I Introduction

Canada Revenue Agency (“CRA”) generally permits the deduction of payments made by an employer to employees who surrender their options under an employee stock option plan (“ESOP”) in the ordinary course of business. Nonetheless, in the context of corporate reorganizations or acquisitions, CRA has characterized such payments as being on account of capital within the purview of paragraph 18(1)(b) of the Income Tax Act. As a consequence, any payment in the aforementioned situation cannot be deducted against income. While the common law on this issue generally favours CRA, it has been shifting in favour of taxpayers until the latest Tax Court of Canada (“TCC”) decision in Imperial Tobacco Canada Limited v. The Queen1 (“Imperial Tobacco”). This article will provide a summary of the common law and analyze the impact of Imperial Tobacco.

II Common Law

Kaiser Petroleum

For many years, Kaiser Petroleum Ltd. V. The Queen2 (“Kaiser”), a 1990 decision from the Federal Court of Appeal (“FCA”), was the authoritative case directly on this issue. Kaiser involved the sale of a subsidiary in Canada by its U.S. parent to Kaiser Resources. At that time, there was an ESOP that allowed employees of the subsidiary to purchase shares in the subsidiary. The sale agreement between the parent company and acquirer required the former to amend the subsidiary’s ESOP and eliminate outstanding options via a cash payment to option holders who surrendered their options. Consequently, most of the option holders accepted the cash offer and the ESOP was ultimately cancelled. The subsidiary deducted the cash payments from income and CRA objected.

The taxpayer prevailed in the TCC but that decision was overturned by the FCA. The FCA found that the elimination of the ESOP altered the taxpayer’s capital structure and provided lasting benefits to the company. Whether an expenditure is on account of capital or income is fact driven and is to be determined in reference to overall circumstances. Although compensation was an element in the termination of the ESOP, the FCA noted that “the compensation was made by means of a reshaping of the capital structure of the respondent's organization” which dominated “the whole set of circumstances revealed by the evidence and constitutes the guiding element”. 3

Shoppers Drug Mart and Imperial Tobacco

Almost two decades later, the TCC revisited the issue in Imperial Tobacco Canada Limited (Successor by amalgamation to Shoppers Drug Mart Limited) v. Her Majesty The Queen4 (“Shoppers”). Shoppers Drug Mart Limited (“SDM”) was a fully owned subsidiary of Imasco Limited (“Imasco”). Imasco was being acquired by British American Tobacco (“BAT”) in a going private transaction. Certain key employees of SDM participated in Imasco’s ESOP which gave them options to purchase shares of Imasco. The ESOP also allowed Imasco to accelerate vesting and to offer option holders a cash payout to surrender their options. After Imasco was approached by BAT, Imasco amended its ESOP to instead allow option holders the right to surrender their unexercised options for a cash payment. In addition, Imasco exercised its prerogative to accelerate the vesting of options under the ESOP. Later, Imasco agreed to encourage employees to exercise or surrender their options and accelerate the vesting of options in the Transaction Proposal Agreement. Subsequently, the acquisition was approved and Imasco paid all option holders who took up Imasco’s offer.

SDM reimbursed Imasco for the amount of cash paid to SDM’s employees and deducted the reimbursed amount as an expense. Likewise, Imasco deducted from income the amount of cash paid to its employees. CRA challenged and disallowed both deductions.

On appeal, the TCC ruled in favour of SDM. Unlike the situation in Kaiser, Bowman C. J. found no enduring benefits to SDM or changes to SDM’s capital structure or business. It was SDM’s parent that was restructuring. Hence, Bowman C. J. declined to follow Kaiser. In addition, Bowman C. J. made several remarks in his judgment that strongly hinted at his dissatisfaction with CRA’s position and the current state of common law on the issue. For example, he expressed scepticism that payments that would ordinarily be deductible as expense are somehow transformed into capital payments when such payments are made in the context of an acquisition or reorganization.

The judgment by Bowman C. J. in Shoppers offered optimism that the impact of Kaiser is being mitigated and that the TCC may be more inclined to favour taxpayers in similar disputes with CRA within the confines of the higher court decision in Kaiser.5 However, any optimism must now be tempered by the more recent TCC decision in Imperial Tobacco which stems from the same going private transaction in Shoppers.

In contrast to Shoppers, CRA prevailed against the taxpayer in Imperial Tobacco. Citing the FCA’s approach in Kaiser, Bowie J. regarded all “the “guiding features”….of the case” and determined “from a practical and business point of view what the payments in question were intended to accomplish”.6 He refused to view the actions and cash payment relating to Imasco’s ESOP in isolation from the going private transaction.

Bowie J. also rejected the argument that the redemption payment is necessary to settle up with employees since these employees could have easily sold their shares for cash after exercising the options. Likewise, fairness to employees with unvested options only required accelerated vesting of the unvested options and not the cash payout. Even though an amendment to Imasco’s ESOP a few years prior to the going private transaction allowed the acceleration of vesting, Imasco only chose to do so at the time of the going private transaction. Taking all factors into account, Bowie J. believed that Imasco’s actions were ultimately designed to facilitate the going private transaction which dwarfed any element of compensation.

The court also rebuffed the taxpayer’s effort to rely on Shoppers. Unlike Shoppers, there is a change to the capital structure of Imasco that is connected to the cash payment. Hence, Bowie J. ruled that the precedent set in Kaiser should govern. Importantly, Bowie J. dismissed the taxpayer’s effort to distinguish Kaiser as “distinctions without a difference”7. For example, the taxpayer drew attention to the fact that Imasco’s ESOP permitted accelerated vesting and cash surrender even before BAT approached Imasco whereas in Kaiser, the purchase agreement required the subsidiary to amend its ESOP to allow early vesting.8

III Analysis

To the detriment of taxpayers, the judgment in Imperial Tobacco effectively restores the pre-eminence of Kaiser and reduces the scope and influence of Shoppers.

Despite the FCA’s endorsement in Kaiser, the judgment by Bowman C. J. in Shoppers dismissed the use of “a common sense appreciation of all the guiding factors”9 as being unhelpful. However, in Imperial Tobacco, Bowie J. disagreed and reverted to the FCA’s approach. It may be the embrace of this approach that caused Bowie J. to view the taxpayer’s effort to distinguish Kaiser as irrelevant.

This is a troubling development as it is now more difficult for a taxpayer to prevail by relying on simple distinctions with Kaiser. For instance, based on the precedent set in Imperial Tobacco, it is likely insufficient for a taxpayer to merely point out differences between its ESOP and the one in Kaiser. Instead, a taxpayer now has to convince the court, from a practical and business view point, that all the actions leading to the cash payout was not designed to facilitate a corporate reorganization or acquisition. This is a vague and fluid standard that is more dependent on subjective judgment.

As aforementioned, Bowman C. J. made remarks in his decision that are favourable to taxpayers. Nevertheless, in Imperial Tobacco, Bowie J. did not acknowledge any of these remarks nor did he appear to be swayed by them. Furthermore, in Shoppers, Bowman C. J. reproduced portions of the ESOP and Transaction Proposal Agreement in his judgment without explicitly mentioning the importance of these portions to his decision. One might be tempted to infer that the reproduced information had some bearing on his decision to favour the taxpayer. However, even assuming that the factors were of significance to Bowman C. J., the same factors did not appear to be important to Bowie J. Faced with almost identical facts, Bowie J. came to the opposite conclusion.

This is likely due to the fact that Bowie J. interpreted Shoppers very narrowly and restricted its applicability to instances where cash payments relating to an ESOP are made by a corporation whose capital structure remains unchanged. Other than this difference, the facts in Shoppers and Imperial Tobacco are identical given that both cases stem from the same going private transaction. Yet, this one difference was crucial and sufficient for Bowie J. to decline to follow Shoppers. Hence, one should be wary about making any inferences or relying on the favourable remarks made by Bowman C. J.

IV Concluding Remarks

The judgment in Imperial Tobacco means that Shoppers should indeed be interpreted as a narrow exception to Kaiser. The approach adopted and reasoning used by Bowie J. in Imperial Tobacco leaves taxpayers with few less than ideal tax planning options. For example, in crafting an ESOP, a corporation may include provisions to automatically accelerate the vesting of options in the event of an acquisition or reorganization and allow option holders to surrender their unexercised options for a cash payout at their discretion.10 However, these provisions have their disadvantages as they attenuate the ability of a corporation to manage its ESOP and control the number of shares issued and outstanding. This may be problematic if the corporation is the target of an unwanted corporate takeover. In addition, allowing option holders the ability to seek a cash payout at their discretion can disrupt a corporation’s cash flow management. Hopefully, given the proliferation of ESOP as a means of compensation since Kaiser, the FCA will be presented with an opportunity to revisit its decision from Kaiser.