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. Whether the proposed conversion of SAR units to DSUs and the adding of dividend equivalents result in an immediate income inclusion. 2. Whether the GAAR should be used to challenge the tax benefits obtained through a fully-leveraged EPSP structure.
Position: 1. Yes. 2. Recommend that matter be referred to the GAAR Committee.
Reasons: 1. The proposed changes represent a fundamental change to the units and therefore a disposition of the participants rights under the plan. 2. The proposed structure is highly artificial, provides significant tax deferral and rate reduction benefits on employment compensation and represents an abuse of the EPSP rules.
February 6, 2019
Len Lubbers HEADQUARTERS
Director Income Tax Rulings
Abusive Tax Avoidance and Directorate
Technical Support Division V. Pietrow
Withdrawn request for an advance income tax ruling by XXXXXXXXXX (“Employerco”)
This memo relates to an Advance Income Tax Ruling request that was made on behalf of Employerco involving its equity-based compensation plan (the “Plan”). Employerco proposed to amend the Plan to convert share appreciation rights (SARs) to full-value deferred share units (DSUs), and to establish a fully-leveraged employee’s profit sharing plan (EPSP) to provide a mechanism for funding the Plan and issuing shares to Participants.
We refused to provide a favourable ruling on technical grounds and Employerco withdrew its ruling request. However, we are concerned that the technical issues could be overcome, or avoided altogether by implementing the structure on a prospective basis only. If the CRA encounters such a structure in the course of an audit, we would recommend that it be referred to the GAAR Committee for consideration. In our view, the structure is highly artificial, provides significant tax deferral and rate reduction benefits on employment compensation, and represents an abuse of the EPSP rules.
Description of existing SAR units
Pursuant to the Plan, certain employees of Employerco and related corporations have been issued SAR units. Each SAR unit entitles the Participant to a lump sum payment equal to the increase, from the date of issuance of the unit to the date of redemption, in the closing price of a share (“Share”) of a particular class of capital stock of Employerco that is listed on a designated stock exchange. No adjustment is made for the dividends paid on the Shares. Vested SAR units may only be redeemed upon the Participant’s retirement, termination of employment, or death (“Retirement”) and are payable in cash, or if the Participant so chooses, in the form of Shares purchased on the open market.
All of the units are now fully vested. The Share price has risen and Employerco has a significant liability because of the outstanding units under the Plan.
Employerco would establish an arrangement to be administered through a trust (the “EPSP Trust”) intended to qualify as an EPSP under section 144 of the Income Tax Act (the “Act”). The Participants would be offered a one-time election to convert the units under the Plan from SARs to DSUs to be paid upon Retirement by way of a distribution of Shares from the EPSP Trust.
With respect to Participants who make the election:
- The redemption value of each unit would be changed from the appreciation in the value of a Share at the time of the issuance of the unit to simply the full value of a Share. This change would result in the units (which are SARs, prior to the conversion) becoming DSUs.
- Consistent with this change in redemption value, the number of DSUs held by the Participant would be readjusted downwards in a manner that ensures that the total redemption value of the DSUs held by the Participant immediately after conversion is equal to the total redemption value of the SAR units held by the Participant immediately before conversion.
- As well, a standard dividend equivalent feature would be added to the units.
- The timing for the satisfaction of the redemption value would remain unchanged, i.e., upon the Participant’s Retirement. The EPSP Trust would distribute Shares in full satisfaction of the redemption value, and Employerco’s liability under the Plan as regards the retiring Participant.
Employerco would make an “out of profits” election under subsection 144(10), which would give itself maximum flexibility in determining the amount and timing of the contributions it would make to the EPSP Trust. Three different categories of contributions are contemplated – Basic Annual Contributions, Deficiency-Makeup Contributions and Balloon Contributions.
The amount of the Basic Annual Contribution per year would be determined by Employerco, subject to a minimum of $100 per beneficiary and a maximum of 1% of Employerco’s profits. The $100 minimum is necessary to comply with the requirements set out in paragraphs 6 and 8 of IT-280R Employees Profit Sharing Plans – Payments Computed by Reference to Profits. While not specifically stated in the Ruling request, we expect that the Basic Annual Contribution would never exceed the $100 minimum.
The EPSP Trust would borrow sufficient funds from Employerco on arm’s length terms and conditions (the “Loan”) to purchase Shares on the open market equal to the number of outstanding DSUs under the Plan.
When dividends are paid on the Shares, Employerco would make additional loans to the EPSP Trust each year (“Additional Loans”) equal to the amount of the dividends received to enable the EPSP Trust to acquire additional Shares on the open market in connection with the additional DSUs provided to the Participants as dividend equivalents.
Throughout the duration of the Loan and Additional Loans (collectively, the Loans), interest-only payments on the Loans would be made by the EPSP Trust.
The EPSP Trustee would use the cash proceeds it receives from dividends on the Shares, together with the Basic Annual Contributions, to pay the interest on the Loans each year. As this would be insufficient to cover the significant interest expense, Employerco would make a Deficiency-Makeup Contribution in the year to enable the EPSP Trustee to pay the balance owing. The Participant will have no income inclusion in the year under subsection 144(3) because there is no net amount for the EPSP Trustee to allocate to the Participant. The EPSP Trust’s interest expense fully offsets the EPSP Trust’s allocable receipts (i.e., the dividend income, the Basic Annual Contribution, and the Deficiency-Makeup Contribution).
Upon Retirement of any particular Participant, Employerco would make a Balloon Contribution to enable the EPSP Trustee to repay the portion of the principal amounts of the Loans (and the current year’s interest on the Loans) that reasonably relates to the Participant’s DSUs. The EPSP Trust would allocate the whole amount of this Balloon Contribution to the Participant. The EPSP Trust would then distribute, to the Participant, Shares equal in number to the Participant’s DSUs in full satisfaction of the Participant’s rights under the Plan.
Employerco would have a deduction for the Balloon Contribution, by virtue of subsection 144(5) and paragraph 20(1)(w). The EPSP Trust would have no capital gain on the disposition of the Shares, as its proceeds of disposition are deemed by virtue of paragraph 144(7.1)(a) to be equal to its cost amount. The amount of the Balloon Contribution would be allocated to the retiring Participant and included in their income under subsection 144(3). Paragraph 144(7)(b) would then exclude that amount from being included under subsection 144(7) in the Participant’s income in connection with their receipt of the Shares. By virtue of subparagraph 144(7.1)(b)(iv), that amount would also be deemed to be the Participant’s cost of the Shares. Thus, any gain accrued during the time the Shares were held by the EPSP Trust would not be realized until the Shares are ultimately sold by the Participant. Note that any such gain would be a capital gain (and therefore, taxed on the taxable capital gain portion), rather than income from employment.
Since the Proposed Transactions failed on technical grounds, we refused to provide a favourable ruling and Employerco withdrew the ruling request. However, we are concerned that it is possible that the Proposed Transactions could be revised to overcome the technical issues or that the structure could be implemented by other taxpayers on a prospective basis only, thereby avoiding the technical issues.
As noted earlier, the structure is highly artificial, provides significant tax deferral and rate reduction benefits on employment compensation, and represents an abuse of the EPSP rules. Here, there is no profit-sharing in purpose or effect. The real purpose and effect of the fully-leveraged EPSP is to access the beneficial tax attributes of the EPSP rules while avoiding the less desirable ones.
Furthermore, we note that the favourable tax results under the Proposed Transactions are similar, in large part, to those available under the employee stock option rules in subsections 7(1) and (1.1) and paragraphs 110(1)(d) and (d.1) of the Act, even though the Plan is not an employee stock option agreement, Employerco is not a Canadian-controlled private corporation, the Participant might not necessarily be dealing at arm’s length with Employerco, and the requirements of paragraph 110(d) or (d.1) are not satisfied. Although the Participant would have an income inclusion in the year of Retirement for the cost of the Shares, taxation on the amount by which the Shares appreciated while held by the EPSP Trust would be deferred until the year in which the Participant disposes of the Shares. That amount (which would otherwise be income from employment) will be a component in calculating the Participant’s capital gain on the Shares.
If the CRA encounters such a structure in the course of an audit, we would recommend that it be referred to the GAAR Committee for consideration. We would be pleased to assist you in the preparation of the referral.
We trust that the foregoing will be of assistance to you. If you have any questions or if you would like to discuss any of these issues further, please do not hesitate to contact Dave Wurtele at 613-793-2686 or Victor Pietrow at 604-666-9668.
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch
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