Equity-based incentive plans have in recent years become a common component of the compensation package for executive employees in Canada. Employers often design the plans in such a way as to enable the employer to claim a tax deduction for the value of the equity-based compensation. In the case of treasury shares issued under stock bonus plans, the Canada Revenue Agency (CRA) has historically taken the position that the value of treasury shares issued under such plans is not deductible by the employer for tax purposes. However, a recent decision of the Tax Court of Canada allowed the employer to deduct the fair market value of treasury shares issued to executive employees under a discretionary stock bonus program.
Section 7 of the Income Tax Act (Canada) (Act) governs the taxation of stock option plans. Subsection 7(3) of the Act denies the deduction of the value of treasury shares issued under such plans where a corporation “has agreed” to sell or issue securities to an employee. The subsection also applies to ensure an employee is not considered to have received a taxable benefit under any other provision of the Act because of the “agreement”. This subsection has often been used by the CRA to deny the deduction of the value of treasury shares issued under stock bonus plans.
However, in Transalta Corporation v. R, the Tax Court of Canada ruled that Transalta could claim a deduction for the fair market value of the shares it issued to employees under its ‘Performance Share Ownership Plan’. In brief, each year employees were informed whether they had been selected by the Human Resources Committee for participation in the plan and were eligible receive a bonus at the end of the award’s 3-year term. At the end of the term Transalta would determine, in its sole discretion, whether and to what extent the award would be paid in cash or by the issuance of treasury shares. In each taxation year under appeal Transalta increased its stated capital account by an amount equal to the fair market value of the shares issued under the plan on the basis that the shares were issued for past service, and claimed a corresponding deduction for those amounts.
The key to the Court’s decision is its interpretation of the words “agreement” and “agree” in subsection 7(3) of the Act as requiring a legally binding agreement to issue shares. The Court found that the plan was explicitly discretionary and did not create legally binding rights or enforceable obligations, prior to the delivery of the shares, to receive an award. It therefore concluded that the plan was not caught by section 7, and the deductions were therefore not denied by subsection 7(3).
The CRA did not appeal the Court’s decision and it remains to be seen whether an amendment to the Act will be pursued. Although the CRA has previously expressed the view that no expenses would be deductible (whether in the form of a sale or issuance of shares) with respect to any form of stock option or stock purchase plan as a result of the application of section 7 (see, e.g. ACC-9596), it may see the proposed addition of section 143.3 as being sufficient. Proposed section 143.3 acts to deny the characterization of the cost of granting of an option or issuing shares as an expenditure in certain circumstance, including those where no binding agreement to do so exists. Interestingly, however, that provision would not have applied to reduce the deductions taken in this case.
Employers that provide equity-based incentive plans that issue treasury shares on a discretionary basis may wish to review their plans with their advisors to determine the appropriate tax treatment.