20 January 1994 External T.I. 9400755 - EBP'S, EPSP'S, DPSP'S AND SECTION 7

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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

RULINGS DIRECTORATE
CORRESPONDENCE SUMMARY

Principal Issues:

Whether section 7 applies to EPSP, EBP or DPSP where plan investments in treasury shares take place.

Position TAKEN:

Section 7 does not apply to DPSP; it will apply to EPSP and EBP's where employer contributions are invested in treasury shares.

Reasons FOR POSITION TAKEN:

See Review Committee submission 930689.

XXXXXXXXXX 940075

Attention: XXXXXXXXXX

January 20, 1994

Dear Sirs:

Re: Paragraph 6(1)(a); Subsection 7(1); Section 144 of the Income Tax Act (the "Act"); ATR-17

Impact of: Placer Dome Inc. v. The Queen
MNR v. Chrysler Canada Ltd. et al.

By facsimile transmission of February 25, 1993, you wrote to us concerning the above-noted matter and requested our views. We have now completed our study of the cases and their impact on the interpretation of section 7, section 144, section 147, and the Act's provisions respecting employee benefit plans. Our comments follow.

EMPLOYEE BENEFIT PLANS

Our position concerning these plans has not changed as a result of the above-mentioned cases. As discussed in ATR-17, if employer contributions can only be used to purchase, on the open market, employer's shares or shares of a corporation with which it does not deal at arm's length ("employer shares"), then section 7 of the Act will not apply and a deduction under subsection 32.1(1) of the Act will be allowed. A hybrid plan under which employee contributions will be used to purchase employer treasury shares and employer contributions used for employer shares sold on the open market will be considered an "employee benefit plan" within the meaning of subsection 248(1) of the Act.

EMPLOYEES PROFIT SHARING PLANS

We intend to treat employees profit sharing plans (EPSP's) in the same manner as employee benefit plans. That is, if employer contributions can be used to purchase treasury shares, section 7 of the Act will apply and the employer will be denied a deduction pursuant to paragraph 7(3)(b) of the Act.

You provided several arguments as to why an EPSP should only be subject to section 144 of the Act. Our analysis of the issues follows. (Note the discussion of the taxation of employer and employee is general and not intended to be comprehensive.)

An EPSP is a profit sharing plan set up to benefit employees, but the employer contributions, property income, and capital gains and losses of the plan are taxable in the employees' hands each year as they arise. Accrued gains may, upon election by the trustee, also be allocated. If the employee forfeits an amount already allocated, there is a tax credit of 15% awarded in the year of forfeiture. (Proposed amendments would provide the employee a deduction equal to the amount previously included in income.) There is a flow-through of the income type so that the capital gains deduction, foreign tax deduction and dividend tax credit can be claimed by the employees. The employer is entitled to a deduction for the year for all contributions, but the employee contributions, if any, are non-deductible.

There are no restrictions on the type of investments which can be made by an EPSP; the total of the plan property could, therefore, be invested in employer shares.

An employees profit sharing plan may be structured as a profit sharing plan but have as a purpose the sale or issuance of employer shares. An employees profit sharing plan is not subject to special taxing provisions that give preferential treatment to the receipt of employer shares by the employee (as compared, for example, to a deferred profit sharing plan - see below). In an EPSP there is immediate taxation and no special deduction relating to employer shares. If the employer were a Canadian-controlled private corporation (CCPC), taxation under section 144 would be especially detrimental to the employee - the tax deferral under subsection 7(1.1) would be inapplicable. There is no apparent tax reason an EPSP set up to purchase employer shares at a discount cannot be treated as a section 7 stock option plan.

In our view, an EPSP can be structured to be an agreement by an employer to sell or issue shares, and in such circumstances section 7 of the Act would be more specific than section 144 of the Act in its application.

DEFERRED PROFIT SHARING PLANS

A deferred profit sharing plan (DPSP) will be subject only to section 147 of the Act and section 7 will not apply. Our analysis on this topic is as follows.

A DPSP is a plan registered by the Department pursuant to section 147 which is an arrangement under which an employer makes contributions based on its profits or profits from a non-arm's length corporation to a trustee for the benefit of the employees.

DPSP's are subject to the qualified investment rules contained in paragraph 204(e) of the Act and sections 4900 through 5103 of the Income Tax Regulations. Several of these rules would permit a DPSP investment in employer shares (e.g. subparagraphs 204(e)(iv), (vi) and (ix) of the Act) and at least one arguably permits the acquisition of treasury shares (subparagraph 204(e)(vi) of the Act).

There is specific recognition in the Act that an employee can receive employer shares under a DPSP and provision for the deferral of capital gains until disposition of those shares by the employee (subsections 147(10.1), (10.2) and (10.5) of the Act).

Although the scheme of a DPSP must be an arrangement to let the employees share in the profits of an employer or related corporation, there is nothing to prohibit an additional purpose of such an arrangement as being the sale of issue of employer shares to the employee. (For plans registered after 1990, no employee contributions are permitted and, therefore, no "sale" of shares can occur under these plans.) Thus, a DPSP can accommodate the definitions in both sections 147 and 7 of the Act. Applying the reasoning in Chrysler, a DPSP which has as a goal the issuing of shares to employees should be treated as a stock option plan unless section 147 can be considered more specific.

Once registered, a DPSP, the contributing employer, and the employee beneficiaries, are subject to tax consequences unique to this type of plan and, in particular, employees are provided a special election respecting the deferral of capital gains tax on receipt of employer shares to the date the shares are disposed of. Furthermore, the section 110 deduction of 25% is available for all types of shares received under a DPSP; section 7 of the Act only defers the taxation of the employee to the date the employee disposes of or exchanges the shares if the employer is a CCPC. In addition, the section 110 deduction respecting stock option plan shares is limited to CCPC shares held for at least two years or non-CCPC fully-participating common shares purchased at fair market value established on the date the option is granted. This special treatment for employer shares received under a DPSP supports the conclusion that, even if a DPSP can be considered primarily "an agreement to issue shares", the treatment under section 147 of the Act is more specific and, therefore, paramount to the section 7 provisions.

Aside from providing a specific treatment of shares, the rules respecting DPSP's are part of the greater retirement income provisions which also govern registered pension plans and registered retirement savings plans. The operation of DPSP's is subject to the comprehensive and complex rules which ensure that employers and employees receive similar tax treatment no matter the retirement scheme to which they belong. Where a profit sharing plan combines aspects of both a stock option plan and a retirement income plan, the purpose of the Income Tax Act is best served by applying section 147 in preference to section 7.

Although the foregoing comments are not binding on the Department, we trust they satisfactorily explain our position on these matters.

Yours truly,

for Director
Financial Industries Division
Rulings Directorate