FEBRUARY 2011
EMPLOYEE STOCK OPTION SURRENDER
PAYMENTS NON-DEDUCTIBLE
On December 21, 2010, the Tax Court of Canada dismissed the taxpayer’s appeal in
Imperial Tobacco Canada Limited v. The Queen.1 The case concerned whether the
taxpayer, the successor by amalgamation to Imasco Limited, was entitled to deduct
in computing its income for its 2000 taxation year, a total of $118,575,528 paid to its
employees for surrendering stock options under its employee stock option plan (SOP).
While the taxpayer contended that the amounts were paid as employee compensation
to satisfy its obligations under the SOP, the Crown successfully argued that the
deduction was precluded by paragraph 18(1)(b) of the Income Tax Act (Canada)
(the Act) as the amounts were paid on account of capital in the course of a corporate
reorganization, and not as employee compensation.
TAX LAW BULLETIN
FACTS
Imasco established the SOP in 1983 to grant stock
options to certain employees. In 1999, British
American Tobacco p.l.c. (BAT), which indirectly
owned 42.5% of the outstanding common shares
of Imasco, issued a news release stating that it had
entered into discussions with Imasco to acquire all
of the Imasco common shares held by public
shareholders. Two days later, Imasco’s Board of
Directors resolved to amend the SOP to grant
option holders the discretion to surrender (rather
than to exercise) options, and to receive on
surrender cash equal to the amount of the excess
of the then market value of the relevant number of
Imasco common shares over the purchase price of
the shares specified in the option. Under the terms
of a Transaction Proposal Agreement (TPA) entered
into by Imasco, BAT and its Canadian acquisition
company, Imasco accelerated the vesting of options
under the SOP so that all outstanding options
became exercisable prior to the completion of the
going private transaction. Imasco also encouraged
1
2010 TCC 648 (T.C.C.).
all option holders to exercise or surrender their
options. Both the accelerated vesting and the
exercise/surrender of options were made
conditional upon the completion of the going private
transaction. Prior to the closing of the transaction,
all of the then outstanding stock options issued
under the SOP were either exercised or surrendered
and then cancelled. No further stock options were
issued, nor were other activities carried out under
the SOP after the transaction was completed,
although the SOP was not formally wound up.
TAX COURT DECISION
The taxpayer asserted that the option surrender
payments were made in the normal course of
administering its SOP, to discharge liabilities
arising as part of its employee compensation
arrangements. As such, they were deductible
business expenses rather than capital outlays.
The Tax Court judge (at paragraph 5 of the decision)
disagreed with the taxpayer’s characterization of
the payments:
TAX LAW BULLETIN | FEBRUARY 2011
2
To take this view of the matter one would
have to consider the decision to accelerate
the vesting of unvested options, the decision
to amend the SOP to permit the holders of
options the discretion to surrender them for
cash, and the cessation of the granting of
options all in isolation from the going private
transaction whereby BAT Canada sought to
acquire all the outstanding shares of Imasco.
Doing so would be contrary to the test in B.P.
Australia Ltd. v. Commissioner of Taxation 2, as
approved by the Supreme Court of Canada in
Johns-Manville v. The Queen.3 Under that test, the
Tax Court judge had to consider all of the “guiding
features” of the taxpayer’s case in determining
from a practical and business point of view what
the taxpayer’s payments under the SOP were
intended to accomplish.
In analyzing the taxpayer’s circumstances, the Tax
Court judge considered a prior case on point relied
on by the Crown. In Kaiser Petroleum Ltd. v. The
Queen 4, the Federal Court of Appeal held that the
taxpayer’s payment to extinguish an employee
share option plan was a payment on account of
capital. Although employee compensation was the
reason for the initial implementation of the stock
option plan, as well as a purpose of terminating the
plan, under the B.P. Australia Ltd. test the “guiding
element” of the payment was to reshape the capital
structure of the taxpayer.
To support its position, the taxpayer relied upon the
judgment in Imperial Tobacco Canada Limited
(Successor by Amalgamation to Shoppers Drug
Mart Limited) v. The Queen 5, in which the Tax Court
distinguished the Kaiser case. While that case also
involved the Imasco going private transaction,
Shoppers Drug Mart (SDM) paid the amounts in
question to its parent, Imasco, to reimburse Imasco
for paying SDM’s employees for surrendering their
options under the SOP. While Imasco’s payments to
SDM’s employees were made in the context of
reorganizing Imasco’s capital structure, the Tax
2
[1966] AC 224 (J.C.P.C.).
[1985] 2 S.C.R. 46 (S.C.C.).
4
90 DTC 6603 (F.C.A.).
5
2008 DTC 2043 (T.C.C.).
6
Supra, footnote 1 at paragraph 11.
3
Court held that SDM’s payments to Imasco were
deductible since SDM made them to reimburse
Imasco, not to reshape its capital structure. The Tax
Court judge easily dismissed the relevance of that
case to the present facts since the taxpayer’s
capital structure was clearly restructured.
The Tax Court also disagreed with the taxpayer’s
assertions that Kaiser was distinguishable from the
facts before it. The taxpayer argued that it had only
agreed to encourage the surrender or exercise of
stock options and, thus, its payments were made to
satisfy obligations to its employees under the SOP,
not to make the takeover transaction possible as in
Kaiser. The taxpayer also noted that, in contrast to
Kaiser, the TPA did not require the taxpayer to
extinguish the SOP, and the SOP was not formally
terminated; the taxpayer’s payments were not
related to employee retention, and its payment
obligation arose under the SOP and not the TPA; the
taxpayer’s employees had the right to surrender
vested options under the SOP whether or not the
going private transaction was completed, and could
choose to exercise, surrender or retain their options
rather than being required to surrender their
options for cash or have them terminated; and the
SOP allowed both early vesting and cash surrender
of options since 1995.
The Tax Court judge concluded that these were “all
distinctions without a difference”.6 While fairness
to Imasco’s employees in the context of the
impending going private transaction might have
necessitated the accelerated vesting of unvested
options, it did not require Imasco to make the
option surrender payments. Considering all of the
relevant facts surrounding the option surrender
payments, the Court concluded:
It is clear from the [TPA] at section 5.8 that
the mutual intention of BAT and Imasco was
that, so far as it was feasible to do so, all
outstanding options to purchase shares
would be eliminated before the completion
of the [going private] transaction. If
3
compensation was an element of the
decision to make the payments then
nevertheless, as in the Kaiser Petroleum
case, the reshaping of [Imasco’s] capital
structure “dominate[d] the whole set of
circumstances…and constitute[d] the
guiding element…”.
The real question in each case is “what was
the expenditure calculated to effect from a
practical and business point of view?” Given
the timing of the amendment to the SOP on
June 7, 1999, coincident with the press
release the same day by which BAT
announced that discussions were taking
place, and followed on August 2, 1999 by
the signing of the [TPA] in which section 5.8
set out the parameters for the elimination,
so far as possible, of outstanding options,
there can be no serious doubt as to what the
expenditure was calculated to effect. It was
calculated to give BAT some assurance that
on completion of the going private
transaction there would be few or no
outstanding options remaining in the hands
of Imasco employees. If all that Imasco
intended was to settle up with its
employees, as counsel contends, then it
need only have accelerated the vesting of
unvested options. Employees could then
have exercised them at will.7
Finally, the judge dealt briefly with the taxpayer’s
reliance on prior Tax Court decisions in which
payments were held to be deductible: Boulangerie
St. Augustin v. The Queen 8, International Colin
Energy Corp. v. The Queen 9, and BJ Services
Company Canada v. The Queen.10 In the Court’s
view, since the facts of those cases were
significantly different than the present facts, it
was bound by the Kaiser decision to dismiss the
taxpayer’s appeal. Accordingly, the Court upheld
the Minister’s assessment denying the taxpayer’s
deduction of the option surrender payments.
COMMENT
The Tax Court’s decision may do little to clarify the
circumstances in which taxpayers engaged in
transactions are able to deduct stock option
surrender payments as current expenses. It is
hoped that the Federal Court of Appeal will provide
more guidance on this issue when it considers the
taxpayer’s appeal of the Tax Court decision.
The International Colin Energy and BJ Services
cases may suggest an alternative argument for
the deductibility of the stock option surrender
payments over a five-year period under
subparagraph 20(1)(e)(i) of the Act, on the basis
that the payments were made “in the course of…
[a] sale of…shares of the capital stock of the
taxpayer”. In particular, the Tax Court’s obiter
comments in International Colin Energy provide a
compelling argument that the words “issuance or
sale” in subparagraph 20(1)(e)(i) should be
interpreted to include not only a sale by a
taxpayer of its own shares from treasury
but also a sale of a taxpayer’s shares by the
taxpayer’s shareholders.11
7
Supra, footnote 1 at paragraphs 11 and 12.
95 DTC 164 (T.C.C.), aff’d 97 DTC 5012 (F.C.A.).
9
2002 DTC 2185 (T.C.C.).
10
2004 DTC 2032 (T.C.C.).
11
Supra, footnote 9, at paragraphs 58-59:
“The word ‘issuance’ implies an issuance by the corporation of its own treasury stock. That is not of course what happened here.
Here the sale was not by the corporation but by its shareholders. It may well be that even if the payment here is caught by paragraphs
18(1)(a) and (b) it falls broadly within the purpose of paragraph 20(1)(e). The question is however whether ‘in the course of the sale…
of the shares of the capital stock of the taxpayer…’ is to be restricted to a sale by the corporation of its own shares.
8
There are respectable arguments on either side. It is arguable that ‘sale’ by its juxtaposition with ‘issuance’ means a sale by the
company of its own shares and not a sale by shareholders of their shares. It is equally arguable that ‘issuance’ by itself is quite broad
enough to cover a sale by a company of its own shares and that there was no need to add the word sale if all that was meant was a
sale by the company. Therefore ‘sale’ must imply something else and the only thing it can refer to is a sale by the shareholders in the
course of a corporate transaction of the type involved here where the interests of the corporation are affected. I find the argument
attractive not only because it makes sense commercially but because the more restrictive interpretation requires reading into the
statute words that are not there. In light, however, of my conclusion on the principal argument advanced in the case I express no
concluded view on the point.”
AUTHORS
Pamela L. Cross Stephanie Wong
Ottawa
Toronto
613.787.3559 416.367.6198
pcross@blg.comswong@blg.com
TAX LAW GROUP
National Leader
Douglas J. Powrie
Vancouver604.640.4097 dpowrie@blg.com
Regional Leader
Lindsay J. Holmes, Q.C. Calgary
403.232.9605 lholmes@blg.com
Charles P. Marquette Montréal514.954.3121cmarquette@blg.com
Pamela L. Cross
Ottawa 613.787.3559pcross@blg.com
Stephen J. Fyfe
Toronto 416.367.6650sfyfe@blg.com
Douglas J. Powrie
Vancouver604.640.4097 dpowrie@blg.com
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