23 October 1989 Income Tax Severed Letter RCT 7-4316

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.

The Employee Investment Act (British Columbia) (the "EIA") provides for the establishment of employee share ownership plans ("ESOP's") and employee venture capital plans ("EVCP's"). Under an ESOP, eligible employees of a corporation may acquire shares in that corporation or one of its affiliates. Under an EVCP, eligible investors (who must be employed individuals resident in British Columbia) may acquire shares in an Employee Venture Capital Corporation ("EVCC") that invests in other corporations meeting prescribed criteria as to size or extent of operations. You have asked us to review the EIA and to comment on the following issues:

• a) whether the costs of setting up plans under the EIA would be deductible under paragraph 20(1)(e) of the Income Tax Act (Canada) (the "ITA");
• b) whether provincial reimbursement of plan set-up costs would be an employee benefit under paragraph 6(1)(a) of the Act or an inducement payment under paragraph 12(1)(x) of the Act;
• c) whether shares issued in accordance with the plans would be "short-term preferred shares" or "taxable preferred shares" as those terms are defined in subsection 248(1) of the ITA;
• d) whether the depository acting as custodian of shares issued under the plans will be a trustee of those shares for purposes of section 104 of the ITA;
• e) whether an employee will be able to deduct interest expense incurred on money borrowed to purchase shares issued under the plans;
• f) the nature for tax purposes of any repayment of tax credits made on the early disposition of shares issued under the plan;
• g) whether shares issued under the plans will cease to be qualified investments for RRSP's and RRIF's if part of the dividends paid on the shares are in lieu of salary; and
• h) whether employees entitled to tax credits in respect of shares issued under the plans would be eligible for a reduced rate of source deductions under subsection 153(1.1) of the ITA.

XXX has requested that we comment on the following additional issues:

i) whether a deeming provision contained in paragraph 1(2)(c) of the EIA applies for purposes of the ITA;
• j) whether an EVCC qualifies to make an election under subsection 39(4) of the ITA;
• k) the applicability of subsection 15(1) of the ITA to rights to acquire shares under a plan; and
• l) whether the investment protection account established pursuant to section 23 of the EIA is a trust.

Our comments are based on a review of the following documents:

• a) The EIA as it read after passage on third reading in the British Columbia legislature (June 15, 1989);
• b) draft regulations (the "Draft Regulations") to be issued under the EIA (as set out In a copy containing sections numbered 1 to 18 and forwarded to us on September 13, 1989); and
• c) a draft escrow agreement (the "Draft Escrow Agreement') containing the authorized terms and conditions for depositary arrangements referred to in subparagraph 4(1)(d)(iv) of the EIA (for ESOP's), a copy of which was forwarded to us on September 20, 1989 (containing section numbered 1 to 20).

The above documents set out minimum requirements for ESOP's and EVCP's. However, the EIA allows for considerable flexibility in the structure of plans that bet these minimum requirements. Given the wide variety of possible plan structures, our comments are of a general nature only and will not necessarily apply to every plan that may be established in accordance with the EIA.

Set-up Costs: Deductibility under Paragraph 20(1)(e) of the ITA

Paragraph 20(1)(e) of the ITA permits a corporation to deduct qualifying expenses incurred in the course of issuing shares of its capital stock. In essence, the expenses may be deducted over a 5 year period (20% per year). Paragraph 16 of Interpretation Bulletin IT-341R states that paragraph 20(1)(e) does not authorize a deduction for expenses incurred in amending a corporation's charter as a preliminary step to the issuance of shares. Expenses involved in negotiating and evaluating an ESOP or an EVCP seem to constitute mere preliminary steps taken prior to the actual issuance of the shares. Such expenses are incurred for the purpose of establishing the framework within which the shares will be issued and do not qualify under paragraph 20(1)(e).

Expenses incurred in implementing an ESOP or an EVCP will qualify for deduction under paragraph 20(1)(e) if they come within the type of expenses described in paragraph 14 of IT-341R.

Certain expenses may be deductible under other provisions of the ITA. For example, paragraph 20(1)(bb) will apply to the extent an amount is paid by an employee for advice as to the advisability of purchasing a specific share provided that

• a) the employee actually acquires the share; and
• b) the amount is paid to a person whose principal business is advising others on the advisability of purchasing or selling specific shares or securities.

The Department does not generally regard a lawyer or an accountant as a person described in (b).

To the extent an expense does not qualify for deduction under any other provision of the ITA, expenses incurred by an employer may be deductible as an eligible capital expenditure ("ECE",) under paragraph 20(1)(b) and section 14 of the ITA. In general, 3/4 of an ECE may be amortized at a rate of 7% per year. In order to qualify as an ECE, an expense must be incurred for the purpose of gaining or producing income from a business. Expenses incurred in connection with property income do not qualify. Generally, plan set-up costs incurred by an employer who earns business income would be for the purpose of producing income from that business and (to the extent not otherwise deductible) would generally qualify for ECE treatment. However, employees who incur set-up costs would not be able to claim ECE treatment.

Reimbursement of Set-Up Costs

Under section 26 of the EIA, an employee group and certain corporations may receive reimbursement from the British Columbia government for up to one-half of the cost of negotiating, evaluating and implementing an ESOP or an EVCP.

Reimbursements received by an employee group would not constitute employee benefits within the meaning of paragraph 6(1)(a) of the ITA. The payments constitute reimbursement of out-of-pocket costs incurred by reason of the employee group having participated in the establishment of the ESOP or the EVCP. In essence, no benefit arises because the payment "puts nothing in the pocket but merely saves the pocket" [see Ransom v MNR, [[1967] C.T.C. 346] 67 DTC 5235 (Exch), at p. 5244] and no economic advantage accrues to the employee as a direct result of the reimbursement.

Reimbursements received by an employer would not come within paragraph 12(1)(x) of the ITA to the extent they reduce the amount of the expense.

Reimbursements received by an employee group would also appear to not come within paragraph 12(1)(x) of the ITA.

Redemption of Shares

Under paragraphs 4(1)(h) and 10(1)(h) (respectively) of the EIA, an ESOP and an EVCP must require that the corporation redeem a shareholder's shares in certain circumstances for an amount determined in accordance with paragraphs 4(1)(f) and 10(1)(f) (respectively) of the EIA. Due to this potential retraction right of the shareholder, shares issued under an ESOP or an EVCP could be "short-term preferred shares" and "taxable preferred shares" as those terms are defined in subsection 248(1) of the ITA.

A share is a short-term preferred share (and by definition also a taxable preferred share) if the issuing corporation may be required to redeem the share within 5 years from the date of its issuance. Any agreement concerning the share is to be read without reference to a provision under which a person agrees to acquire the share for an amount that

• a) does not exceed the fair market value of the share at the time of the acquisition; or
• b) is determined by reference to the assets or earnings of the corporation if the determination may reasonably be considered to be used to determine an amount that does not exceed the fair market value of the share at the time of the acquisition.

For purposes of both (a) and (b) above, fair market value must be determined without reference to the agreement containing the retraction feature.

The EIA requires that the retraction price for the share reflect the value of the share, which value may be determined by:

• a) an independent opinion from a qualified person;
• b) a formula referencing financial information of the corporation; or
• c) a formula referencing the trading value of a class of shares of the corporation trading on a public stock exchange;

provided that the valuation method

• d) applies consistently over the life of the plan;
• e) does not provide for a premium for control or discount of minority interests; and
• f) is computed without reference to any tax credit provided under the ITA or the Income Tax Act of British Columbia.

The tax credit identified in (f) will be available only to the original holder of the share and does not represent a liability of the corporation. Consequently, the provision of the tax credit does not affect the value of the share from the perspective of a subsequent purchaser.

However, a person purchasing a minority interest in a private corporation will almost always insist on a minority discount. To the extent that the retraction price does not provide for a minority discount, it could exceed the fair market value of the share and therefore be outside of the exception in the short-term preferred share definition.

If the only way to dispose of the share were through the retraction feature, the fair market value of the share would normally be equal to the retraction price. However, fair market value for purposes of the exception must be determined without reference to the retraction right. If the retraction feature were the only way to dispose of the share, fair market value determined without reference to the retraction feature would arguably be nil or some amount considerably less than the retraction price.

XXX we assume that this means such corporations will be "prescribed laboursponsored venture capital corporations" described in section 6701 of the Regulations to the ITA. If so, such corporations will generally qualify as "financial intermediary corporations" ("FIC's") as defined in subsection 191(1) of the ITA [subject to exceptions set out in paragraphs (g) to (i) of that definition]. Dividends paid by a FIC are "excluded dividends" for purposes of Part VI.1 tax notwithstanding that the dividends may be paid on short-term or taxable preferred shares. As well, dividends received from a FIC are "excepted dividends" for purposes of Part IV.1 tax.

Depository Arrangement

Under subparagraph 4(1)(d)(iv) of the EIA and paragraph 11(1)(b) of the Draft Regulations (respectively), an ESOP and an EVCP must provide that shares acquired under the plan will be "held, for 3 years from the date of the purchase, in the custody of an authorized depository". The authorized terms and conditions of the custodianship arrangement referred to in subparagraph 4(1)(d)(iv) of the EIA are set out in the Draft Escrow Agreement. While we have not reviewed any authorized terms and conditions for depository arrangements described in the Draft Regulations, we assume that they will be the same as those set out in the Draft Escrow Agreement.

While the relevant provisions of the EIA and the Draft Regulations indicate that the "shares" are to be held by a depository, the Draft Escrow Agreement provides that the depository is to hold only the share certificates. The depository described in the Draft Escrow Agreement appears to be a bailee of the share certificates and not a trustee of the shares. Consequently, sections 104 to 108 of the ITA will not apply to the depository.

Deductibility of Interest on Money Borrowed to Acquire Shares

By virtue of subparagraphs 4(1)(d)(i) and 10(1)(d)(i) (respectively) of the EIA, shares issued pursuant to an ESOP or a EVCP must be "equity shares". Subsection 1(1) of the EIA defines an "equity share" to mean essentially a common share (one that participates fully in both dividends and capital of the corporation).

In order for interest on borrowed money to be fully deductible, the money must be used for an income-producing purpose. A capital gain does not qualify as income for these purposes. Normally, the Department considers that funds used to purchase common shares are used for an income-producing purpose because the potential dividend return on the shares may exceed the borrowing cost. It is conceivable, however, that it might be unreasonable in respect of specific shares to expect a potential dividend return in excess of the interest costs on the borrowed money. This will be a question of fact in each case. In and of itself, the retraction feature attached to shares issued under a plan will not render interest non-deductible.

Even if shares are not acquired for an income-producing purpose, interest on money borrowed to acquire those shares will be deductible to the extent dividends are actually received on those shares in a taxation year. In the case of individuals, the amount of deductible interest is determined by the amount of the dividend after application of the federal gross-up provision.

Interest ceases to be deductible if the shares become worthless (for example, through the insolvency of the corporation). In that case, the borrowed money can no longer be said to be used for an income-producing purpose.

Qualified Investment Status

Shares of certain corporations may constitute qualified investments for RRSP's and RRIF's under subsection 4900(6) of the ITA Regulations. This qualified investment status ceases pursuant to subsection 4900(8) of the ITA Regulations if the annuitant provides services to the issuer of the share (or a person related to the issuer) and it is reasonable to consider that an amount received in respect of the share is on account of, in lieu of or in satisfaction of payment for the services. In making this determination, one must consider dividends provided on the share.

A person's dual status as both an employee and a shareholder of a corporation will not, in and of itself, cause a share to lose its status as a qualified investment for that person's RRSP or RRIF. In order for subsection 4900(8) to apply, it must be reasonable to consider that an amount received in respect of the share is on account of, in lieu of or in satisfaction of payment for services provided by the employee-shareholder. This will be a question of fact in each case. For example, subsection 4900(8) might apply if wage rates for employees performing substantially the same work were lower for employees who had acquired shares under a plan and the lover wage was compensated through dividends paid on the shares.

Repayment of Tax Credits

Section 29 of the EIA requires a recipient of a tax credit to repay the credit if shares are disposed of within specified periods of time.

Subparagraph 40(1)(a)(i) of the ITA allows a gain to be decreased by out lays and expenses made or incurred "for the purpose" of making a disposition. Repayment of the tax credit is made as a consequence of the disposition and not for the purpose of making the disposition. Accordingly, the repayment does not serve to reduce a gain or increase a loss realized on the disposition of the shares.

Repayment of the tax credit is a non-deductible outlay for income tax purposes and is not a capital loss.

Reduction in Withholding

Subsection 153(1.1) of the ITA authorizes the Minister of National Revenue to order a reduction in the normal rate of source deductions in cases of "undue hardship". Under paragraph 900(2)(b) of the ITA Regulations, the Minister's power has been delegated to the Director-Taxation in each District Office. Accordingly, we make no comment on the criteria to be employed in exercising this discretion.

Effect of Paragraph 1(2)(c) of EIA for Income Tax Purposes

Paragraph 1(2)(c) of the EIA provides as follows:

• (2) For the purposes of this Act [...] (c) a shareholder shall be deemed to have purchased, held or disposed of shares that are purchased, held or disposed of by a trust where the shareholder has beneficial ownership of the shares.

Paragraph 1(2)(c) of the EIA is an interpretation provision that applies only for purposes of interpreting the various provisions of the EIA. Consequently, it has no effect on interpreting the ITA. For purposes of the ITA,

• (a) dividends paid to a trust will be considered to have been paid to an employee beneficiary only if the trust makes the appropriate designation under subsection 104(19) or (20) of the ITA; and
• (b) no tax credit will be available to an employee beneficiary under subsection 127.4(2) of the ITA if qualifying shares are acquired by the trust (rather than by the employee) as the first purchaser.

Shares Held by a Corporation Established Pursuant to an EVCP: Whether on Income or Capital Account

Paragraph 9(f) of the EIA requires that the "business" of an EVCC be restricted to "making investments" permitted under the EIA. While it is a question of fact whether a taxpayer holds shares on income or capital account, paragraph 9(f) of the EIA raises a concern that an EVCC will be holding shares on income account. As well, an EVCC will be a venture capital corporation. As indicated in response to question 16 at the 1986 Revenue Canada Round Table, a venture capital corporation normally holds its investments on income account.

Taxpayers may elect under subsection 39(4) of the ITA to have all their acquisitions and dispositions of Canadian securities treated as being on capital account. This election is not available to taxpayers described in subsection 39(5) of the ITA, which includes traders and dealers in securities. During the 1986 Revenue Canada Round Table, the Department expressed the following position concerning whether a venture capital corporation could make a subsection 39(4) election (see 1986 Conference Report, page 51:10):

• Whether a venture capital corporation is a trader or dealer in securities can only be determined on the particular facts. Given the somewhat restricted interpretation of trader or dealer in paragraph 5 of Interpretation Bulletin IT-479R (dated February 29, 1984), it is the department's view that venture capital corporations would generally not be regarded as traders or dealers. Accordingly, in most cases, venture capital corporations would be entitled to make an election pursuant to subsection 39(4) of the Act with respect to their Canadian securities.

Nothing in the EIA would render an EVCC a trader or dealer in securities and preclude it from making a subsection 39(4) election. However, actual qualification to make the election will be a question of fact in each case. For example, clause 9(f)(i)(A) of the EIA indicates that an EVCC may provide business and managerial expertise to corporations in which the EVCC has invested. If an EVCC utilizes special knowledge (not available to the public) to realize a quick gain on securities, it will be regarded as a trader or dealer of those securities. However, it will not be so regarded merely by virtue of having had such knowledge throughout the period in which it held a true investment.

Applicability of Subsection 15(1) of the ITA

Under paragraph 4(1)(c) of the EIA, an ESOP must provide qualifying employees with an equal right to purchase shares under the plan or a pro-rata right to purchase shares, which takes into account length of service. Under paragraph 10(1)(d) of the EIA, an EVCP must provide identical rights to qualifying employed persons.

The Department would not apply subsection 15(1) of the ITA as a consequence of the granting of these rights, in and of themselves.

Investment Protection Account

Section 23 of the EIA requires an EVCC to pay certain amounts into an investment protection account. An EVCC that is about to make an eligible investment may withdraw funds from the account on the authorization of the administrator appointed under the EIA. If accounts become payable in connection with the repayment of tax credits, money shall be paid out of the account to the Minister of Finance and Corporate Relations.

We have not reviewed any terms and conditions of an investment protection account. However, the account would not result in the creation of a trust provided that it is a simple security mechanism in the nature of a deposit and all funds in the account continue to be the property of the EVCC unless and until the EVCC is required to pay funds to the Crown under subsection 23(3) or (5) of the EIA.

Addendum

On September 25, 1989 XXX telephoned and advised that some employees may subscribe personally for EVCC shares in order to obtain the tax credit described in section 127.4 of the ITA. Immediately following such acquisition, the employee may transfer the shares to an RRSP or RRIF of which the employee is annuitant.

The Department takes the position that the Immediate transfer of an EVCC share by an employee to an RRSP or RRIF of which the employee is annuitant would not, in and of itself, give rise to a gain on income as opposed to capital account.

In valuing such contribution to the RRSP or RRIF, it is our position to accept that the fair market value of such shares will be equal to their original cost less the amount of any provincial tax credit received.

General

We trust that the above comments are satisfactory for your purposes. We communicated the general tenor of our responses to XXX during a telephone conversation on September 20, 1989. If you have any questions, please do not hesitate to contact us.