable in respect of the situations presented.

For example, in the situation where an employer establishes an arrangement under which it undertakes to award a bonus based on the employee reaching certain measurable performance objectives and the employer agrees to pay this bonus in shares, then this arrangement could be an agreement contemplated by section 7.

On the other hand, if an employer establishes an arrangement under which it has full discretion to award a bonus or has full discretion as to the mode of payment of this bonus (in shares or in cash), the discretion of the employer under this arrangement would ensure that it could not be an agreement for purposes of section 7 because there is no enforceable commitment to issue shares.

It is possible that an arrangement which is not initially within section 7 due to the employer's discretion as to whether or not to grant shares could become an agreement in which section 7 applies at the time the employer undertakes to issue shares. This could be the case in the situation where an employer establishes an arrangement under which an employee is entitled to a bonus ranging from 0 to 100 shares payable within two years from the date of the arrangement. After the first year, the employer exercises its discretion and sets the amount of the bonus at 75 shares, which is payable in shares at the end of the year if the employee is still employed by the employer. In this situation, we consider that the employer's undertaking [“engagement”] to pay the bonus in shares is an agreement for purposes of section 7 from the time that the employer sets the value of the bonus at 75 shares.

Subsection 7(1.1) modifies when an employee is deemed to have received a benefit in respect of shares of a corporation under paragraph 7(1)(a). One of the conditions for applying this rule is that the corporation in question is a CCPC at the time it agreed to issue a share of its capital stock. Subject to the comments made above, it is possible that subsection 7(1.1) applies where an agreement gives an employee the choice between a bonus in shares or a bonus in cash and the employee chooses payment in shares. We are of the view that the choice of the employee, in itself, does not preclude an undertaking from being an agreement to issue shares. In such a situation, the time when the employee is deemed to have received a benefit because of the application of paragraph 7(1)(a) as modified by subsection 7(1.1) is the taxation year in which the employee disposed of or exchanged the securities rather than the taxation year in which the shares were acquired.

CRA response to Q.21(c)

The long-standing position of the CRA regarding the starting point for calculating the PUC of a class of shares, in subparagraph (b)(iii) of the definition of "paid-up capital" in subsection 89(1), is described in paragraph 2 of the Interpretation Bulletin IT-463R2 as follows:

“Since subparagraph (b)(iii) of the definition of "paid-up capital" provides that the amount of the paid-up capital of a class of shares is initially determined without reference to the provisions of the Income Tax Act, the calculation is based on the relevant corporate law rather than tax law.”

For example, subsection 26(1) of the Canada Business Corporations Act ("CBCA") provides that "[a] corporation shall maintain a separate stated capital account for each class and series of shares it issues.”

Furthermore, subsection 26(2) CBCA provides that "[a]corporation shall add to the appropriate stated capital account the full amount of any consideration it receives for any shares it issues.”

Thus, the practice of the CRA is to determine the PUC of any particular class of shares in the capital stock of a corporation by examining, in particular, the share register, minutes of Board meetings , resolutions or by-laws passed at those meetings, financial statements, notes to the financial statements, deeds of sale, rollover tax forms and by considering the corporate law and applicable generally accepted accounting principles.

To the extent that the liabilities of the CCPC were reduced by an amount not less than $50,000, subsection 84(1) would not be applicable by reason of the exception in paragraph 84(1)(b).

In finishing, the above comments disregard the possible application of other provisions of the Income Tax Act given the absence of information on the subsequent transactions which were carried out in respect of shares issued by the corporation.

Response 21 (a) and (b) prepared by
Catherine Ayotte
(613) 670-8897
October 7, 2016
2016-065590

Response 21(c) prepared by
Jean Lafrenière
October 7, 2016
613-670-9013

FOOTNOTES

Due to our system requirements, the footnotes contained in the original document are reproduced below:

1 97 DTC 1097 (TCC)
2 Qualifying person has the meaning given under subsection 7(7).
3 2012 TCC 86
4 CANADA REVENUE AGENCY, Interpretation Bulletin IT-463R2 Archived, Paid-up Capital, September 8, 1995.