29 July 2016 Internal T.I. 2015-0600941I7 - Share Based Deferred Compensation - 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.

Principal Issues: Are various types of share based compensation plans subject to section 7 of the Act? If so, will paragraph 7(3)(b) apply to deny the employer a deduction?

Position: Question of fact, depends on whether an agreement to issue shares exists for purposes of section 7. If section 7 applies, in general, paragraph 7(3)(b) will apply to deny an employer a deduction in respect of the agreement.

Reasons: If the share based compensation plan creates an agreement where an employer has a legally binding obligation to issue shares of the employer to an employee and the employee has an enforceable right to be issued the shares, the provisions of section 7 will apply. As a result, in general, the provisions of 7(3)(b) will apply.

						July 29, 2016

	XXXXXXXXXX				Income Tax Rulings Directorate
						G. Allen
	XXXXXXXXXX TSO			(613) 670-9051

						2015-060094

XXXXXXXXXX (“Canco”) - Equity Based Compensation Plans

We are writing in response to your memo concerning the audit of the equity-based compensation plans offered to employees of Canco and the employees of XXXXXXXXXX. We have reviewed your memo, the documentation enclosed with your memo and the documentation attached in your email of October 6, 2015. Our comments, which also apply in respect of XXXXXXXXXX, are provided below.

Unless otherwise stated in this memo, all references in this memo to a statute are to the Income Tax Act (Canada), R.S.C. 1985, c. 1 (5th Suppl.), as amended to the date of this memo.

Facts

Our understanding of the relevant facts is as follows:

• Canco is a subsidiary of XXXXXXXXXX (“USco”).
• The USco XXXXXXXXXX (the “Plan”) provides various types of equity-based compensation to employees of Canco.
• One of the purposes of the Plan is to encourage ownership of USco’s stock by employees of USco, its subsidiaries and affiliates.
• The Plan provides awards of Deferred Stock, Restricted Stock, Performance Shares, Stock Appreciation Rights and Stock Options.
• The Plan provides for common shares of USco to be issued to employees of Canco in respect of the awards granted under the Plan.
• The USco XXXXXXXXXX (“ESPP”) is also available to Canco employees.
• Canco is billed by USco for the costs incurred by USco in connection with the common shares issued at a discount to Canco’s employees.
• Canco has claimed deductions in respect of the reimbursement payments that Canco is required to make to USco.

Taxpayer’s Position

Canco takes the position that the decision in Transalta Corporation v. The Queen (2012 TCC 86) (Transalta) applies, as in Canco’s view, a legally binding agreement to issue shares does not exist for purposes of section 7 and therefore, paragraph 7(3)(b) does not apply to deny Canco a deduction in respect of the reimbursement payments.

Audit’s Position

In general, Audit’s position is that despite the Transalta decision, previous jurisprudence from higher level courts concerning what constitutes an “agreement”, in the context of section 7, provides support to deny the deductions claimed by Canco in respect of the reimbursement payments to USco.

Summary of Transalta

• Transalta had a share bonus plan.
• At the beginning of each 3-year period, Transalta advised each participating employee of the maximum number of shares that could be earned as a bonus for the period.
• Transalta determined at the end of the period the number of shares earned and whether the bonus would be paid in the form of shares issued from treasury or the cash equivalent.
• Payment of the bonus and the form of payment were entirely at the discretion of Transalta.
• Once Transalta determined that an employee was entitled to a bonus, Transalta then decided how to satisfy the bonus either by issuing shares from treasury or by paying the equivalent in cash.
• The employee had no rights to require payment be made in shares.
• The TCC concluded that Transalta’s stock bonus plan was not an “agreement” to sell or issue securities to employees as contemplated by section 7 and therefore paragraph 7(3)(b) had no application. The plan was explicitly discretionary and no legal rights or obligations were created by it.

Our Comments

It is our view that Transalta confirms previous case law (footnote 1) that an arrangement to issue or sell shares need not be a detailed written contract to be subject to section 7, but nonetheless the arrangement must create legally binding rights and enforceable obligations. A discretionary arrangement is not an agreement for purposes of section 7.

In determining whether section 7 has application to the various types of equity based compensation and the ESPP provided to the employees of Canco it is necessary to analyze the Plan and ESPP documentation. If the documentation supports the existence of an arrangement that creates a legally binding agreement and enforceable obligations section 7 will have application.

We are summarizing below the relevant features of each type of equity compensation based on the documentation you provided and have identified whether, in our view, the arrangement falls within the scope of section 7.

Deferred Stock Grants (section XXXXXXXXXX of Plan; Deferred Stock Agreement (“DSA”):

• Deferred Stock shall be evidenced by a DSA (XXXXXXXXXX)
• issue of shares is deferred until date specified in Plan and DSA (XXXXXXXXXX)
• shares of Deferred Stock shall be issued and delivered to Awardee (an employee) (XXXXXXXXXX)
• shares of Deferred Stock issued at end of 3 year deferral period (XXXXXXXXXX)
• DSA refers to employee’s right to sell/transfer their right to future issuance of Deferred Stock (XXXXXXXXXX)

Based on the above, it is our view that the DSA and Plan constitute an agreement to issue shares that falls within the scope of section 7 as USco appears to have a legal obligation to issue shares to a Canco employee and the employee appears to have a legal right to be issued USco shares. USco does not appear to have discretion concerning how to settle Deferred Stock Grants. Accordingly, in our view, paragraph 7(3)(b) should apply.

Restricted Stock (section XXXXXXXXXX of Plan):

• shares of Restricted Stock to be granted to Awardee (XXXXXXXXXX)
• the Committee shall direct that a share certificate be issued to Awardee as registered owner of the Restricted shares (XXXXXXXXXX)
• the share certificate shall either have restrictions or the certificate is to be deposited with USco with a stock power endorsed in blank
• once the restricted period is over the restrictions shall be removed or the shares delivered in respect of the number of Restricted shares granted to the Awardee (XXXXXXXXXX)

Although a specimen Restricted Stock Agreement was not part of the documentation provided, based on the above, it is our view that where the Restricted Stock Agreement conforms to the Plan requirements section 7 has application since USco appears to have a legal obligation to issue shares to a Canco employee and the employee appears to have a legal right to be issued USco shares. USco does not appear to have discretion concerning how to settle Restricted Stock. Accordingly, in our view, paragraph 7(3)(b) should apply.

Options (section XXXXXXXXXX of Plan; Non-Qualified Stock Option Agreement):

• the Options shall be evidenced by Option agreements (XXXXXXXXXX)
• a typical stock option arrangement where employee is given the right to acquire share at the exercise price specified (XXXXXXXXXX)
• the Non-Qualified Stock Option Agreement specifies when option may be exercised and the Option’s term (XXXXXXXXXX)
• the Awardee has right to acquire the number of shares at the option price specified in the letter attached to the Non-Qualified Stock Option Agreement (XXXXXXXXXX)

Based on the above, it is our view that the Plan and the Non-Qualified Stock Option Agreement constitute an agreement to issue shares that falls within the scope of section 7 as USco appears to have a legal obligation to issue shares to a Canco employee and the employee appears to have a legal right to be issued USco shares. USco does not appear to have discretion concerning how to settle the Option. Accordingly, in our view, paragraph 7(3)(b) should apply.

Stock Appreciation Rights (“SAR”)(section XXXXXXXXXX of Plan):

• the SAR provide a right to receive a payment in cash or shares, as selected by the Committee (XXXXXXXXXX)
• the right will be set forth in a Stock Appreciation Right agreement (XXXXXXXXXX),
• payment may be in cash, shares or in any combination, as the Committee shall determine (XXXXXXXXXX)

In our view, USco does not appear to have a legally binding obligation to issue shares under the SAR arrangement, nor would a Canco employee appear to have a legally enforceable right to require USco to issue shares to the employee. The issue of shares or payment in cash in satisfaction of the SAR is at the Committee’s complete discretion. Accordingly, Transalta will apply and paragraph 7(3)(b) will not apply to deny Canco a deduction.

Performance Shares (Performance Shares Deferred Stock Agreement (“PSDSA”):

• USco provides Awardee with the number of Performance Shares of Deferred Stock as specified in an award letter attached to the PSDSA that an Awardee may obtain (Target Shares) (XXXXXXXXXX)
• the Performance Shares are earned over a 3 year period based on Awardee’s performance
• after the 3 year period, the employer determines the total number of Performance Shares earned by the Awardee and at that point the appropriate number of shares of Deferred Stock are issued and delivered to the Awardee (XXXXXXXXXX)

Based on the PSDSA, section 7 has application as USco appears to have a legal obligation to issue shares to a Canco employee and the employee appears to have a legal right to be issued USco shares. USco does not appear to have discretion concerning how to settle Performance Shares. Accordingly, in our view, paragraph 7(3)(b) should apply.

XXXXXXXXXX (“ESPP”):

• the purpose of the ESPP is to provide employees with an opportunity to purchase shares of Common Stock by payroll deductions or direct payments during specified time periods. (XXXXXXXXXX)
• USco may make an Offering to an eligible employee to purchase shares of Usco (XXXXXXXXXX)
• the employee signs the Subscription Contract for purposes of participating in the Offering (XXXXXXXXXX)
• after a subscription under an Offering is fully paid, the employee will receive either a certificate, deposit into a book entry account or a brokerage account for the number of shares for which the employee has paid (XXXXXXXXXX)

When USco makes an Offering to an eligible employee to purchase shares of Common Stock of USco, in respect of the Offering, it would appear that USco is legally obligated to issue the number of shares subscribed for, provided the employee pays the full amount for the number of shares subscribed for in the Offering. Therefore, in our view, a legally binding agreement to issue shares for purposes of section 7 would appear to exist, and paragraph 7(3)(b) should apply.

We trust the above comments will be of assistance.

Lita Krantz, CPA, CA
Deferred Income Plans Section II
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

c.c. XXXXXXXXXX

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 MNR v Chrysler Canada Ltd (92 DTC 6346 and 91 DTC 5526); Placer Dome v Canada (92 DTC 6402); McNulty v. R. (2001 DTC 942)