27 October 1986 Income Tax Severed Letter 8-0041 - [XXXX Stock Option Agreement - Cash in lieu of 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.

OCT 27 1986

TO        Appeals Branch
          Appeals & Referrals Division

ATTENTION H. Roodman

FROM      Small Business &General
            Division
          N.R. Mitchell
          (613) 957-2139

RE: XXXX Stock Option Agreement - Cash in lieu of Shares

This is in reply to your memorandum of May 22, 1986 concerning the above-captioned subject. We regret the unavoidable delay in responding. The matter at issue in this case is whether the benefit accruing to these taxpayers on the exercise of "share appreciation rights" contained in a stock option agreement with their employer is taxable under the provisions of paragraph 7(1)(b) of the Income Tax Act and is therefore eligible for deferral as qualifying income for Income Averaging Annuity Contract ("IAAC") purposes or, alternatively, is taxable under subsection 5(1) and paragraph 6(l)(a) of the Act and consequently cannot be deferred through an IAAC.

The facts of the matter are as follows. Stock option agreements between the taxpayers and their employer provided for certain "share appreciation rights" an alternative to the purchase of shares at an agreed price. The taxpayers, as their option, could elect to receive, in cash, an amount equal to the difference between the market price of the employer company's stock at the date notice was given and the option exercise price under the agreement, multiplied by the number of shares in respect of which these rights could be exercised. The employees could also decide to receive shares equal in value to their stock appreciation rights as determined above, but this would be subject to the consent of the employer who could choose not to issue shares and only to pay the value in cash. The taxpayers chose to exercise these share appreciation rights in 1981, asked and received payment in cash, which they considered to be qualifying income pursuant to paragraph 61(2)(f) of the Act and purchased IAACs. The Department took the position that this income was not qualifying income for IAAC purposes, but rather was taxable under subsection 5(1) or paragraph 6(1)(a) and not pursuant to paragraph 7(1)(b) of the Act. The deductions in respect of the taxpayers' purchases were therefore disallowed.

We have reviewed the documentation submitted and, largely for the same reasons as those set out in the opinion dated May 1, 1986 by Mr. William Mah of the Department of Justice, we are of the view that the benefit at issue can be brought within the terms of paragraph 7(1)(b) of the Act.

The recent Federal Court of Appeal decision of Greiner 84 DTC 6073 dealt with an employee who surrendered his stock option rights to shares of his (previous) employer in return for a cash settlement from the company which had purchased the former company. The Court held that the employee was in receipt of a benefit taxable pursuant to paragraph 7(1)(b) of the Act. The Court in Greiner gave a broad interpretation to the scope of paragraph 7(1)(b) - it had no hesitation in concluding that this paragraph was applicable to a surrender of rights for value.

We understand that the reassessments of the taxpayers in the case at hand were based on the view that the Greiner decision was not applicable to their situation. This position was supported by informal consultations with the predecessor of this Directorate. The rationale for this position was that these taxpayers had not "surrendered" their rights under the stock option agreements as was done in the Greiner situation, rather, they had simply used or exercised their rights in a manner specifically contemplated by the agreement. In the notes on the file the view is expressed that to have "exercised" such rights is not to have "transferred or otherwise disposed of rights under the agreement", in the sense required by paragraph 7(1)(b) of the Act. This view would seem to be based on a restricted interpretation of the words "disposed of", used more or less as a synonym for "surrender". We have come to the conclusion that this term can be given broader scope.

Mr. Justice Stone, speaking for the Federal Court of Appeal in Greiner at 6078 stated that what is taxable under paragraph 7(1)(b) is "the benefit equal to the value of the consideration for the disposition". He went on to say that "I can find nothing in the language of s. 7(1)(b) to suggest that it was intended to be restricted in its application only to a transfer or other disposition of rights to a person other than the optionor". In the result, the Court did hold that paragraph 7(1)(b) could encompass the receipt of non-share (i.e., cash) consideration from the optionor himself (i.e., the employer) in return for a disposition of the employee's rights flowing from a stock option agreement. A surrender of such rights was held to be a disposition in Greiner. In the situation before us, the question therefore remains whether or not the use or exercise of rights in a manner specifically provided for in an agreement is a "disposition" with respect to those rights.

The Supreme Court of Canada considered the term "dispose of" in Compagnie Immobilière BCN Ltee 79 DTC 5068, wherein the following passage appears:

The verb "to dispose" has a very broad meaning; it is defined as follows in the Oxford English Dictionary (see To dispose of):

     b. to put or get (anything) off one's hands; to
        put away, stowaway, put in a settled state or 
        positions; to deal with (a thing) definitely;
        to get rid of; to get done with, settle, finish
        ...
        (emphasis added)

The trial level decision in Greiner, 81 DTC 5371 relied on the common ordinary meaning attributed to the expression "to dispose of" and cited the following dictionary meanings:

1. Jowitt Dictionary of English Law: Disposition comprehends every mode by which property can pass.

2. Oxford Illustrated Dictionary: To get off one's hands.

3. The Concise English Dictionary: To part with, to alienate, to put in another's hand or power; to get rid of.

4. The Living Webster Encyclopedic Dictionary: To part with; to alienate, to put into another's hand or power; to get rid of.

5. Funk and Wagnall's Standard Dictionary: To settle, to make over, to alienate.

Black's Law Dictionary (5th ed.) includes under the heading for "dispose of" such definitions as "... to exercise finally, in any manner, one's power of control over ... to bargain away ..." West's Law and Commercial Dictionary and the Canadian Law Dictionary both define the related term "disposal" in the following terms: "sale, pledge, giving away, use, consumption or any other disposition of a thing". We also note that the terms "disposition" and "dispose of" are partially defined elsewhere in the Income Tax Act in broad terms (although it is recognized that these definitions are not expressly stated as being applicable to section 7 of the Act). We refer for example, to paragraphs 54(c) and 13(21)(c), the latter of which states that a "disposition of property includes any transaction or event entitling a taxpayer to proceeds of disposition". Paragraph I of IT-460 states that "a disposition can generally be regarded as an event or transaction where possession, control and all other aspects of property ownership are relinquished". A valuable right under a stock option agreement - whether to receive shares or cash - is clearly property.

In the situation under consideration it would appear that there are (at least) two ways of looking at the transaction. First, we might consider the taxpayers to have exercised their right to a cash payment calculated under the agreement with reference to the increase in value of their employer's shares. Given the very broad interpretation which evidently must be given to the term "disposed of", it is likely that by so doing the taxpayers did indeed make a disposition with respect to their rights under the agreement to which paragraph 7(1)(b) would apply. The taxpayers had a specific right under what was (arguably?) an agreement by their employer to issue shares and they "traded it in" for the cash value to which it entitled them.

Alternatively, we might consider that the taxpayers were given an option to acquire shares under the agreement, but should they choose not to do so, the cash consideration they would receive in return for foregoing this right to acquire shares was expressly provided for under the terms of their agreement with the employer. Seen in this light, the transaction would not appear to differ greatly from a situation where rights to acquire shares were "surrendered" in return for cash payment, as was the case with the transaction considered by the Court in Greiner. The fact that the alternative course of action which was actually selected was specifically provided for in the terms of the agreement would not, it would appear, take the transaction out of the purview of paragraph 7(1)(b); indeed, given that the relevant provision of the Act does refer to "rights under the agreement", the situation under discussion might more readily be brought within paragraph 7(1)(b) than that which was considered by the Court in Greiner.

With respect to your comments to the effect that the position endorsed by this memorandum would require a change to paragraph 8 of IT-113R2 , we would respond as follows. The Bulletin states that:

A stock option agreement sometimes provides that an employer may elect to pay cash in lieu of issuing shares. Subsection 7(1) has no application where the employer so elects and, in such cases, the amount of cash received by the employee is taxable under subsection 5(1). [emphasis added]

In the situation under consideration in your file, the employee (see section 1 of the stock option agreement) was given the right to purchase shares at a specified option price. The employer could not refuse to issue shares and instead pay the employee in cash. Only if the employee decided to exercise the stock appreciation rights feature of the agreement (under section 5) would the right or ability of the employee to receive the value of his rights under the agreement in the form of shares, rather than cash, be subject to the consent of the employer. On this basis, we would distinguish the case at hand from that considered by the Bulletin. Given the terms of section 1 of the agreement, we would submit that, taken as a whole, the agreement did not give the employer the right to choose to pay cash rather than issue shares. The employee could always have acquired shares under the agreement - although we concede that, as a practical matter, there might be little incentive for him to go this route.

Furthermore, we would continue to maintain that where the election to pay cash rather than issue shares remains the employer's option, and the employer does elect to pay cash, subsection 7(1) is not applicable to the transaction for the reason that, in such a situation, the employer has not (necessarily) "agreed to sell or issue shares" as required by the words of the preamble to that subsection. Agreements structured in this manner would continue to be taxed pursuant to subsection 5(1) of the Act. However, where the election to receive shares or cash is left to the employee, the agreement of the employer to issue shares (should the employee so wish) would still be present.

In reviewing this matter, an underlying concern in our minds has been the possible impact of paragraph 110(1)(d) of the Act on similar stock arrangements arising after February 15, 1984 in the event that we conclude that an employee receiving such stock appreciation rights in cash has received a subsection 7(1) benefit. We sought the views of the Department of Finance on this subject and have attached a copy of their reply for your reference. Finance evidently has no objections to the deduction in paragraph 110(1)(d) being available with respect to subsection 7(1) benefits arising from the disposition of rights under a stock option agreement, unless it is apparent on the face of the agreement - and, we would submit, having regard to all of the surrounding circumstances - that the parties never truly contemplated the issuance of shares under the agreement. In examining the terms of the stock option agreement and the other documentation on this particular file, we could not conclude that there was never any intention to issue shares under the agreement. Appeals Branch may wish to consider if they are aware of any facts or circumstances in the case at hand which would lead to a different conclusion. However, we would add that our current view with respect to paragraph 110(1)(d) is that this deduction should indeed only be available where the subsection 7(1) benefit received by the employee is actually in the form of shares. We note that subparagraph 110(1)(d)(ii) stipulates that "the share is a prescribed share at the time of its sale or issue, as case may be," In our opinion, in order for the deduction in paragraph 110(1)(d) to be available in the case of non-share (i.e., cash) benefits under subsection 7(1), the subparagraph cited above would have to read: "the share is or would be a prescribed share .. " as was in fact stated in this subparagraph (with reference to "qualifying shares") prior to its most recent amendment. This issue is currently the subject of discussion with Current Amendments.

Finally, we would refer to the issue of the deductibility of cash payments made by an employer company to discharge its obligations pursuant to a stock option agreement with its employees. In our view, paragraph 7(3)(b) of the Act would not apply to deny a deduction in computing the company's income for the year. We cannot read that paragraph as having any application to benefits other than those conferred on employees by the sale or issue of shares. We disagree in this respect with the view suggested by the Department of Finance in the attached memorandum (see the third paragraph of the second page) that subsection 7(3) would deny a deduction to the corporation pursuant to section 9 and paragraph 18(1)(a) of the Act in all cases where the amount in question was deemed to be a benefit to an employee under subsection 7(1) of the Act.

We hope this will be of assistance. Your files are returned herewith.

DRIGINAL SIGNED BY ORIGINAL SIGNÉ PAR

P.D. FUOCO

for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch