REASONS
FOR JUDGMENT
C. Miller J.
[1]
Mr. Donald Fettes was an employee of
USFWatergroup, Inc., later known as Watergroup Companies Inc. He was granted
stock options for shares in a related company, Culligan Ltd., on December 30,
2004 and February 10, 2005. In these two Option Agreements the option price was
$10 per share for 10,000 shares and 45,000 shares respectively, valued at that
time at the same $10 per share. In 2008, Mr. Fettes exercised options for
41,250 shares that had vested at an exercise or strike price of $2.02 per
share: the shares had a fair market value at that time of $8.05. The Minister
of National Revenue (the “Minister”) applied
section 7 of the Income Tax Act (the “Act”)
to bring into Mr. Fettes’ 2008 income, as a benefit of employment, an amount
substantially equal to the value of the shares less the amount paid for them
($8.05 - $2.02). No amount was deducted from income pursuant to paragraph
110(1)(d) of the Act. Mr. Fettes appeals on the basis that he is
entitled to a deduction, pursuant to paragraph 110(1)(d) of the Act
in 2008 of half the benefit brought into income, because he met the three
requirements of that paragraph:
i.
The shares were common shares.
ii.
He was at arm’s length with his employer and the
issuer of the shares.
iii.
The amount payable under the option agreement
was not less than the fair market value of the shares at the time the
agreements were made.
[2]
The Respondent concedes the first two points but
argues that because the exercise or strike price was reduced to $2.02 from
$10.00, Mr. Fettes does not meet this third requirement.
[3]
Initially this case raised a number of issues
but the above is a distillation of where the Parties were left at trial. I am
therefore only going to review those facts that relate directly to the sole
issue of whether the circumstances of Mr. Fettes’ options meet the
requirements in paragraph 110(1)(d) of the Act, in particular
that the amount payable by Mr. Fettes to acquire the shares under the agreement
is not less than the fair market value of the shares at the time the agreement
was made.
[4]
Mr. Fettes was, in 2004 and until dismissed in
2008, an executive of Watergroup Companies Inc. governed by an employment
agreement of September 30, 1997 between himself and what was then known as
USFWatergroup, Inc. I will simply refer to the Watergroup companies as (“Watergroup”). Through various acquisitions and
changes of control since 1998, by 2004 Watergroup was a subsidiary of Culligan
of Canada Ltd., part of the Culligan group of companies, including a Bermuda
company, Culligan Ltd. The Culligan companies, like Watergroup, were in the
water treatment related business, though operated as separate businesses.
Culligan Ltd. and Watergroup did not deal at arm’s length.
[5]
Mr. Fettes provided advice to the Culligan
group. He was invited to acquire 5,000 Culligan Ltd. common shares, and flowing
from that, to participate in the Culligan Ltd. Stock Incentive Plan.
[6]
Pursuant to an Employee Stock Option Plan
entered on December 30, 2004, Culligan Ltd. granted Mr. Fettes an option to
purchase 10,000 common shares of Culligan Ltd. for an exercise price of $10 per
share. Similarly, on February 10, 2005, there was a further grant of an option
of 45,000 common shares at $10 per share. Pursuant to these agreements the
shares would vest over a four year period in four equal instalments. The fair
market value of the shares at the time of these agreements was $10 per share.
By August 8, 41,250 option shares had vested.
[7]
Mr. Fettes’ counsel stressed the importance of
section 4 of the Employee Stock Option Agreement so I will reproduce portions
of it:
(a) General. Subject to such reasonable
administrative regulations as the Board may adopt from time to time, the
Employee may exercise vested Options by giving at least 15 business days prior
written notice to the Secretary of the Company specifying the proposed date on
which the Employee desires to exercise a vested Option (the “Exercise Date”), the number of whole shares with
respect to which the Options are being exercised (the “Exercise
Shares”) and the aggregate Option Price for such Exercise Shares
(the “Exercise Price”); … Unless otherwise
determined by the Board, and subject to such other terms, representations and
warranties as may be provided for in the Employee Stock Subscription Agreement,
(i) on or before the Exercise Date the Employee shall deliver to the Company
full payment for the Exercise Shares in United States dollars in cash, or cash
equivalents satisfactory to the Company, in an amount equal to the Exercise
Price plus any required withholding taxes or other similar taxes, charges or
fees and (ii) the Company shall register the issuance of the Exercise Shares in
the name of the Voting Trustee, pursuant to the Voting Trust Agreement, on its
records (or direct such issuance to be registered by the Company’s transfer
agent).
[8]
Mr. Fettes’ employment with Watergroup was
terminated on July 15, 2008, effective August 1, 2008. He was advised by Mr.
Seales, the CEO, by letter of July 15, 2008, that the company would assist Mr.
Fettes in exercising his vested options to buy shares. This letter was followed
by an email from a paralegal with Culligan, Amy McLean, attaching an Option
Exercise Stock Subscription Agreement, setting out the withholding calculations
and requesting a cheque for $46,866.02 U.S. (representing an exercise price of
$2.02 per share for 23,201.01 shares). This arises from the following
withholding calculation provided by Ms. McLean:
[9]
In considering exercising the options, Mr.
Fettes requested some information from Culligan and was provided with a sheet
called Culligan Ltd. Stock Incentive Plan – Equity Summary – Example, which I
attach as Schedule A to these Reasons.
[10]
I note in the bottom chart of the attached
Schedule A that on May 28, 2007, the strike price was shown as $2.02,
presumably having fallen to that amount due to the effect of what the chart
shows as a cash bonus paid on that date. Mr. Fettes, the only witness, could
offer no explanation regarding the circumstances surrounding this reduction in
the exercise price established in the original Stock Option Agreements. He paid
the $46,866.02 U.S. requested, exercising his options.
[11]
Mr. Fettes signed the Option Exercise Stock
Subscription Agreement in September 2008, though never received a signed copy
back from Culligan Ltd. This Agreement stipulated in Section 1 (a):
In General. Subject to all of the terms of this Agreement, at the Closing, the
Former Employee shall purchase, and the Company shall sell, the aggregate
number of Common Shares set forth on the signature page hereof (the “Shares”), at a purchase price of $2.02 per Share,
pursuant to the Former Employee’s exercise of Options.
[12]
The Agreement also stipulated the shares could
not be sold back to the company for at least six months. In early 2009,
Mr. Fettes did sell the 23,201 shares back to the company for $5.00 per share,
reflected in section 2 of a Stock Purchase Agreement:
Share Purchase
Price. The Company and the Stockholder agree that
the purchase price for the Shares shall be US $116,005.00 (the “Purchase Price”). The Company and the Stockholder
acknowledge and agree that the Purchase Price is equal to the number of Shares
multiplied by their Fair Market Value of $5.00 per Share (as defined in the
Culligan Ltd. Stock Incentive Plan) as of the date of this Agreement.
[13]
Mr. Fettes testified that after his termination
in 2008 his relationship with Culligan and Watergroup deteriorated
significantly: lengthy litigation ensued. In early 2009, Mr. Fettes received a
T4 from Watergroup setting out his remuneration including his salary and a
severance payment of $458,856. There was no mention of any benefit arising from
the exercise of the options. The Respondent provided an affidavit of a Canada
Revenue Agency (“CRA”) officer attaching a copy
of a CRA screen print out indicating an amended T4 had been received from
Watergroup, and that Mr. Fettes’ income was $692,620 ($233,764 greater than the
original T4). Mr. Fettes never received a copy of an amended T4.
[14]
On examination for discoveries the Respondent’s
representative indicated that no paragraph 110(1)(d) of the Act
deduction was provided as the amended T4 did not report Mr. Fettes’ entitlement
to such in box 39 of the T4 form.
Legislation
[15]
Parts of Section 7 of the Act read as
follows:
(1) Subject
to subsection (1.1), where a particular qualifying person has agreed to sell or
issue securities of the particular qualifying person (or of a qualifying person
with which the particular qualifying person does not deal at arm’s length) to
an employee of the particular qualifying person (or of a qualifying person with
which the particular qualifying person does not deal at arm’s length),
(a) if the employee has acquired securities under the
agreement, a benefit equal to the amount, if any, by which
(i) the
value of the securities at the time the employee acquired them
exceeds the total
of
(ii) the amount paid or to be paid to the particular
qualifying person by the employee for the securities, and
(iii) the amount, if any, paid by the employee to acquire the
right to acquire the securities
is deemed to have
been received, in the taxation year in which the employee acquired the
securities, by the employee because of the employee’s employment;
…
(1.4) Where
(a) a taxpayer disposes of rights under an agreement referred
to in subsection (1) to acquire securities of a particular qualifying person
that made the agreement or of a qualifying person with which it does not deal
at arm’s length (which rights and securities are referred to in this subsection
as the “exchanged option” and the “old securities”, respectively),
(b) the taxpayer receives no consideration for the
disposition of the exchanged option other than rights under an agreement with a
person (in this subsection referred to as the “designated person”) that is
(i) the
particular person,
(ii) a qualifying person with which the particular person does
not deal at arm’s length immediately after the disposition,
(iii) a corporation formed on the amalgamation or merger of
the particular person and one or more other corporations,
(iv) a mutual fund trust to which the particular person has
transferred property in circumstances to which subsection 132.2(1) applied,
(v) a qualifying person with which the corporation referred
to in subparagraph (iii) does not deal at arm’s length immediately after the
disposition, or
(vi) if the disposition is before 2013 and the old securities
were equity in a SIFT wind-up entity that was at the time of the disposition a
mutual fund trust, a SIFT wind-up corporation in respect of the SIFT wind-up
entity
to acquire
securities of the designated person or a qualifying person with which the
designated person does not deal at arm’s length (which rights and securities
are referred to in this subsection as the “new option” and the “new
securities”, respectively), and
(c) the
amount, if any, by which
(i) the total value of the new securities immediately after
the disposition
exceeds
(ii) the total amount payable by the taxpayer to acquire the
new securities under the new option
does not exceed
the amount, if any, by which
(iii) the total value of the old securities immediately before
the disposition
exceeds
(iv) the amount payable by the taxpayer to acquire the old
securities under the exchanged option,
for the purposes
of this section,
(d) the taxpayer is deemed (other than for the purposes of
subparagraph (9)(d)(ii)) not to have disposed of the exchanged option and not
to have acquired the new option,
(e) the new option is deemed to be the same option as, and a
continuation of, the exchanged option, and
(f) if the designated person is not the particular person,
the designated person is deemed to be the same person as, and a continuation
of, the particular person.
…
[16]
At the relevant time subparagraphs 110(1)(d)(i)
and (ii) of the Act read:
110(1) For the purpose of computing the taxable income of a
taxpayer for a taxation year, there may be deducted such of the following
amounts as are applicable
(d) an amount equal to 1/2 of the amount of the benefit deemed
by subsection 7(1) to have been received by the taxpayer in the year in respect
of a security that a particular qualifying person has agreed after February 15,
1984 to sell or issue under an agreement, or in respect of the transfer or
other disposition of rights under the agreement, if
(i) the security
(A) is a prescribed share at the time of its sale or issue, as
the case may be,
(B) would have been a prescribed share if it were issued or
sold to the taxpayer at the time the taxpayer disposed of rights under the
agreement,
(C) would have been a unit of a mutual fund trust at the time
of its sale or issue if those units issued by the trust that were not identical
to the security had not been issued, or
(D) would have been a unit of a mutual fund trust if
(I) it were issued or sold to the taxpayer at the time the
taxpayer disposed of rights under the agreement, and
(II) those units issued by the trust that were not identical
to the security had not been issued,
(ii) where rights under the agreement were not acquired by
the taxpayer as a result of a disposition of rights to which subsection 7(1.4)
applied,
(A)
the amount payable by the taxpayer to acquire
the security under the agreement is not less than the amount by which
(I)
the fair market value of the security at the
time the agreement was made
exceeds
(II)
the amount, if any, paid by the taxpayer to
acquire the right to acquire the security, and
(B)
at the time immediately after the agreement was
made, the taxpayer was dealing at arm’s length with
(I)
the particular qualifying person,
(II)
each other qualifying person that, at the time,
was an employer of the taxpayer and was not dealing at arm’s length with the
particular qualifying person, and
(III)
the qualifying person of which the taxpayer had,
under the agreement, a right to acquire a security, and
…
Issue
[17]
Is Mr. Fettes entitled to a deduction pursuant
to paragraph 110(1)(d) of the Act, specifically, was the amount
payable by him to acquire the shares under the agreement not less than the fair
market value of the shares at the time the agreement was made? So, what was the
amount payable by Mr. Fettes to acquire the shares under the agreement: if it
was $10 per share he is eligible for the paragraph 110(1)(d) of the
Act deduction; if it was $2.02 per share he is not eligible for the
deduction.
[18]
Mr. Fettes’ counsel argues I can only look to
the original agreement which stated the option price was $10. The Respondent’s
counsel argues that the agreement was amended to reflect an option price of
$2.02 and that was the amount payable under the agreement.
[19]
I had asked the Parties to consider whether
subsection 7(1.4) and subparagraph 110(1)(d)(iii) of the Act were
applicable. They provided submissions agreeing that subsection 7(1.4) of the Act
was not in play as there had been no disposition of rights under the original
Stock Option Agreement. I will therefore not pursue this avenue of
analysis further.
[20]
The Respondent emphasized the time to determine
whether the amount payable under the agreement is the time of the agreement.
Clearly, the original agreement stipulated an exercise price of $10 per share,
and at that time the shares were valued at $10 per share. The condition of
clause 110(1)(d)(ii)A of the Act is therefore met argues the
Appellant. But equally clearly, the agreement was at some point altered to
reflect an exercise price of $2.02 per share. That was the price ultimately
paid by Mr. Fettes. The evidence indicates that amount was less than the fair
market value at the time of the original agreement and also less than the fair
market value at the time of the exercise of the options at $2.02. I also
find that the $2.02 was less than the fair market value at the time there was
an agreement that the exercise price would be $2.02.
[21]
The original written Stock Option Agreement
defines the option price as $10 and goes on in section 4 to define the exercise
price as the aggregate option price. That was not however the actual price
paid, so how can it be said that it is the original agreement under which Mr.
Fettes acquired the shares? The Appellant argues that section 4 describes the
process for exercising the options and provides flexibility for a change in
price. I disagree with the Appellant that this somehow sets the $10 per share
price in stone so that parties could simply change the price and still take
advantage of paragraph 110(1)(d) of the Act, affording capital
gains treatment. No, the agreement under which Mr. Fettes acquired the shares
to which subsection 7(1) of the Act applies could only have been an
agreement at an option price of $2.02. There is no written agreement to that
effect, nor any detailed explanation of how or when the option price changed to
$2.02, but clearly it did.
[22]
A repricing of the agreement occurred, and it is
the repriced option agreement that was exercised.
[23]
It makes no sense to me from a policy
perspective that an option agreement set at a price equal to fair market value
can willy-nilly be altered to a price less than the fair market value and still
claim it reflects a policy to provide an incentive to an employee: there is no
future incentive - the employee is receiving an immediate benefit. To suggest
treating it otherwise would open the floodgates to abusive tax planning with a
written agreement stipulating one thing and reality dictating another. I am not
for an instant suggesting that is the case with Mr. Fettes. He presented
as an honest, straightforward individual caught in the tangled web of
complicated tax legislation.
[24]
In summary, I interpret the term “agreement” in clause 110(1)(d)(ii) of the Act
to refer to the agreement Mr. Fettes had to acquire shares at $2.02 per share,
a price less than the fair market value of the shares at the time of the
original agreement, at the time of the repricing and at the time of the
exercise. In these circumstances, the benefit Mr. Fettes realized pursuant to
subsection 7(1) of the Act is not the type of benefit contemplated by
paragraph 110(1)(d) of the Act that effectively provides capital
gains treatment to the recipient of the benefit. It was simply an employment
benefit to be brought into income.
[25]
The Appellant goes on to argue that if I find
Mr. Fettes has an employment benefit then the amount has been incorrectly
calculated by CRA. CRA relied on the amended T4 filed by Watergroup, which
indicated additional income of $233,765 with an increase in tax deducted of
$102,250. Yet, the withholding analysis by Culligan (see paragraph 8 of these
Reasons) suggests the withholding of US $108,830. There was no evidence of what
Culligan actually remitted to the CRA. While I agree with the Appellant that
this raises some question as to the accuracy of the numbers relied upon by the
Respondent, the Appellant has not been able to provide me with any accurate
alternative. In these circumstances, I am not prepared to accept the
Appellant has demolished the Minister’s assumptions.
[26]
The Appeal is dismissed with costs to the
Respondent.
Signed at Ottawa, Canada,
this 6th day of August 2015.
“Campbell J. Miller”
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