2004 Ruling 2003-0043361R3 - SAR replacement with an agreement to issue shares

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.

Principal Issues:

1. Will the termination of a SAR and its replacement with an agreement to issue shares result in any immediate taxation?

2. Will the new options be treated as SDAs?

Position:

1. No.

2. No.

Reasons:

1. The transaction is in accordance with our established position on the application of section 7(3)(a).

2. Since the number of shares that will be provided may not be determined until the option is exercised there was a concern that the arrangement was in effect an SDA and not a true stock option plan as contemplated by section 7 of the Act. However the proposal provides for the exercise of the options as soon as practical after their grant. Hence it was concluded that the SDA provisions would not be applicable in the circumstances.

XXXXXXXXXX 2003-004336

XXXXXXXXXX, 2004

Dear XXXXXXXXXX:

RE: Advance Income Tax Ruling
XXXXXXXXXX
XXXXXXXXXX

This letter is in reply to your letter of XXXXXXXXXX, and our electronic correspondence of XXXXXXXXXX, in respect of your request for an advance income tax ruling on behalf of the above-noted individuals.

This letter is based solely on the facts and proposed transactions described below. Any additional documentation submitted with your request does not form part of the facts and proposed transactions and any references thereto are provided solely for the convenience of the reader.

Definitions and Abbreviations

In this letter, the following terms have the meanings specified:

a. "Act" means: the Income Tax Act, R.S.C. 1985 (5th Supp.) c.1, as amended to the date hereof;

b. "CRA" means: the Canada Revenue Agency;

c. "Common Shares" means: Class A common shares of the Corporation;

d. "Corporation" means: XXXXXXXXXX, with its head office located at:

XXXXXXXXXX and

files its tax returns at the XXXXXXXXXX Taxation Centre and the XXXXXXXXXX Tax Services Office.

Its business number is XXXXXXXXXX;

The Corporation is a taxable Canadian controlled private corporation governed by XXXXXXXXXX;

e. "Employee H" means: XXXXXXXXXX who files tax returns at the XXXXXXXXXX Taxation Centre and the XXXXXXXXXX Tax Services Office;

f. "Employee S" means: XXXXXXXXXX who files tax returns at the XXXXXXXXXX Taxation Centre and the XXXXXXXXXX Tax Services Office;

g. "Option Plan" means: the Employee Stock Option Plan as described in 7 below;

h. "Phantom Plans" means: collectively, the S-Phantom Plan and the H-Phantom Plan as described in 2 and 4 below;

i. "Shares" means: shares issued under the proposed Option Plan as described in 7 and 8 below;

j. "Subsidiary" means: XXXXXXXXXX; and

k. "Regulations" means: the Income Tax Regulations, C.R.C. 1977, c. 945, as amended.

The expression "Canadian-controlled private corporation" has the meaning assigned by subsection 89(1) of the Act, and "qualified small business corporation share" has the meaning described in subsection 110.6(1) of the Act.

Facts

1. Employee S does not own any shares of the Corporation and Employee H owns XXXXXXXXXX Common Shares of the Corporation.

2. Effective XXXXXXXXXX, the Corporation and Employee S, entered into the S-Phantom Plan. In accordance with the terms of the S-Phantom Plan, the Corporation agreed to pay Employee S an amount on a future date, where the amount to be paid is based on the increase in the value of the Corporation on that future date over the value of the Corporation on the date the S-Phantom Plan was instituted.

The essential terms of the S-Phantom Plan are as follows:

(a) On termination of employment for any reason, including death, Employee S is entitled to receive an amount (the "S-Amount"), equal to XXXXXXXXXX% of the increase from XXXXXXXXXX, in the net tangible shareholders' equity of the Corporation excluding certain amounts such as payments for subscriptions for capital stock of the Corporation and including dividends paid. On XXXXXXXXXX, the value of the S-Amount was nil;

(b) The S-Amount determined under (a) is payable to Employee S in XXXXXXXXXX equal annual installments with each installment being equal to the greater of $XXXXXXXXXX and XXXXXXXXXX% of the S-Amount plus an amount payable in respect of interest accruing from the termination of employment. However, if the S-Amount is payable after Employee S has attained the age of XXXXXXXXXX and Employee S has retired, then the minimum annual installment is increased from $XXXXXXXXXX to $XXXXXXXXXX. The total of all such payments cannot exceed the S-Amount plus an amount payable in respect of interest accruing from the termination of employment;

(c) If all or substantially all of the Common Shares, or all or substantially all of the assets of the Corporation, are sold while Employee S is an employee of the Corporation, or within XXXXXXXXXX months of ceasing employment (assuming Employee S is not working for a competitor of the Corporation at that time), to a person acting at arm's length with the Corporation, then Employee S is entitled to receive:

(i) the S-Amount determined under (a) that he would have been entitled to receive had his employment terminated on the date of the sale, plus

(ii) XXXXXXXXXX% of the amount paid by such purchaser on account of the goodwill of the Corporation, which shall be increased so that the after-tax proceeds shall be equal to the after-tax proceeds had such amount been realized by a sale of Common Shares by Employee S and such shares had been qualified small business corporation shares. If the purchaser also directly or indirectly acquires the Corporation's shares of Subsidiary, then the goodwill amount shall be adjusted to deduct therefrom any amount paid in excess of the book value of Subsidiary. If such excess has not been specifically determined by the vendor and purchaser, then such amount shall be determined by a real estate appraiser appointed by the Corporation and having at least XXXXXXXXXX years experience in the appraisal of real estate in the province of XXXXXXXXXX, whose determination shall be final and binding.

3. If Employee S's employment with the Corporation is terminated for any reason other than death, disability, or legal cause, and it is terminated at the request of the Corporation, Employee S is entitled to severance pay equal to his monthly salary payable prior to termination plus $XXXXXXXXXX per month for XXXXXXXXXX months, plus one extra month for every year of service after XXXXXXXXXX, up to a maximum of XXXXXXXXXX months.

4. Effective XXXXXXXXXX, the Corporation and Employee H entered into the H-Phantom Plan. In accordance with the terms of the H-Phantom Plan, the Corporation agreed to pay Employee H an amount on a future date, where the amount to be paid is based on the increase in the value of the Corporation on that future date over the value of the Corporation on the date the plan was instituted.

The essential terms of the H-Phantom Plan are as follows:

(a) On termination of employment for any reason, including death, Employee H is entitled to receive an amount (the "H-Amount") equal to XXXXXXXXXX% of the increase from XXXXXXXXXX, in the net tangible shareholders' equity of the Corporation excluding certain amounts such as payments for subscriptions for capital stock of the Corporation and including dividends paid. On XXXXXXXXXX, the value of the H-Amount was nil;

(b) The H-Amount determined under (a) is payable to Employee H in monthly installments with each installment being equal to the greater of $XXXXXXXXXX and XXXXXXXXXX of the H-Amount plus an amount payable in respect of interest accruing from the termination of employment. The total of all such payments cannot exceed the H-Amount plus an amount payable in respect of interest accruing from the termination of employment; and

(c) If all or substantially all of the Common Shares, or all or substantially all of the assets of the Corporation, are sold while Employee H is an employee of the Corporation, or within XXXXXXXXXX months of ceasing employment (assuming Employee H is not working for a competitor of the Corporation at that time), to a person acting at arm's length with the Corporation, then Employee H is entitled to receive:

(i) the H-Amount determined under (a) that he would have been entitled to receive had his employment terminated on the date of the sale, plus

(ii) XXXXXXXXXX% of the amount paid by such purchaser on account of the goodwill of the Corporation, which shall be increased so that the after-tax proceeds shall be equal to the after-tax proceeds had such amount been realized by a sale of Common Shares by Employee H and such shares had been qualified small business corporation shares. If the purchaser also directly or indirectly acquires the Corporation's shares of Subsidiary, then the goodwill amount shall be adjusted to deduct therefrom any amount paid in excess of the book value of Subsidiary. If such excess has not been specifically determined by the vendor and purchaser, then such amount shall be determined by a real estate appraiser appointed by the Corporation and having at least XXXXXXXXXX years experience in the appraisal of real estate in the province of XXXXXXXXXX, whose determination shall be final and binding.

5. If Employee H's employment with the Corporation is terminated for other than cause, then Employee H will receive XXXXXXXXXX months severance pay, which will cease if he begins to work for a competitor of the Corporation.

6. Employee S and Employee H (the "Employees") deal at arm's length with the Corporation and will continue to deal at arm's length with the Corporation immediately after the proposed transactions are implemented.

Proposed Option Plan and Proposed Transactions

7. After this income tax ruling is issued, the Corporation will establish the Option Plan to replace the Phantom Plans. The Option Plan will be issued in respect of the employment of the Employees, and have the following characteristics:

(a) Under the Option Plan, the Corporation may, from time to time, grant one or both of the Employees with the right to acquire Shares for a specified price; and

(b) If an Employee exercises the Employee's rights under the Option Plan, the Corporation will issue the Shares to that Employee in exchange for the payment of the exercise price.

8. Shortly after the Option Plan is established as provided in 7 above, the Corporation shall make initial grants of rights under the Option Plan ("Initial Grants") as follows:

(a) Employee S will have the right to acquire common or preferred shares as set out in the Grant, with the number of Shares determined at the date of exercise of the Option, for an exercise price of $XXXXXXXXXX in the aggregate. The aggregate fair market value of the Shares shall equal the fair market value of the S-Amount as of the date of exercise and the number of shares issued will depend on the class such that:

i. if the Shares are common shares of the Corporation, then the number of Shares will be equal to the result obtained by multiplying the S-Amount by the fraction determined when the number of common shares then outstanding is divided by the "S-remaining Value", where the "S-remaining Value" is equal to the amount, if any, by which the fair market value of all common shares of the Corporation exceeds the S-Amount;

ii. if the Shares are preferred shares of the Corporation with a redemption price of $XXXXXXXXXX, then the number of shares issued will equal the fair market value of the S-Amount at exercise time;

(b) Employee S will also have the right to acquire XXXXXXXXXX additional preferred shares for an exercise price of $XXXXXXXXXX in the aggregate. These preferred shares will be of a class of shares of the Corporation that have a redemption value, in total, equal to the amount specified in 2(c)(ii) above, if any, as determined at the time of a sale of all the Common Shares or all or substantially all of the assets of the Corporation as described in 2(c) above;

(c) Employee H will have the right to acquire common or preferred shares as set out in the Grant with the number of Shares determined at the date of exercise of the Option, for an exercise price of $XXXXXXXXXX in the aggregate. The aggregate fair market value of the Shares shall equal the fair market value of the H-Amount as of the date of exercise and the number of shares issued will depend on the class such that:

i. if the Shares are common shares of the Corporation, then the number of Shares will be equal to the result obtained by multiplying the H-Amount by the fraction determined when the number of common shares then outstanding is divided by the "H-remaining Value", where the "H-remaining Value" is equal to the amount, if any, by which the fair market value of all common shares of the Corporation exceeds the H-Amount;

ii. if the Shares are preferred shares of the Corporation with a redemption price of $XXXXXXXXXX then the number of shares issued will equal the fair market value of the H-Amount at exercise time;

(d) Employee H will also have the right to acquire XXXXXXXXXX additional preferred shares for an exercise price of $XXXXXXXXXX in the aggregate. These preferred shares will be of a class of shares of the Corporation that have a redemption value, in total, equal to the amount specified in 4(c)(ii) above, if any, as determined at the time of the sale of all the Common Shares or all or substantially all of the assets of the Corporation as described in 4(c) above; and

(e) Notwithstanding 8(b) and 8(d) above, XXXXXXXXXX months or more after ceasing employment the preferred shares held by the Employees may be redeemed or purchased for cancellation by the Corporation for an amount equal to or less than the amount calculated in 8(b) or 8(d) above as applicable. The Corporation will negotiate the amount with the Employees. However, under no circumstances will the share repurchase / redemption price exceed the amount as calculated in 8(b) and 8(d) above as determined at time of sale.

9. To clarify the provisions of 8 above, assume the current plan is replaced by the Option Plan and the Options are exercised when the H- or S-Amount (the "Amount") is $XXXXXXXXXX . At that time, there are XXXXXXXXXX common shares of the Corporation outstanding with a fair market value of $XXXXXXXXXX ($XXXXXXXXXX per share). Then:

a. if common shares are issued to the particular employee, the number of common shares would be calculated as follows:

i. fair market value of common shares at time of exercise	$XXXXXXXXXX
	less Amount				  XXXXXXXXXX
	Remaining Value				$ XXXXXXXXXX 

ii. Multiplier: equals number of shares/ Remaining Value
	   equals XXXXXXXXXX /$XXXXXXXXXX  =		         XXXXXXXXXX 

iii. Number of common shares equals Multiplier times Amount
	   equals XXXXXXXXXX  x $XXXXXXXXXX  =		            XXXXXXXXXX  Shares;

b. if preferred shares with a redemption value of $XXXXXXXXXX are issued to the particular employee, the number of preferred shares would be calculated as XXXXXXXXXX shares; and,

c. if preferred shares of a class of shares of the Corporation with a redemption price, in total, equal to the amount calculated and determined in the manner specified in 2(c)(ii) or 4(c)(ii) above at the time of the sale of all the Common Shares, or all or substantially all of the assets of the Corporation are sold, then XXXXXXXXXX Shares shall be issued for $XXXXXXXXXX.

10. Shortly after the transactions described above are completed and within the period provided below for the completion of the proposed transactions:

a. the Corporation will amend the share conditions of the Corporation to create any new share classes necessary;

b. the Corporation will have a valuation performed to determine the value of the S-Amount and the H-Amount, and immediately thereafter:

i. the Phantom Plans will be terminated such that no amounts will be paid or become payable under or as a consequence of the Phantom Plans or the termination of the Phantom Plans;

ii. the Employees will exercise the initial grant of rights; and

iii. the Corporation will issue the Shares.

11. The Corporation shall redeem or repurchase the Shares in accordance with the terms of the agreement at the direction of the Employees at an unspecified future date. However, it is expected that the Employees will hold the Shares for at least two years.

Purpose of the Proposed Option Plan and the Proposed Transactions

12. The purpose of the original Phantom Plans was to permit the Employees to participate in the increase in the value of the shares of the Corporation. The Corporation has now decided that it is in its best interests that the Employees have the potential to hold shares directly in the Corporation to gain the benefits of share ownership, such as the right to receive dividends and to vote (depending on the class of shares issued).

Additional Information

13. To the best of your knowledge and that of the Corporation, and the Employees none of the issues involved in this ruling are:

(a) in an earlier return of the Corporation or the Employees, or any person related to the Corporation or the Employees;

(b) being considered by a tax services office or tax centre in connection with a previously filed tax return of the Corporation or the Employees, or any person related to the Corporation or the Employees;

(c) under objection by the Corporation or the Employees, or any person related to the Corporation or the Employees;

(d) before the courts; nor

(e) the subject of an income tax ruling previously issued by CCRA to the Corporation or the Employees.

Rulings

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, the proposed Option Plan, the proposed transactions and the purpose of the proposed Option Plan and the proposed transactions and the wording of the Option Plan are and continue to be substantially as described above, we rule as follows:

A. Paragraph 7(3)(a) of the Act will apply in respect of an Employee where, as described in 8 above, the Employee is granted rights under the Option Plan such that, except as provided in section 7 of the Act, as ruled on in C below, the Employee shall not be considered to have received or enjoyed any benefit to which subsection 5(1), paragraphs 6(1)(a) or (i) or section 15 of the Act would otherwise apply, as a result of the grants or from the acquisition of Shares under the Option Plan.

B. Subsection 39(1) shall not apply in respect of an Employee as a result of the termination of the Phantom Plans as described in 10 above.

C. Provided an Employee continues to deal at arm's length with the Corporation immediately after the Corporation grants rights as described in 8 above, subsection 7(1.1) and paragraph 7(1)(a) of the Act will apply to deem the Employee to have received a benefit calculated in accordance with those provisions in the year the Employee disposes of or exchanges a Share acquired by the Employee under the Option Plan.

D. Provided the conditions in paragraph 110(1)(d.1) of the Act are met, an Employee may deduct an amount, as calculated under that provision, in the year in which the Employee disposes of or exchanges a Share acquired by the Employee under the Option Plan as described in C above.

The above rulings, which are based on the Act in its present form and do not take into account any proposed amendments thereto, are given subject to the general limitations and qualifications set out in Information Circular 70-6R5 dated May 17, 2002, and are binding on the CRA provided that the Option Plan is implemented, and the grants described in 8 and 10 above are made and exercised by XXXXXXXXXX.

Comments

While a ruling has not been requested, in our view, the provisions of paragraph 7(3)(b) of the Act will apply in respect of the proposed transactions such that the income for a taxation year of any person, including the Corporation, is deemed to be not less than its income for the year would have been if a benefit had not been conferred on an Employee by the sale or issue of the securities.

Yours truly,

XXXXXXXXXX
for Director
Financial Industries Division
Income Tax Rulings Directorate