A Federal Court of Appeal ruling will make it very difficult for executives and employees to treat share transfers from their companies as capital gains rather than income.
The decision involved Kitchener, Ont.-based D2L Corp., whose intention was to distribute appreciated shares of the company, held in a trust, to various employees. In turn, the employees sold the shares to the controlling shareholder and sought to treat the profit as capital gains, which attract tax at one half the rate on normal income. They did so in the belief that their gains attracted the rules applicable to prescribed trusts under the Income Tax Act regulations.
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“Had the approach worked, there would have been a tax-free crystallization for the controlling shareholder and a tax-free receipt of proceeds for the arm’s length employees,” says David Rotfleisch, a tax lawyer at Rotfleisch & Samulovitch Professional Corp. “A nice win for everyone but the Canada Revenue Agency.”
But it wasn’t to be. In mid-November, the court of appeal ruled the profits garnered by D2L employees Mathew McNeeley, Kenneth Chapman and John Baker, the company’s chief executive officer and controlling shareholder, were derived from what amounted to an employee benefits plan under the tax act and should be treated as part of their normal employment income. To the extent that the regulations governing prescribed trusts conflicted with the statute’s definition of employee benefits plans, the statute governed.
“Parliament could have provided that a prescribed trust is not an employee benefit plan,” the court reasoned. “[The] definition of an employee benefit plan exclude[s] a number or arrangements and trusts from the definition of an employee benefit plan. If Parliament had also intended to exclude prescribed trusts from the definition of an employee benefit plan, a reference to a prescribed trust could have been added.”
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Baker, who received the bulk of the share distribution, also argued that it wasn’t income in his hands because he received the payment in his capacity as founding shareholder rather than CEO.
The court acknowledged that the tax act excluded certain payments in determining whether an arrangement was an employee benefits plan. But once the determination was made that an arrangement was an employee benefits plan, all payments under that plan constituted employment income.
“In my view, the reference to the exclusion of certain payments in determining whether an arrangement is an employee benefit plan means that each payment to be made from a particular arrangement is examined to ascertain whether such payment is an excluded payment or not,” wrote the court. “If all of the payments are excluded payments, the arrangement is not an employee benefit plan. If, however, the arrangement includes at least one payment that is not an excluded payment, the arrangement is an employee benefit plan.”
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Put another way, the tax act’s definition of an employee benefits plan didn’t contemplate that a portion of an arrangement might not be an employee benefits plan. Once it was determined that the arrangement was an employee benefits plan, all payments amounted to employment income.
“What the court concluded was that, for tax purposes, you can’t have two types of animals in the same trust or [employee benefits plan],” says Dov Begun, an employment and executive compensation tax partner in Osler, Hoskin & Harcourt LLP’s Toronto office.