15 February 1988 Income Tax Severed Letter 7-1822 - [Applicability of section 7 of the Income Tax Act]

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.

MEMORANDUM

February 15, 1988

TORONTO DISTRICT OFFICE Audit Review 148-2-1

HEAD OFFICE Financial Industries W.C. Harding (613)957-3499

Attention: A. Stackle

RE: Request for Opinion J. Nalevka Basic Files

XXXX

This is in reply to your memorandum of May 25, 1987 wherein you requested our opinion as to the applicability of section 7 of the Income Tax Act (the Act) in respect of certain transactions undertaken by the above-noted taxpayer.

Background Information

XXXX

Taxpayer's Position

The taxpayer's accountants, XXXX prepared a submission, provided by you, outlining their position. The main points raised were as follows:

Section 7 applies to stock options, not stock bonuses. Section 7 requires an agreement. The employees did not acquire shares at less than fair market value. IT-113R2 , paragraph 3 requires that a corporate employer issue its shares for section 7 to apply, and in this case it was not the shares of the employer that were issued.

District Office Opinion

Arguments, in corresponding order to those above, are as follows: IT-113R2 , para. 3 states "Section 7 applies where a corporate employer issues shares to an employee as a salary bonus or under a stock bonus plan."

Mr. David N. Finkelstein in "Tax Planning for Executive and Employee Compensation and Retirement", "Corporate Management Tax Conference 1985", pages 25 and 26 discusses bonus shares and the application of section 7. The author writes that, "It may be that the requirements of Section 7 are met once a corporation has determined to issue or sell shares and has so informed the employee." IT-113R2 , paragraph 2 states that, "Section 7 applies where an employing corporation agrees to sell or issue to an employee its own shares or to sell or have issued those of a corporation with which it does not deal at arm's length, at less than fair market value or for no monetary consideration.

In this case the bonus was shares of the parent given to the employees for no consideration.

Head Office Opinion

In our opinion, the provisions of section 7 of the Act apply in the circumstances of your case and this finding is consistent with the Department's comments as set out in Interpretation Bulletin IT-113R3 as that bulletin has read since the publication of IT-113R dated December 26, 1980.

As you are aware, subsequent to your referral XXXX made written submissions to us on behalf of XXXX (enclosed) and requested they be provided with an opportunity to discuss the issue further. In consequence, a meeting was held in our Offices on February 3, 1988, at which time the taxpayer's arguments were presented and our position clearly set out. In finalizing the meeting we advised that our next action would be to advise you of our conclusions.

While agreement on the issues was not reached through the discussions, they did provide an opportunity for the Department to clearly state its position. In this regard a number of points were covered which are briefly set out here for your consideration.

1. Section 7 of the Act covers the distribution of shares under stock bonus plans including those plans where shares are not "issued" by a corporation as that term is defined in IT-113R3 . Through our review it was determined that paragraph 3 of the IT was added upon the publication of IT-113R dated December 26, 1980 to indicate that, as of that date and contrary to our previously held position, bonus and option plans would be treated equally under the provisions of section 7 of the Act. It was not intended and it should not be inferred that paragraph 3 of the bulletin was intended to restrict the application of section 7 to bonuses only where shares of the employer were issued.

2. A bonus plan or the distribution of shares thereunder constitutes an "agreement" as was contemplated by the provisions of section 7. A bonus can properly be considered as a unilateral agreement whereunder the employee has a right to refuse or accept its conditions, but cannot change those conditions. This is a well established view of the Department with concurrence by both the Departments of Justice and Finance.

3. It is our view that subsection 7(3) of the Act was intended and is properly worded to disallow laid out costs incurred with respect to any agreement to issue shares to employees of a corporation. The provision is not merely intended to prohibit claims for values (fair market or PUC) attributed to shares distributed from treasury. The wording of the provision does not provide for any discrimination of application in consequence of the source or method of acquiring shares for allocation under the agreement.

We have ruled as published in advance ruling ATR17 that amounts are deductible if they are paid to a trust for the purpose of acquiring shares on the open market for distribution to employees. This was partially based upon the fact that Canadian law prevents a corporation from acquiring its own shares except for cancellation. In contrast, XXXX can apparently buy their own shares on the open marked and return them to treasury. In their case, it is our view that subsection 7(3) is applicable.

4. The Act does not require any consolidation of separate and distinct corporate entities for tax purposes but there are, however, for various reasons, a number of provisions where transactions between non-arm's length parties are treated in accordance with specifically legislated rules. Subsection 7(3) has application to deny the deduction of an amount paid by a corporation to a related corporation to acquire shares of that company, whereas, if the amount was paid to an unrelated corporation for its shares, it would be allowed as an expense. It is our view that this legislative differentiation is intended and this view is again supported by Finance.

5. If a corporation pays a bonus to an employee which is in some way paid conditional upon his acquiring treasury shares of the corporation or a related corporation, we have taken the position that section 7 of the Act is applicable.

XXXX in its written submission, state that XXXX never acquired any shares of its parent but acted only to cause the issue of shares by its parent to its employees. In so doing they state "that it could almost be said that the employer acted as the employees' agent since they paid the U.S. company with the bonsues that were due to the employees."

XXXX in any event, it is our view that an unrestricted bonus was clearly not issued and used at the employees' option to acquire shares of the parent corporation. Hence section 7 of the Act is applicable.

Conclusion

It is our view that section 7 is applicable to the circumstances of your case as outlined to us. We apologize for the delay in responding which was caused by having to wait for submissions from and meetings with the representatives.

for Director Financial Industries Division Rulings Directorate