Principal Issues: Whether an arrangement is governed by section 7 or the EBP rules.
Position: The EBP rules apply.
Reasons: There is no agreement to sell or issue shares to employees; employees only receive a contingent beneficial interest in the trust’s property, subject to the trustees’ unfettered discretion regarding distributions so the arrangement is not subject to section 7. Subsection 7(2) cannot apply in the absence of an agreement to sell or issue securities to an employee and cannot apply when shares are not allocated to specific employee beneficiaries at the time they are acquired by the trust.
FEDERAL TAX ROUNDTABLE, OCTOBER 7, 2021
APFF CONFERENCE 2021
Question 1
The calculation of the 24-month holding period for an employee trust for the purposes of subsection 7(2)
A discretionary trust ("Trust") has held shares ("Shares") of a private company, ABC Inc. since January 1, 2021. In order to attract and retain its workforce, the Trust provides that all current and future employees of ABC Inc. are potential beneficiaries. One employee, Mr. X, is hired by ABC Inc. on January 1, 2022, and, accordingly, was designated as a discretionary beneficiary of the trust at that time. For greater certainty, the shares subscribed for by the Trust in the capital of ABC Inc. on January 1, 2021, were not subject to any exchange, conversion, sale or other disposition whatsoever and continued to be held by the Trust before and after January 1, 2022. Also, the Trust did not acquire additional shares.
Subsection 110.6(16) (footnote 1) deems a trust described in subsection 7(2) to be a personal trust for the purposes of the definition of "qualified small business corporation share" ("QSBCS") in subsection 110.6(1). In addition, a trust described in subsection 7(2) may designate an amount to a beneficiary as a net taxable capital gain on a disposition of a QSBCS pursuant to subsections 104(21) and 104(21.2). This is to allow the beneficiary to claim the capital gains deduction ("CGD") pursuant to subsection 110.6(2.1), if the other conditions for claiming the CGD are otherwise met.
Under the definition of QSBCS in paragraph 110.6(1)(b), an individual, including a personal trust, or a person related to the individual, must hold the share throughout the 24-month period preceding the particular time (e.g., the time of disposition of the share) (the "Holding Period").
Subsection 7(2) provides that if a trust holds a share for an employee, the employee is deemed to have acquired the share at the time the trust began to hold the share, for the purposes of section 7.
In addition, Technical Interpretation 2012-0439271E5 (footnote 2) explains that, generally speaking, an individual need not be a beneficiary of a personal trust for 24 months to meet the Holding Period in order to claim the CDG under subsection 110.6(2.1), provided the personal trust itself satisfies the Holding Period for the share. This interpretation of paragraph 110.6(1)(b) was also repeated in Pellerin v. The Queen (footnote 3). Technical Interpretation 2015-0571801E5 (footnote 4) also supports that interpretation.
Question to the CRA
In view of the above, from what date will the 24 month holding period be calculated for Mr. X in respect of the Shares?
CRA Response
In general, where contributions are made by a corporation to a trust established for the benefit of the corporation's employees and those contributions are used by the trust to subscribe for shares of the corporation, the trust plan established will be subject to either section 7 or the employee benefit plan ("EBP") rules. If both the section 7 rules and the EBP rules apply to the same trust plan, the section 7 rules take precedence, as the courts have concluded that the section 7 regime is more specific than the EBP rules (footnote 5).
In Transalta Corporation v. The Queen (footnote 6), the Tax Court of Canada held that a discretionary arrangement was not an agreement to issue or sell shares for the purposes of section 7 since no legal rights or obligations were created. According to the Court, the meaning of the words "agreed"; and "agreement"; in section 7 refers to a legally enforceable undertaking, that is, the granting of legal rights to employees and the creation of corresponding obligations for the employer. The Canada Revenue Agency ("CRA") applies that principle in determining whether or not an arrangement falls within the application of section 7. Thus, the question of whether, in a particular situation, an arrangement constitutes an agreement to issue shares for the purposes of section 7 is one of fact and law that can only be resolved after a review of all the relevant facts and documents.
That being said, a trust plan providing that the allocation and distribution of the corporation's shares to its employees, who are beneficiaries of the trust, will be made on an entirely discretionary basis would not be governed by s. 7. Indeed, such a discretionary plan does not imply a legally enforceable commitment, since neither the corporation nor the trust is obliged to transfer shares to a given beneficiary and no employee-beneficiary has an enforceable right to the shares unless and until the trustees of the trust have exercised their discretion in the employee’s favour.
In that regard, it is important to specify that subsection 7(2) does not serve to deem the existence of an agreement to issue or sell shares for the purposes of section 7 where such an agreement does not in fact exist. That subsection has no relevance, and therefore no application, in the absence of an agreement to issue or sell shares within the meaning of section 7. That subsection cannot apply to a discretionary trust in which the employee beneficiaries are not entitled to a specified number of shares that have been specifically allocated to them pursuant to a legally enforceable undertaking constituting an agreement to issue or sell shares for the purposes of section 7.
In the situation described, the Trust is a discretionary trust and all current and future employees of ABC Inc. are potential beneficiaries of the Trust. We understand that under the Trust's governing instrument, the trustees would have full discretion to determine the share of income and capital of the beneficiaries, and that that discretion would include the ability to distribute all of the income or capital of the Trust to one or more beneficiaries, to the exclusion of others. We further understand that that discretion could be exercised from time to time by the trustees and would generally only be exercised at the time of (or shortly before) making a distribution.
Thus, based on our understanding of the situation described, when he becomes a discretionary beneficiary of the Trust on January 1, 2022, Mr. X will not be entitled to a specified number of Shares under an enforceable obligation. Instead, the trustees will only allocate Shares to Mr. X at the time of (or shortly before) making a distribution and only if they decide to exercise their discretion in his favour, which may never happen, or may happen several years after the Trust has acquired the Shares. Such a discretionary plan would not involve a legally enforceable obligation and would therefore not be governed by section 7.
Since section 7 would be inapplicable, the tax treatment resulting from the trust plan put in place would be governed by the rules applicable to EBPs. In particular, the fair market value ("FMV") (determined at the time of the distribution) of the Shares distributed by the Trust to each employee beneficiary in favour of whom the trustees would have exercised their discretion would have to be included in the computation of that employee's income by virtue of paragraph 6(1)(g). Thus, the full value of the Shares distributed to Mr. X would be included in the computation of his income as employment income, to which the CGD would obviously be inapplicable. Furthermore, Mr. X would only be considered to own the Shares so received as of the date of the distribution.
Finally, it should be noted that in McNeeley v. The Queen (footnote 7), currently under appeal to the Federal Court of Appeal, the Tax Court of Canada considered a discretionary trust plan similar to the one in the situation described and concluded that the EBP rules applied.
Mélanie Beaulieu
(343)543-2154
October 7, 2021
2021-090089
FOOTNOTES
Due to our system requirements, footnotes contained in the original document are reproduced below:
1 R.S.C., 1985, c. 1 (5th Supp.) ("ITA").
2 CANADA REVENUE AGENCY, Technical Interpretation 2012-0439271E5, June 4, 2012.
3 2015 TCC 130.
4 CANADA REVENUE AGENCY, Technical Interpretation 2015-0571801E5, June 23, 2015.
5 MRN v. Chrysler Canada Ltd., 92 D.T.C. 6346 (F.C.T.D.).
6 2012 TCC 86.
7 2020 TCC 90.