Principal Issues: [TaxInterpretations translation] How should an amount paid by an employer to an employee to compensate the latter for the loss incurred on the disposition of shares acquired on the exercise of a stock option be taxed in the hands of the employee?
Position: The taxation of the compensation in the hands of the employee will depend on the amount it is intended to replace.
Reasons: The surrogatum principle. Subsections 5(1) and 6(1), section 40 and paragraph 53(1)(j) of the Income Tax Act.
XXXXXXXXXX 2005-012331
July 6, 2005
Dear Madam,
Subject: Request for technical interpretation: Tax treatment of a payment made to an employee to settle a dispute
This is in response to your letter of March 29, 2005 in which you requested our opinion on the above subject.
Facts
Your letter refers to two hypothetical situations where a public corporation would agree to compensate an employee for the loss of value suffered on the disposition of shares acquired upon the exercise of stock options. The following hypothetical facts are common to both situations:
- Mr. X was an employee of a public corporation and held 25,000 stock options in the corporation with an exercise price of $5 per share.
- Two years later, when the share price was $10, Mr. X exercised his stock options at the request of the corporation. The exercise of his options resulted in a taxable benefit of $5 per share, for tax of approximately $1.20 per share.
- At the corporation's request, Mr. X refrained from disposing of the newly acquired shares for a certain period of time. No consideration was paid to Mr. X in consideration of this undertaking. This restriction was not part of the terms of the stock option agreement, nor was it part of Mr X's employment contract.
- Mr. X disposed of the corporation's shares at a value of only $4 per share.
First situation
In the first situation, Mr. X claimed damages from the corporation for the loss of value sustained on the disposition of his shares between the time of exercise and the disposition of the shares ($6 per share). We have assumed that the corporation agreed to compensate Mr. X in order to avoid litigation.
Second situation
In the second situation, Mr. X claimed damages for the net disbursement he incurred as a result of exercising the stock options, that is, the difference between the purchase price of the shares ($5 per unit) and the sale price of such shares ($4 per share) plus the income tax payable due to the inclusion of the benefit resulting from the exercise of the stock options under section 7 of the Income Tax Act (the "Act"), i.e., the sum of $30,000.
Questions
In both situations, you would like our opinion on the appropriate tax treatment of the payments received by Mr. X - depending on the method used to quantify the loss sustained by him - in settlement of a potential dispute with the corporation. On the basis of the facts you have provided, Mr. X's loss resulted from the corporation's restriction on the sale of Mr. X's shares of capital stock.
As stated in paragraph 22 of Information Circular 70-6R4 dated January 29, 2001, it is the practice of the Canada Revenue Agency ("CRA") not to issue written opinions on proposed transactions otherwise than by way of advance rulings. We can, however, offer the following general comments which we hope you will find helpful. In the event that the facts that you have provided to us with respect to the two hypothetical situations change, it is possible that the conclusions we share with you may no longer be relevant.
Our Comments
Our comments below with respect to both situations are based on the premise that the amounts paid by the corporation to Mr. X are paid as compensation or in settlement of a dispute. Obviously, if that were not the case, the amounts paid by the corporation to Mr. X would be taxed as employment income in Mr. X's hands.
First Situation
For the purposes of this first situation, we have assumed the following facts:
- The corporation paid compensation of $6 per share, which is the difference between the proceeds of disposition per share that the taxpayer could have obtained in the absence of the restriction imposed on the exercise of the stock options ($10) and the proceeds of disposition that he actually received.
- The compensation was intended only to compensate Mr. X for the loss of capital from the sale of the shares and was not intended to compensate him for any other loss, such as the loss of future income (for example, from dividends paid on the shares).
- You will understand that we will not comment on the legal responsibility of the corporation to make such a payment or on the rights of Mr. X to claim such compensation.
In order to determine whether the compensation received by Mr. X is taxable, it is necessary to identify the amount that the compensation is intended to replace. As found in Tsiaprailis1, the surrogatum principle requires that the taxation of an amount received as compensation or settlement reflects the taxation of the amount that the compensation or settlement is intended to replace. This principle was made clear in London and Thames Haven Oil Wharves v Attwooll (Inspector of Taxes):2
Where, pursuant to a legal right, a trader receives from another person compensation for the trader’s failure to receive a sum of money which, if it had been received, would have been credited to the amount of profits . . ., the compensation is to be treated for income tax purposes in the same way as that sum of money would have been treated if it had been received instead of the compensation. (as quoted in the Tsiaprailis decision of the Supreme Court of Canada)
In Tsiaprailis, Charron J. set out the two questions to be answered when applying the surrogatum principle:
1) What was the payment intended to replace?
2) Would the replaced amount have been taxable in the recipient’s hands?3
(1) What was the payment intended to replace?
In this case, according to the assumptions on which our technical interpretation is based and in the absence of the restriction imposed when the stock options were exercised, Mr. X would have sold his shares at $10 per unit. The proceeds of disposition that Mr. X would have received from the sale of his shares (a capital property) would be capital in nature.
(2) Would the proceeds of disposition have been taxed in Mr. X’s hands?
Proceeds of disposition of $10 would have been included in computing Mr. X's capital gain or loss pursuant to section 40. Under the facts of this case, such proceeds of disposition would have been tax neutral because of the computation under subsection 40(1).
Under paragraph 53(1)(j), the amount of the benefit to be included in Mr. X's income was added to the adjusted cost base of the shares, so that proceeds of disposition of $10 per unit did not give rise to a capital gain or loss.
It seems clear that the compensation paid by the corporation to Mr. X was intended to replace a portion of the proceeds from the disposition of capital property4 that Mr. X would have received in the absence of the restriction imposed on the exercise of his stock options. The surrogatum principle therefore dictates that this compensation be taxed as would the amount it was intended to replace.
The Federal Court of Appeal decision in Schwartz determined that a settlement paid to compensate the taxpayer for lost wages and lost stock options should be taxed as income and not as a capital payment. This indirectly supports our conclusion in this case.5
Thus, we are of the view that the compensation paid by the corporation to Mr. X would be taxed on capital account.
Second situation
In this second situation, the tax treatment of the settlement received by Mr. X from the corporation would depend on the amount that the settlement was intended to replace. In that regard, the settlement was intended to replace two amounts: the difference between the amount paid by Mr. X for the shares and the proceeds of disposition received for the shares; and the tax paid by Mr. X as a result of the inclusion in his income of the benefit arising from the exercise of the stock options.
1. Compensation for the difference between the amount paid by Mr. X for the shares and the proceeds of disposition received for those shares
Under the surrogatum principle and in accordance with our observations and conclusions above, we are of the view that the portion of the compensation attributable to the difference between the amount paid by Mr. X for the shares and the proceeds of disposition received for those shares should be taxed on capital account.
2. Compensation for the tax paid as a result of the inclusion in Mr. X's income of the benefit arising from the exercise of the stock options
As set out above, in order to determine the manner of treatment of the compensation for the tax payable by Mr. X as a result of the inclusion of the section 7 benefit, it is necessary to identify the amount that the compensation was intended to replace. Once that amount is identified, what the tax treatment of that amount would have been in the hands of Mr. X must be determined.
The question to be decided is therefore whether, through the corporation's payment of tax on the taxable stock option benefit, Mr. X received remuneration from the corporation as described in section 5 or a taxable benefit pursuant to section 6.
Section 5 of the Income Tax Act
Pursuant to subsection 5(1), salary, wages or other remuneration, including gratuities, from an office or employment received by a taxpayer in the year are included in the taxpayer’s income for the year.
In order to determine whether the portion of the settlement paid by the corporation, attributable to the tax paid by Mr. X, represents salary, wages or other remuneration, it is necessary - in accordance with the surrogatum principle - to determine whether the amount that the settlement was intended to replace would have been paid for services performed.
The determination of what constitutes employment income under section 5 is a question of fact that can only be resolved after a complete analysis of all the facts related to a particular situation including, inter alia, an analysis of the agreement between the employer and the employee.
In the second situation you presented to us, and in light of the facts set out in your letter, we are of the view that the portion of the settlement relating to the reimbursement of Mr. X's tax liability ($30,000) will not constitute employment income under subsection 5(1) since this amount would not have been paid as part of Mr. X's total compensation package nor would it have been paid for services rendered.6
Section 6 of the Income Tax Act
Paragraph 6(1)(a) requires the value of board, lodging and other benefits of any kind whatever received or enjoyed by a taxpayer in the year in respect of, in the course of, or by virtue of an office or employment to be included in computing the taxpayer's income.
The Queen v. Savage7 sets out the test for determining what is a taxable benefit:
If it is a material acquisition which confers an economic benefit on the taxpayer and does not constitute an exemption, e.g., loan or gift, then it is within the all-embracing definition of s.3.8
Similarly, the Federal Court of Appeal adopted this principle in Huffman,9 where the issue was whether the reimbursement to a plainclothes police officer of clothing expenses constituted a benefit. According to Heald JA, the applicable test is as follows:
It is therefore necessary to consider whether the facts here show that there was a material acquisition conferring an economic benefit on the taxpayer.10
In order to determine whether the payment of an employee's tax liability constitutes the granting of a taxable benefit, it is necessary to consult both The North British Railway Corporation v. Scott11 and Gernhart.12 Both of those decisions support the principle that an employee must include in the employee’s employment income not only the amount of salary paid by the employee’s employer, but also the amount of tax that the employer assumes in respect of the employee's salary.
The following passage from Bonner J.'s decision in Gernhart is relevant to the question of whether an employer who discharges a tax burden that would otherwise have been borne personally by the employee is conferring a benefit on such employee that is required to be included in the employee's income under section 6. As that judge so aptly put it:
The tax equalization payment is an obvious advantage when the appellant's position is compared with that of any other resident of Canada in receipt of the same income but not in receipt of tax equalization. Inherent in the tax treatment sought by the appellant is a privilege offensive to the principle that individuals in similar financial circumstances should pay similar amounts of tax.13
The Federal Court of Appeal in Gernhart, in dismissing the taxpayer's appeal, noted that the Ransom,14 Hoefele15 and Splane16 decisions were distinguishable on the basis that they dealt with losses incurred or payments made by the employee in the course of employment and not with an expense incurred by the taxpayer by reason of the individual’s compensation.
In light of the jurisprudence in this area, we are of the view that the portion of the compensation attributable to the tax payable by Mr. X as a result of the inclusion of the stock option benefit should be included in Mr. X's income as a taxable benefit.
In fact, in accordance with the test developed under the jurisprudence, there was an obvious economic advantage conferred on Mr. X since his patrimony was enriched by the corporation's payment of the tax imposed on the taxable benefit under section 7. In addition, Mr. X would be in a very advantageous position vis-à-vis any other employee who would have included an amount under section 7 without receiving reimbursement from the corporation.
We disagree with your position that "the payment made under this second scenario would not be intended to confer a benefit or advantage on Mr. X, but rather to restore him (in whole or in part) to the state he would have been in, had he not been obliged to exercise his stock options or been restricted from disposing of said shares.
Since the surrogatum principle requires that the compensation be taxed in the same manner as the amount it is intended to replace, we are of the view that the portion of the compensation attributable to the payment of the $30,000 tax should be included in Mr. X's employment income.
These comments are not advance income tax rulings and do not bind the Canada Revenue Agency with respect to any particular factual situation.
Best regards,
Phil Jolie
Director
Business and Partnerships Division
Income Tax Rulings Directorate
ENDNOTES
1 2005 SCC 8
2 [1967] 2 All E.R. 124 (C.A.), at page 134
3 This analysis was repeated in many decisions, including those in Schwartz v. Canada, [1996]1 S.C.R. 254, Au v. Canada, [2005] T.C.J. No. 202, Compagnie des chemins de fer nationaux du Canada v. The Queen, [1988] F.C.A. no. 524 (1st instance) and Prince Rupert Hotel (1957) Ltd. v. Canada, [1995] F.C.A. no. 492 (F.C.A.).
4 Under section 54, capital property is defined to include any property the disposition of which would result in a capital gain or loss to the taxpayer. See also paragraph 39(1)(a) which defines capital property in the negative.
5 The Federal Court of Appeal's decision was subsequently overturned by the Supreme Court of Canada, but its conclusions remain germane for our purposes. Indeed, if the facts had led to the conclusion that the damages had been paid to compensate the taxpayer for the loss of his job and the loss of stock options, the lump sum would have been taxed as income. This finding indirectly supports our position that the settlement received by Mr. X should be taxed on capital account, since the settlement is intended to compensate Mr. X for the capital gain he could have realized in the absence of the restriction.
6 See Gernhart, [1996] T.C.C. No. 821, aff'd by [1997] F.C.A. No. 1736, where the agreement between the taxpayer and the employer that the employer would assume a portion of the taxpayer's tax burden was clearly part of the taxpayer's contract of employment and compensation.
7 [1983] 2 S.C.R. 428
8 Ibid, at page 441
9 (1990), 71 D.L.R. (4th) 385 (F.C.A.)
10 Ibid, at page 388
11 (1922), 8 T.C. 332
12 Supra, note 5
13 Ibid, in paragraph 12
14 [1968] 1 Ex. C.R. 293
15 [1996] 1 F.C. 322 (F.C.A.)
16 (1991), 92 D.T.C. 6021 (F.C.A.)