2005 Ruling 2005-0120771R3 - Stock option plan

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: Will section 7 apply to a particular employee incentive plan ?

Will the employees be entitled to the 110(1)(d) deduction?

Position: Yes
Yes

Reasons: The plan satisfies the requirements of section 7
The plan satisfies the requirements of paragraph 110(1)(d)

XXXXXXXXXX 2005-012077

XXXXXXXXXX, 2005

Dear XXXXXXXXXX:

Re: Advance Income Tax Ruling
XXXXXXXXXX. ("PartnerCo 1")
XXXXXXXXXX. ("PartnerCo 2")
(collectively "the Partners")

This is in reply to your letter of XXXXXXXXXX in which you requested an advance income tax ruling on behalf of the above-named taxpayers. We also acknowledge your subsequent submissions of XXXXXXXXXX.

We understand that, to the best of your knowledge and that of the Partners, none of the issues involved in the ruling request is:

(i) in an earlier return of the Partners or a related person,

(ii) being considered by a tax services office or taxation centre in connection with a previously filed tax return of the Partners or a related person,

(iii) under objection by the Partners or a related person,

(iv) before the courts, or

(v) the subject of a ruling previously issued by the Directorate to the Partners or a related person.

Unless otherwise stated, all references to a statute are to the Income Tax Act (Canada), R.S.C. 1985, c.1 (5th Supp.), as amended to the date of this letter, (the "Act"), and all terms and conditions used herein that are defined in the Act have the meaning given in such definition unless otherwise indicated.

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

"Agreement" means an employee stock option agreement between ManagementCo and a Participant;

"CBCA" means the Canada Business Corporations Act, R.S.C. 1985, c. c-44, as amended;

"Eligible Employee" means an employee of ManagementCo;

"Exercise Price" means the price specified in an Agreement as the price to be paid by a Participant to acquire an Option Share pursuant to the Option. The Exercise Price specified in any Agreement will be not less than the Fair Market Value of the Option Shares on the Grant Date;

"Expiry Date" means the XXXXXXXXXX anniversary of the Grant Date of an Option;

"Fair Market Value" of an Option Share means the value as determined by the Board of Directors of ManagementCo, which determination will be based upon a valuation by an independent valuator or by some other method considered by the Board of Directors of ManagementCo to provide a reasonable basis for the valuation of the Option Shares.

"Grant Date" means the date ManagementCo grants an Option to a Participant pursuant to an Agreement;

"Option" means a right granted by ManagementCo to an Eligible Employee to purchase an Option Share at the Exercise Price and upon the terms specified in an Agreement;

"Option Share" means a non-voting common share of ManagementCo described in 6(b) below;

"Participant" means an Eligible Employee who is granted an Option pursuant to an Agreement;

"Partnership" means the XXXXXXXXXX; a general partnership having business number XXXXXXXXXX that was formed in XXXXXXXXXX;

"Partnership Employees" means the employees of the Partnership;

"Plan" means the employee stock option plan to be implemented by ManagementCo under which Options may be granted to Eligible Employees;

"Preferred Share" means a voting preferred share of ManagementCo described in 6(a), below;

"Prescribed Shares" means prescribed shares as defined in section 6204 of the Income Tax Regulations (the "Regulations");

"Redemption Amount" of a Preferred Share shall be the amount calculated in accordance with the terms specified in the Articles of Incorporation of ManagementCo.;

"Services Fees" means the fees to be paid by the Partnership to ManagementCo, which will be equal to ManagementCo's cost of providing the services to the Partnership plus a specified percentage, expected to be less than XXXXXXXXXX%;

"Specified Amount" means the fair market value of the consideration paid to ManagementCo at the time of the first subscription for Preferred Shares;

"Successor Entity" means a corporate entity into which all or substantially all of the assets and liabilities of the Partnership are transferred, and

"Taxable Canadian Corporation" has the meaning assigned in subsection 89(1) of the Act.

Our understanding of the facts, proposed transactions and the purpose of the proposed transactions is as follows:

Facts

1. PartnerCo1 is an indirect, wholly owned subsidiary of XXXXXXXXXX, a corporation incorporated under the laws of the XXXXXXXXXX. PartnerCo1 is a Taxable Canadian Corporation incorporated under the CBCA with its head office located at XXXXXXXXXX. PartnerCo1 is served by the XXXXXXXXXX Tax Services Office and files its tax returns with the XXXXXXXXXX Taxation Centre.

2. PartnerCo2 is a wholly owned subsidiary of XXXXXXXXXX., a corporation that is an indirect, wholly-owned subsidiary of a Canadian public company. PartnerCo2 is a Taxable Canadian Corporation incorporated under the CBCA with its head office located at XXXXXXXXXX. PartnerCo2 is served by the XXXXXXXXXX Tax Services Office and files it tax returns with the XXXXXXXXXX Taxation Centre.

3. Each of PartnerCo1 and PartnerCo2 has a 50% interest in the Partnership. XXXXXXXXXX

4. The Partnership currently employs the Partnership Employees.

Proposed Transactions

5. The Partners will incorporate ManagementCo under the CBCA. It will be a Taxable Canadian Corporation with its head office located at XXXXXXXXXX. It will be served by the XXXXXXXXXX Tax Services Office and will file its tax returns with the XXXXXXXXXX Taxation Centre. One share of ManagementCo will be issued to XXXXXXXXXX acting for the Partners, as incorporator, for nominal consideration. ManagementCo will have two Directors. One Director shall be a representative of PartnerCo1 and the other Director shall be a representative of PartnerCo2.

6. ManagementCo's Articles of Incorporation will provide that its authorized capital will consist of:

(a) Preferred Shares having the following attributes:

(i) each Preferred Share will be redeemable, subject to applicable law, at any time at the option of ManagementCo for the Redemption Amount;

(ii) each Preferred Share will be retractable, subject to applicable law, at any time at the option of the holder for proceeds equal to the Redemption Amount;

(iii) the holder of each Preferred Share will be entitled to preferential non-cumulative cash dividends at a specified rate as and when declared by the Board of Directors from time to time, which dividends need not also be declared on any other class of shares of ManagementCo;

(iv) there will be a provision that will prohibit the payment of returns of capital on other classes of shares if the payment of any such return of capital would reduce the fair market value of the Preferred Shares to an amount less than the aggregate Specified Amount or would render ManagementCo incapable of redeeming all of the issued and outstanding Preferred Shares;

(v) the holder of each Preferred Share will be entitled, upon the liquidation, dissolution or winding-up of ManagementCo, to a payment in priority to all other classes of shares of ManagementCo of an amount equal to the Redemption Amount therefor to the extent of the amount or value of property available under applicable law for payment to shareholders upon dissolution and in addition, if there are no other classes of shares of ManagementCo that are issued and outstanding, the holders of the Preferred Shares will also be entitled to share pro rata in the remaining property and assets of ManagementCo; and

(vi) each Preferred Share will entitle the holder to one vote at meetings of shareholders of ManagementCo.

(b) Option Shares, which will be common shares having the following attributes:

(i) subject to the prior rights or to any preference as to dividends provided to the holders of the Preferred Shares with respect to priority in the payment of dividends, the holders of the Option Shares shall be entitled to receive dividends as and when declared by the Board of Directors of ManagementCo;

(ii) the holder of each Option Share will be entitled, upon the liquidation, dissolution or winding-up of ManagementCo and subject to the prior rights of the holders of the Preferred Shares, to share pro rata in the remaining property and assets of ManagementCo;

(iii) unless there are no issued and outstanding Preferred Shares, the Option Shares will not entitle the holder to vote at meetings of shareholders of ManagementCo, other than as required under the relevant corporate legislation;

(iv) the Option Shares shall rank junior to the Preferred Shares and shall be subject in all respects to the rights, privileges, restrictions and conditions attaching to the Preferred Shares; and

(v) The Option Shares will be Prescribed Shares at all times.

7. A corporation ("ManagementSubCo") will be incorporated under the CBCA, with one share being issued for nominal consideration to XXXXXXXXXX acting for the Partners, as incorporator. ManagementSubCo will be a Taxable Canadian Corporation with its head office located at XXXXXXXXXX. It will be served by the XXXXXXXXXX Tax Services Office and will file its tax returns with the XXXXXXXXXX Taxation Centre.

8. Following the creation of ManagementCo, ManagementCo will hire certain of the Partnership Employees at which time they will become Eligible Employees and will cease to be employees of the Partnership. Effective XXXXXXXXXX, ManagementCo will hire the remaining Partnership Employees at which time they will become Eligible Employees and will cease to be employees of the Partnership.

9. At all times, all Eligible Employees and all Participants will deal at arm's length with ManagementCo.

10. Under the terms of a management services agreement between the Partnership and ManagementCo, ManagementCo will provide services necessary for the operation of the Partnership's business. These services will include, inter alia, such things as management services, administration, marketing and XXXXXXXXXX. The Eligible Employees will be employed by ManagementCo to provide these services to the Partnership. The Partnership will pay the Services Fees to ManagementCo for these services.

11. In order to fund an indirect acquisition of an interest of approximately XXXXXXXXXX% in the Partnership by ManagementCo, PartnerCo1 and PartnerCo2 will each make an equal cash payment to ManagementCo to subscribe for an equal number of Preferred Shares. The ManagementCo share originally issued to the incorporator on incorporation will be redeemed for nominal value. PartnerCo1 and PartnerCo2 may purchase additional Preferred Shares in the future to fund additional indirect acquisitions of interests in the Partnership by ManagementCo.

12. ManagementCo will use all or substantially all of the proceeds from the issuance of Preferred Shares to the Partners to acquire shares of ManagementSubCo. The ManagementSubCo share originally issued to the incorporator on incorporation will be redeemed for nominal value.

13. ManagementSubCo will use the proceeds from the issuance of shares to ManagementCo to acquire for fair market value an interest of approximately XXXXXXXXXX% in the Partnership.

14. ManagementCo will establish the Plan. On the same day that PartnerCo1 and PartnerCo2 subscribe for Preferred Shares in accordance with 11 above, but prior to the acquisition of ManagementSubCo shares in accordance with 12 above and prior to the subsequent acquisition of a Partnership interest by ManagementSubCo, Options will be granted to such of the Eligible Employees and in such amounts, up to a maximum number of Options, as may be determined in the discretion of the Board of Directors of ManagementCo (or any person or persons designated by the Board of Directors of ManagementCo to administer the Plan). Grants of Options will be documented in an Agreement. Although not provided, it is our understanding that the relevant terms of the Plan and the Agreements will be as follows:

(a) Under an Option, the Exercise Price to acquire an Option Share will not be less than the Fair Market Value of an Option Share on the Grant Date.

(b) If a Participant was employed by the Partnership prior to the incorporation of ManagementCo, such Participant's Options will vest on a graduated scale as follows:

XXXXXXXXXX

(c) Where a Participant was not employed by the Partnership prior to the incorporation of ManagementCo, such Participant's Options will vest on a graduated scale as follows:

XXXXXXXXXX

(d) A Participant (or his or her legal representative) will be entitled to exercise an Option provided three conditions are met. Firstly, the Option must be vested in the Participant. Secondly, the Option must not have expired or have been cancelled or forfeited under the terms of the Plan or the Agreement. Thirdly, a Qualifying Event must have occurred. A Qualifying Event is any one or more of the following:

(i) The sale or transfer of all or substantially all of the units of the Partnership to a person who is not a Successor Entity of the Partnership;

(ii) The sale or transfer of all or substantially all of the assets of the Partnership to a person who is not a Successor Entity of the Partnership;

(iii) The liquidation, dissolution, termination or winding up of the Partnership other than a decision made to dissolve the Partnership in connection with the transfer of the Partnership assets to a Successor Entity or a transfer of Partnership units to a Successor Entity;

(iv) An initial public offering by the Partnership or Successor Entity;

(v) The disposition of XXXXXXXXXX% or more of all of the units of the Partnership by either PartnerCo 1 or PartnerCo2 (or a combination of them);

(vi) The disposition of any of the Preferred Shares of ManagementCo by either PartnerCo 1 or PartnerCo 2, subject to certain exceptions;

(vii) The termination of the Participant's employment with ManagementCo as a result of:

(A) The Participant reaching the age designated by the Board of Directors of ManagementCo as the normal retirement age. Any vested Options may only be exercised in the XXXXXXXXXX period following the date the Participant reaches normal retirement age. Any unvested options will be cancelled;

(B) The Participant becoming entitled to long-term disability benefits in accordance with ManagementCo's benefit policies. Any vested Options may only be exercised in the XXXXXXXXXX period following the date the Participant becomes entitled to long-term disability benefits. Any unvested options will be cancelled;

(C) The death of the Participant. Any vested Options may only be exercised in the XXXXXXXXXX period following the date of death. Any unvested options will be cancelled;

(D) The "not for cause" termination of the Participant's employment by ManagementCo. Any vested Options may only be exercised in the XXXXXXXXXX-month period following the date of termination of employment. Any unvested options will be cancelled; and

(viii) Either XXXXXXXXXX (depending on the date the particular Participant's employment began) of the year that is XXXXXXXXXX years after the commencement date of the Participant's employment with either the Partnership or ManagementCo;

(e) Without limiting the application of 14(d) above, if a Participant's employment with ManagementCo is terminated by reason of the resignation of the Participant, any vested Options of such a Participant may only be exercised in the XXXXXXXXXX-month period following the occurrence of the first Qualifying Event to occur. Any unvested Options will be cancelled.

(f) If a Participant's employment with ManagementCo is terminated for cause, then upon termination the Participant's vested Options will be forfeited and his or her unvested Options will be cancelled.

(g) Subsequent to the termination of a Participant's employment with ManagementCo for any reason, ManagementCo will have the discretion to cancel that Participant's vested Options if the Participant has commenced employment with a competitor of the Partnership.

(h) Subject to the time limitations described in 14(d)(vii) and 14(e) above, applicable to the exercise of an Option in the event of termination of employment, a Participant may exercise a vested Option that has not been forfeited or cancelled at any time after the occurrence of a Qualifying Event and before the Expiry Date of the particular Option ("Exercise Date") by giving notice to ManagementCo in the manner prescribed in the Agreement.

(i) On the Exercise Date, a Participant may:

(i) Pay the Exercise Price to ManagementCo and receive one Option Share for each vested Option so exercised, or

(ii) Elect to surrender the vested Option in consideration for a cash payment from ManagementCo equal to the amount by which the Fair Market Value of an Option Share on the Exercise Date exceeds the Exercise Price specified in the Agreement ("Share Appreciation Payment" or "SAP"), less any applicable withholding taxes.

(j) The Plan will provide that in the event of any stock dividend, stock split, combination or exchange of Option Shares, merger, consolidation, spin-off or other distribution (other than normal cash dividends) of ManagementCo's assets to shareholders, or any other change in the capital of ManagementCo affecting the Option Shares, such proportionate adjustments, if any, as the ManagementCo Board of Directors in its discretion may deem reasonably appropriate to reflect such change, shall be made to the Agreements. The decision of the Board of Directors shall be binding and conclusive for all purposes of the Agreement and the Plan.

(k) To create a market for the Option Shares, each Agreement will provide the Participants with the right to sell the Option Shares to PartnerCo1 and PartnerCo2 for an amount that is not more than the Fair Market Value of such Options Shares, which right may be limited in certain circumstances.

(l) As a condition to the exercise of vested Options and receipt of Option Shares, Participants will be required to execute a shareholders' agreement. Although a copy of the shareholders' agreement has not been provided, its materially relevant terms include:

XXXXXXXXXX

15. It is anticipated that in its discretion, the Board of Directors of ManagementCo may make further grants of Options to Eligible Employees, but only to the extent that previously granted Options have been cancelled or forfeited.

Purpose of the Proposed Transactions

16. The purpose of the proposed transactions is to advance the interests of the Partners by:

(a) increasing the indirect interests of the Participants (through the issuance of Options on the common share capital of ManagementCo) in the business of the Partners;

(b) aligning the motivation of the Participants with the interests of the Partnership and, thus, of the Partners; and

(c) encouraging the Participants to continue providing their services (indirectly through ManagementCo) for the benefit of the Partnership business.

Rulings Given

Provided that the preceding statements constitute a complete and accurate disclosure of all of the relevant facts, proposed transactions and purpose of the proposed transactions, and provided that the proposed transactions are implemented as described above, we rule as follows:

A. No amount will be included in a Participant's income under section 5 or section 6 of the Act by the mere granting of an Option.

B. Upon the exercise of an Option in accordance with 14(i)(i) above, there shall be included in a Participant's income, as a benefit from employment pursuant to section 6 of the Act, the amount determined in accordance with paragraph 7(1)(a) of the Act. Specifically, the amount to be included will be the amount by which the fair market value of an Option Share on the Exercise Date exceeds the Exercise Price paid by the Participant for the Option Share multiplied by the number of Option Shares acquired by exercising the Options.

C. Provided the conditions of paragraph 110(1)(d) of the Act are satisfied with respect to an Option and Option Shares, in computing taxable income for the year in which a Participant exercises the Option, the Participant will be eligible, pursuant to paragraph 110(1)(d) of the Act, to deduct 50% of the benefit calculated pursuant to paragraph 7(1)(a) of the Act.

D. Upon the surrender of an Option by a Participant and his or her election to receive a SAP in accordance with 14(i)(ii) above, there shall be included in the Participant's income, as a benefit from employment pursuant to section 6 of the Act, the amount determined in accordance with paragraph 7(1)(b) of the Act. Specifically, the amount to be included will be the amount of the cash payment paid to such Participant including any amount withheld in respect of taxes and other source deductions.

E. Provided the conditions of paragraph 110(1)(d) of the Act are satisfied with respect to an Option and Option Shares, such that the Participant who holds the Option would be eligible for the deduction under paragraph 110(1)(d) of the Act if the Participant exercised the Option and received an Option Share, in computing taxable income for the year in which the Participant receives a SAP, such Participant will be eligible, pursuant to paragraph 110(1)(d) of the Act, to deduct 50% of the amount of the cash payment the Participant receives upon surrendering the Option and electing to receive a SAP.

F. Subject to section 67 and paragraph 18(1)(a) of the Act, ManagementCo will be entitled to deduct the gross amount of a cash payment made to a Participant pursuant to an election to receive a SAP including any amount withheld in respect of taxes and other source deductions, in calculating its income in respect of the year in which the cash payment was made, in accordance with section 9 of the Act. For greater certainty, paragraph 7(3)(b) of the Act will not apply to deny the deduction for the amount paid by ManagementCo to a Participant in respect of the Participant's election to receive a SAP. Paragraph 7(3)(b) of the Act will apply to deny a deduction by ManagementCo when shares are issued by ManagementCo to a Participant upon the exercise of an Option.

The above advance income tax rulings, which are based on the Act and Regulations in their 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 Advance Income Tax Rulings, dated May 17, 2002, and are binding on the Canada Revenue Agency provided that the proposed transactions are completed, and the Plan is implemented by XXXXXXXXXX

Notes:

This letter is based solely on the facts and proposed transactions described above. Any 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.

The ability of a Participant to claim a deduction under paragraph 110(1)(d) of the Act on the exercise of an Option or upon the election to receive a SAP will depend, in part, on a determination that the amount paid is not less than the fair market value of the Option Share on the date the Agreement was entered into. The fair market value of a share, at any particular time, is a question of fact and nothing in this ruling should be construed as implying our acceptance of any method for the determination of the fair market value of an Option Share for the purposes of the Plan. Nothing in this ruling should be construed as implying that the CRA has reviewed or is making a determination in respect of the fair market value of any share referred to herein.

Yours truly,

XXXXXXXXXX
Director
Financial Sector and Exempt Entities Division
Income Tax Rulings Directorate
Policy and Planning Branch