Employees of Employerco and related corporations have been issued share appreciation right (SAR) units, which entitle such Participants to a lump sum on retirement, termination of employment, or death (“Retirement”) equalling the increase, from the date of issuance to the redemption date of redemption, in the closing price of a listed share of Employerco.
Proposed Transactions
Participants would be offered a one-time election to convert their SAR units under this Plan into deferred share units (DSUs), having an equivalent value (so that there would be a smaller number of DSUs). The DSUs would be paid upon Retirement through a distribution of Shares from a newly-formed employee’s profit sharing plan (EPSP) trust. Employerco would make an “out of profits” election under s. 144(10).
The EPSP Trust would use a “Loan” from Employerco on arm’s length terms to purchase Shares on the exchange equal to the number of outstanding DSUs under the Plan and received “Additional Loans” from Employerco to acquire additional Shares in connection with the additional DSUs issued from time to time as dividend equivalents.
The EPSP Trustee would use the cash proceeds it receives from dividends on the Shares, together with “Basic Annual Contributions” (by Employerco to a maximum of 1% of its profits), and Deficiency-Makeup Contributions from Employerco to pay the Loan interest each year. The Participant will have no s. 144(3) income inclusion in the year because there is no net amount for the EPSP Trustee to allocate to the Participant, i.e., the EPSP Trust’s interest expense fully offsets the EPSP Trust’s allocable receipts (i.e., the dividend income, the Basic Annual Contribution, and the Deficiency-Makeup Contribution).
Upon a Participant’s Retirement, Employerco would make a Balloon Contribution (deducted by it under s. 144(5)) to enable the EPSP Trustee to repay the portion of the Loans relating to the Participant’s DSUs, with such amount being allocated to the Participant for inclusion under s. 144(3). The EPSP Trust would then distribute Shares to the Participant in full satisfaction of the Participant’s rights under the Plan.
S. 144(7)(b) would then exclude that amount from the Participant’s income and, under s. 144(7.1)(b)(iv), that amount would be the Participant’s Share cost. Thus, any gain accrued during the time the Shares were held by the EPSP Trust would not be realized until the Shares are ultimately sold by the Participant.
Disposition on conversion and abusive tax avoidance
CRA found that this plan “failed on technical grounds,” i.e., the conversion of the units from SARs to DSUs and addition of dividend equivalents would trigger an immediate income inclusion, but then went on to indicate that even if this structure were instead implemented on a prospective basis, it would refer it to the GAAR Committee, stating:
[T]he structure is highly artificial, provides significant tax deferral and rate reduction benefits on employment compensation, and represents an abuse of the EPSP rules. Here, there is no profit-sharing in purpose or effect. …
Furthermore … the favourable tax results … are similar … to those available under the employee stock option rules … . even though … the requirements of paragraph 110(d) or (d.1) are not satisfied.