15 April 2009 Internal T.I. 2008-0301171I7 F - 7(3)b) vs 143.3(3)
Principal Issues: [TaxInterpretations translation] Does paragraph 7(3)(b) or subsection 143.3(3) apply in a particular situation?
Position: It is paragraph 7(3)(b).
Reasons: The Act.
April 15, 2009
MONTREAL Tax Service Office HEADQUARTERS
Ms. Marie-France Pleau, M.Fisc. Income Tax Rulings Directorate
Technical advisor - SITI
Validation & Enforcement Division Guy Goulet, CA, M.Fisc.2008-030117
Request for Interpretation - Paragraph 7(3)(b)
This responds to your email of November 21, 2008 in which you asked for our comments regarding the application of paragraph 7(3)(b) in the Particular Situation described below.
Unless otherwise indicated, all legislative references herein are to the provisions of the Income Tax Act ("Act").
Particular Situation:
The Particular Situation as you have explained it to us is as follows:
1. Pubco is a public corporation and a taxable Canadian corporation as defined in subsection 89(1).
2. As part of its compensation program for certain employees (the "Participants"), Pubco has established a stock option plan (the "Plan") under which it grants Participants the right to subscribe for shares of its capital stock (an "Option") at a price generally not less than the FMV of the shares on the date of grant (the "Exercise Price").
3. The grant of any Option is evidenced by an agreement (the "Agreement"). Under the terms of the Plan and the Agreements, a Participant may exercise the Option at any time after the occurrence of the Exercise Date. Upon the exercise of an Option, the Participant must pay the Exercise Price to Pubco in order to receive one covered share for each Option so exercised.
Pubco accounts for the transactions surrounding the granting and exercise of an Option in accordance with the recommendations of Section 3870 of the Canadian Institute of Chartered Accountants Handbook. We understand that Pubco records a "stock-based compensation expense" when an Option is granted and when a share is issued as a result of the exercise of an Option.
Your Questions:
You wish confirmation of the tax consequences to Pubco related to the granting and exercise of Options under the Plan. In addition, you would like our comments on situations where the dates of grant and exercise are not in the same taxation year of Pubco. Finally, you wish comments in light of Alcatel Canada Inc. v. The Queen, 2005 DTC 387 (T.C.C.) ("Alcatel") and the latest version of proposed section 143.3 included in Bill C-10 (39th Parliament, 2nd Session) (the "Legislative Proposals").
Our Comments:
Paragraph 18(1)(a) provides that expenses are not deductible in a year except to the extent that they were incurred or made by the taxpayer for the purpose of gaining or producing income from a business or property. The courts have stipulated that for the purposes of this paragraph, there must be a legal obligation to pay an amount in the year in order to conclude that an expense was incurred or made. In the Particular Situation, we are of the view that the "stock-based compensation expense" recorded by Pubco in a particular taxation year as a result of the grant of an Option is not an expense incurred or made by Pubco in the year since Pubco has no legal obligation to pay an amount in the year. This expense cannot therefore be deducted by Pubco in computing its income for income tax purposes for that particular taxation year.
Section 7 contains specific rules that apply when a corporation agrees to issue securities to one of its employees as is the case in the Particular Situation.
Paragraph 7(1)(a) provides for the calculation of the taxable benefit to be included in computing a particular employee's employment income where the employee exercises an Option. In this case, there must be included in computing the employment income of a Participant, for a taxation year in which the Participant exercises an Option, a benefit equal to the amount, if any, by which the FMV of the shares at the time of their acquisition exceeds the Option exercise price. The income inclusion is therefore made in the year in which the Option is exercised and not in the year in which it is granted.
Paragraph 7(3)(b) contains a presumption that a person's income for a taxation year is deemed not to be less than it would have been for the year if a benefit had not been conferred on the employee by the issue of the securities. We are of the view that in the Particular Situation, this presumption prevents Pubco from deducting in computing its income an amount of expense calculated on the exercise of an Option and the issue of a share that results in a taxable benefit under paragraph 7(1)(a). Consequently, we are of the view that the "stock-based compensation expense" included for accounting purposes in Pubco's results for a particular taxation year following the exercise of an Option is not deductible by Pubco in computing its income for income tax purposes for such taxation year.
Furthermore, in Alcatel, Justice Bonner of the Tax Court of Canada concluded that stock option benefits obtained by employees of a particular corporation constituted an expense made in respect of costs incurred in the year by that corporation for salary or wages within the meaning of subclause 37(8)(a)(ii)(B)(IV), so that the amount of such benefits had to be taken into account for the purpose of calculating the investment tax credit to which that corporation was entitled. We are of the view that this decision does not alter our interpretation of paragraph 7(3)(b) set out above.
Finally, paragraph 143.3(3)(b) of the Legislative Proposals provides that, in computing the income, taxable income or tax payable of a corporation, an expenditure of the corporation that would include an amount because of the corporation having issued a share of its capital stock shall be reduced, if the issuance of the share is a consequence of the exercise of an option, by the amount, if any, by which the fair market value of the share at the time of its issuance exceeds the amount paid, pursuant to the terms of the option, by the holder to the issuing taxpayer for issuing the share.
We are of the view that paragraph 143.3(3)(b) would not be applicable in this case in computing Pubco's income for a particular taxation year in which an Option was granted or exercised since no expense that would include an amount by reason of the granting of an Option or the issuance of a share of its capital stock would be deductible in computing its income for income tax purposes for that particular taxation year.
We hope that our comments are of assistance.
Best regards,
Ghislain Martineau
Manager
Financial Sector and Exempt Entities Section
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch.