14 November 2000 External T.I. 2000-0048355 - STOCK OPTIONS EMPLOYER CASHOUT RIGHT

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: 1. Can we describe, further to our comments in our file 2000-003069, other factors which we would consider relevant in determining whether a cash payout on the termination of a particular securities option plan that includes an employer right to issue shares or cash would result in the application of section 7 or section 5 (or 6)?

2. When does the "agreement to sell or issue shares" arise where a stock option plan provides that the employer can elect to pay an option-holder cash instead of selling or issuing shares? 3. How do we reconcile our position on the deductibility of the cash payment where the employer chooses to pay cash rather than sell or issue shares given the judgment in the Kaiser case?

Position: 1. No. 2. The agreement arises at the time that the employer decides to issue shares or cash. 3. Our position is not inconsistent with Kaiser.

Reasons: 1. The relevance of any factor may vary depending upon all the facts of a particular situation. 2. Until the employer decides that it will sell or issue shares to an option-holder, there is only the possibility, not the certainty, that shares will in fact ever be sold or issued. 3. The result in Kaiser follows from the facts in that particular case and is not inconsistent with our position that the exercise of a cashout option in a stock option plan results in a deductible expense to the employer.

XXXXXXXXXX 					2000-004835
G. Kauppinen
Attention: XXXXXXXXXX 

November 14, 2000

Dear Sirs/Mesdames:

Re: Employee Stock Option Plan (our file No. 2000-003069)

This is in reply to your facsimile transmission dated September 20, 2000 which was further to our letter to you dated August 30, 2000 (our file No. 2000-003069) concerning the application of section 7 of the Income Tax Act (the "Act") to a plan wherein the employer agrees to either issue shares to an employee at a certain price (the "option price") or alternatively will, at its discretion, decide to pay the employee cash equal to the difference between the fair market value of the shares on the date the cash is paid and the option price.

You have asked for our elaboration upon the factors that we would consider relevant to the determination as to whether section 5 (or 6) or section 7 of the Act applied in respect of a cash pay out on termination of a stock option plan which included the right of the employer to elect to pay cash instead of selling or issuing shares upon the exercise of options granted under the plan.

We are unable to comply with your request. The relevancy of given factors may vary from case to case and can only be determined in the context of the facts of a specific situation in the form of a request for an advance income tax ruling.

In response to your request for further clarification of our position with respect to stock option plans where the employer can elect to pay the employee cash instead of selling or issuing shares at a certain price, it is our view that no agreement is entered into until the corporation decides that it will issue shares to an employee upon that employee's exercise of an option. It is at that time that the option in respect of the employee will be subject to the provisions of section 7 of the Act (and not section 5 or 6). The deduction pursuant to paragraph 110(1)(d) of the Act will be denied by virtue of subparagraph (ii) therein if the option price to acquire the shares is less than the fair market value of the shares on the date that the employer decides to issue or sell shares instead of paying cash (i.e. the date that we consider to be "the time the agreement was made" within the meaning of clause (I) of subparagraph 110(1)(d)(ii) of the Act).

We have stated that when a cash payment is made to an employee pursuant to a stock option agreement, that payment will generally be deductible to the employer pursuant to section 9 of the Act and subsection 7(3) of the Act will have no application because no securities have been sold or issued when the cash option is taken (either at the employer's option or the employee's option). You have asked us to reconcile this position with the Kaiser case (Kaiser Petroleum v The Queen, F.C.A.,[ 90 DTC 6603]) wherein the judge concluded that the cash payment made by the employer to certain of its employees in order to cancel options held by them to acquire shares of the employer was on account of capital and not revenue and was therefore non-deductible.

In reply, we have reproduced the following excerpt from Kaiser (beginning at page 6605 therein):

A convenient starting point in dealing with the issue, as to whether the payment made by the respondent should be computed under subsection 9(1) of the Act or whether it represents an amount coming under the exception of paragraph 18(1)(b) of the Act, is the statement made by Fauteux J. in M.N.R. v. Algoma Central Ry.:

Parliament did not define the expressions "outlay... of capital" or "payment on account of capital". There being no statutory criterion, the application or non-application of these expressions to any particular expenditures must depend upon the facts of the particular case. We do not think that any single test applies in making that determination and agree with the view expressed, in a recent decision of the Privy Council, B.P. Australia Ltd. v. Commissioner of Taxation of the Commonwealth of Australia, [1966] A.C. 224, by Lord Pearce. In referring to the matter of determining whether an expenditure was of a capital or an income nature he said, at p. 264:

The solution to the problem is not to be found by any rigid test or description. It has to be derived from many aspects of the whole set of circumstances some of which may point in one direction, some in the other. One consideration may point so clearly that it dominates other and vaguer indications in the contrary direction. It is a commonsense appreciation of all the guiding features which must provide the ultimate answer.

Also in the case of B.P. Australia Ltd. v. Comr. of Taxation of the Commonwealth of Australia, the Privy Council said:

Finally, were these sums expended on the structure within which the profits were to be earned or were they part of the money-earning process?

Undoubtedly, the reasons for establishing the Stock Option Plan was to motivate key employees and to better the respondent's business. Had the respondent pursued the compensation plan, shares would have been issued in due course in return of the employees' payment as agreed under the individual option agreements. Such monies would then have been added to the company's working capital.

This course was not followed. In view of the uncertainty of a change of management and the desire to have key employees realize their gain immediately and develop interest in the new company, amendments were made to the plan following the undertaking under the sale agreement, so as to accelerate the process and make the options exercisable immediately....

...The respondent, in buying out rights under the plan, parted with an asset (the purchase price) and effected a sterilization of future issues of shares. The disbursement made was a once and for all payment which had a direct effect on the capital structure of the corporation. In fact, the Stock Option Plan was later cancelled. Although the plan originated as a form of compensation and immediate compensation was one reason for its termination, and although the arrangement may appear to have been "seeming novations of the original deal", as characterized by the trial judge (probably since the compensation was in money terms instead of shares), it does not follow that the payment, from the point of view of the respondent, had the character of an operating expenditure. What is important is not the purpose pursued by the respondent but what it did and how it did it.

In our view, the result in Kaiser follows from the facts in that particular case and is not inconsistent with our position that the payment by an employer of cash rather than shares pursuant to the terms of a stock option plan will, in the absence of evidence to the contrary (e.g. the fact situation in Kaiser), will be a deductible expense to the employer.

We trust our comments will be of assistance to you.

Yours truly,

for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch