Proposed Amendments On Tax Cost And Expenses

On November 17, 2005, the federal Department of Finance released draft amendments to the Canadian Income Tax Act (the Tax Act) that will change the way costs and expenses paid in the form of shares or options are recognized for tax purposes. In the Ontario Budget of March 23, 2006, Ontario announced that it will parallel the federal proposals if implemented.

These proposals are an overreaction and, in some respects, a misguided reaction to the Alcatel case recently decided by the Tax Court of Canada. In Alcatel, a corporation granted stock options to employees involved in research and development. When the employees exercised those options, the corporation took the position that the stock option benefit (the value of the shares less the exercise price) was an expenditure in respect of salary paid to employees doing research and, therefore, entitled the corporation to an increased investment tax credit. The court agreed with the corporation. It noted that the provision in the Tax Act that denies a deduction from income for stock option benefits to employees is not applicable to investment tax credits.

Not surprisingly, the Department of Finance felt the need to react to the Alcatel decision. If the correct tax policy is that a corporation should not be permitted to deduct employee stock option benefits, it should also not be permitted to obtain tax credits for employee stock option benefits. Whether that is the correct tax policy is another story, but suffice it to say that the Department is currently wedded to it.

The proposed amendments could have been restricted to expanding the provision mentioned above to apply not only to deductions but also to investment tax credits. Unfortunately, this was not the approach taken by the Department. There was concern that the broad interpretation given to "expenditures" in Alcatel has implications beyond employee stock options. Although these have not been identified, the Department has, nevertheless, proposed wide-ranging rules.

The first proposed rule, and the one causing the greatest concern, is that if a corporation acquires property or incurs an expense that is paid for by the issuance of its shares, its cost or expense will be limited to the amount added to its paid-up capital, for tax purposes, of its shares.

If enacted, this rule would replace the existing law, as developed by the courts, that the cost of property acquired through the issuance of shares is the price agreed upon by the parties (unless modified by a specific rule in the Tax Act). As stated by the Federal Court of Appeal in the recent Teleglobe case, absent fraud or other factors that would make the transaction impeachable, "it is the agreement of the parties, not the capital accounts which is determinative of the cost".

It was pointed out to the Department that the existing law as expressed in Teleglobe is sensible and that the proposed rule is not. The main concern is that paid-up capital is not necessarily a good measure of cost. Many corporations have shares with nominal par value. For example, a Delaware corporation could have shares that are worth CAD 100 each but have a par value of only CAD 0.01 each. The paid-up capital for tax purposes cannot exceed the par value of the shares. If the corporation bought all the shares of another corporation at an agreed price of CAD 1,000,000 to be paid for by issuing 10,000 of its shares, its tax cost under the existing law would be CAD 1,000,000 but under the proposals would be CAD 100.

The unfairness of this result has been recognized by the Department. But instead of scrapping the proposal and reverting to the existing law, it has suggested that the proposal will be modified so that tax cost would include not only the amount added to paid-up capital but also any contributed surplus.

Contributed surplus is, however, an accounting concept and the rules for when contributed surplus is recognized are not precise and may differ from jurisdiction to jurisdiction.

There are other problems with the proposal, such as when paid-up capital for tax purposes is reduced by a provision of the Tax Act (e.g., section 84.1 or 212.1) on certain types of transaction. While there are good tax policy reasons to reduce paid-up capital in these situations, it does not make sense to also reduce tax cost.

The Department has been urged, including by the Joint Committee on Taxation of the Canadian Bar Association and the Canadian Institute of Chartered Accountants, to reconsider this proposal and revert to the existing law as set out in Teleglobe, subject to fixing any specific problems the Department might identify.

When a partnership or trust incurs a cost or expense that is paid for by issuance of units or interests of the partnership or trust, the Department is proposing a much more sensible rule.

Here, the cost or expense will be limited to the lesser of the value of the units or interests issued and the consideration received by the partnership or trust.

In most commercial transactions, the parties would agree on a price that is equal to both the value of the units or interests to be issued by the partnership or trust and the consideration to be received by it. In these cases, there would be full recognition of the cost or expense under the proposal. It is not clear why a similar rule is not proposed for corporations as opposed to the proposal discussed above.

The third proposal is that if a taxpayer incurs a cost or expense that is paid for by the issuance of an option to acquire its shares or units, no amount will be recognized for tax purposes.

It is difficult to understand the tax policy reason for denying a cost or expense that is paid for by the issuance of an option. For example, if a corporation buys property at a price of CAD 1,000 and pays the price by issuing share purchase warrants having a value equal to CAD 1,000, its cost of the property should be CAD 1,000. If this proposal is enacted, its cost would be zero.

Finally, we get to the concern raised by the Alcatel decision. The fourth proposal is that if any cost or expense would otherwise be recognized on the issuance of shares or units when an option is exercised (as the court found in Alcatel), that cost or expense is to be reduced by the option benefit.

This proposal would, in many circumstances, make sense from a tax policy perspective if recognition were given for the value of options at the time of their issuance, as argued above, but contrary to the third proposal described above. That is, the cost or expenditure should be determined when the bargain is made and the options are issued. If the options have value at the time they are issued, that value should be recognized for tax purposes as part of the cost or expense. Any increase in value of the options after the time the bargain is struck, should, generally, not be relevant to cost or expense. There could, however, be exceptions.

Let’s consider options granted to non-employee consultants as remuneration for services (staying clear of the provision in the Tax Act mentioned above that denies a deduction for stock option benefits to employees). For example, a taxpayer that issues options to consultants, where the exercise of the options is conditional on continued service, may be giving consideration for those services not just on the grant of the options but also on the exercise of the options. In that example (which is similar to the situation in Alcatel except that there the options were granted to employees), the proper tax policy may be that tax recognition should be given to theoption benefit. Under the Department’s proposals, however, no recognition will be given in any circumstances to the option benefit.

One can only hope that sober second thought will prevail and that the Department of Finance will take heed of the many representations made in reaction to these proposals. To date, though, indications from the Department are that a fundamental rethinking of the issues will not happen. Rather, it seems to be intent on pushing through these proposals with limited modifications, such as to recognize contributed surplus on the issuance of shares. This would be unfortunate. A problem (the Alcatel decision) that could have been fixed with a minor amendment will, instead, trigger changes fraught with uncertainty and unfairness.

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