4 July 2001 External T.I. 2001-0076255 - EMPLOYEE TRUST - VARIOUS QUESTIONS

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.

Principal Issues: Various questions relating to employee trusts, stock options, and qualified small business corporation shares

Position: General comments provided

Reasons: The Act

XXXXXXXXXX 2001-007625
A. Campbell
July 4, 2001

Dear XXXXXXXXXX:

Re: Employee Trusts

This is in your reply to your letter of March 12, 2001, wherein you requested our comments on various questions relating to the establishment of Employee Trusts. Your letter seems to involve proposed transactions for one or more specific taxpayers. As explained in Information Circular 70-6R4, it is not this Directorate's practice to comment on proposed transactions involving specific taxpayers other than in the form of an advance income tax ruling submitted in accordance with the criteria set out in the Information Circular. However, we are prepared to offer the following general comments which may be of assistance.

"Employee Trust" is a term defined in subsection 248(1) of the Income Tax Act (the "Act") and there are special rules in the Act that apply to trusts that qualify as Employee Trusts. We have attached a copy of Interpretation Bulletin IT-502 "Employee Benefit Pans and Employee Trusts" which will provide you with general information on the criteria a trust must meet to qualify as an Employee Trust for the purposes of the Act, as well as the special provisions in the Act that apply to Employee Trust situations. Specifically, we would direct you to the following:

a) Paragraph 34 of IT-502 explains the criteria for a trust to qualify as an "Employee Trust" for the purposes of the Act. Among the criteria is the requirement that payments be made by an employer to a trustee in trust for the sole benefit of employees or former employees of the employer or employees or former employees of a person who does not deal at arm's length with the employer. It is our view that where a person other than an employee or former employee of either the employer or a person not at arm's length with the employer, is a beneficiary of the trust, the trust would generally not qualify as an Employee Trust for the purposes of the Act.

b) Paragraph 34 of IT-502 states the requirement that the trustee must allocate a certain amount annually to beneficiaries. The amount is set out in the definition of Employee Trust in subsection 248(1) of the Act and is discussed in paragraph 37 of IT-502.

c) Paragraph 38 of IT-502 explains the taxation of amounts related to an Employee Trust in the hands of the employee/beneficiaries. The amount allocated annually by the trustee as described in paragraph 37 of IT-502, is taxed as employment income pursuant to paragraph 6(1)(h) of the Act.

d) As noted in subparagraph 47(c) of IT-502, the definition of "trust" in subsection 108(1) of the Act provides that sections 105 to 107 of the Act, which deal with benefits under trusts and transactions involving interests in trusts do not apply to employee trusts. Section 107.1 of the Act specifically deals with distributions by an employee trust to a person who is a beneficiary under the trust in satisfaction of all or part of that person's interest in the employee trust. As described in paragraph 39 of IT-502, paragraph 107.1(1)(a) of the Act, provides that the employee will be considered to have acquired the property from the trust at a cost amount equal to the fair market value of the property at the time of distribution and pursuant to paragraph 107.1(1)(c) of the Act the employee will be considered to have disposed of his or her interest in the trust for an amount equal to the adjusted cost base of the interest such that no gain or loss results on the disposition of the interest.

e) As stated in paragraph 49 of IT-502, the Act does not restrict the investments that an employee trust may acquire. Therefore, the ownership of options to acquire shares of a corporation would not, in and of itself, preclude a trust from qualifying as an "employee trust" for the purposes of the Act.

Your letter contained several questions dealing with options to acquire shares of a private corporation. In this regard, we have enclosed two interpretation bulletins for your reference. Interpretation Bulletin IT-96R6 "Options Granted by Corporations to Acquire Shares, Bonds, or Debentures and by Trusts to Acquire Trust Units" covers income taxation issues related to amounts paid or received for the granting and exercising of options on capital account. The income tax issues related to an option or share acquired by an employee under an agreement by the corporation to sell or issue securities of itself or another corporation with which it does not deal at arm's length to employees, are addressed in Interpretation Bulletin IT-113R4 "Benefits to Employees - Stock Options".

You also raised several questions regarding availability of the capital gains exemption under subsection 110.6(2.1) of the Act, in respect of shares of an employer corporation held by an Employee Trust for the benefit of the employees. As noted in paragraphs 37 and 38 of IT-502, the income allocated to the beneficiaries of an Employee Trust by the trustee, in accordance with the income formula set out in the definition of Employee Trust in subsection 248(1) of the Act, is included in the income of the employee beneficiaries as income from an office or employment by virtue of paragraph 6(1)(h) of the Act. The income allocated from the Employee Trust, does not retain its character as realized by the Employee Trust (e.g. dividends, capital gains, etc.). Furthermore, subsection 110.6(2.1) of the Act, which is the provision that permits the deduction in respect of capital gains on QSBC shares under certain circumstances, does not apply to trusts. Accordingly, it is our view that the Employee Trust would not be able to claim a capital gains exemption in respect of a taxable capital gain realized by it on the disposition of QSBC shares in determining the allocation of income to beneficiaries, nor would the beneficiaries be considered to have realized a taxable capital gain from the disposition of QSBC shares, against which they could personally claim a deduction under subsection 110.6(2.1) of the Act.

Where shares of a corporation have been distributed to an employee from an employee trust, the employee may be able to claim a deduction under subsection 110.6(2.1) of the Act, provided the shares are QSBC shares at the time they are disposed of by the employee. The definition of "qualified small business corporation share" in subsection 110.6(1) outlines the conditions that must be satisfied for a share to be a QSBC share. It will be a question of fact whether the conditions are met in any particular case. The fact that an employee has received a share of a corporation from an employee trust as a consequence of the employee being a beneficiary of the employee trust, will not in and of itself disqualify the share from being a QSBC share. The share could still qualify as a QSBC share provided it meets all of the following conditions:

a) at the time of sale by the employee, it was a share of the capital stock of a small business corporation, and it was owned by the employee, his or her spouse, or a partnership of which he or she was a member (the definition of small business corporation is found in subsection 248(1) and would not include a public corporation);

b) throughout the 24 months immediately before the share was disposed of, no one other than the employee, or a person or partnership related to the employee owned the share; and

c) throughout that part of the 24 months immediately before the share was disposed of, while the share was owned by the employee, or a person or partnership related to the employee, it was a share of a Canadian-controlled private corporation and more than 50% of the fair market value of the assets of the corporation were:

• used mainly in an active business carried on primarily in Canada by the Canadian-controlled private corporation, or by a related corporation;
• certain shares or debts of connected corporations; or
• a combination of these two types of assets.

The foregoing comments represent our general views with respect to the subject matter. As indicated in paragraph 22 of Information Circular 70-6R4, the above comments do not constitute an income tax ruling and accordingly are not binding on the Canada Customs and Revenue Agency.

Yours truly,

F. Lee Workman
Manager
Financial Institutions Section
Income Tax Rulings Directorate
Policy and Legislation Brach