Optimizing the tax treatment of stock options in employees’ hands has long been a staple of Canadian executive compensation design and tax planning. No less important from a corporate perspective, however, is the tax treatment for employers. In this regard, the Tax Court of Canada decision in Imperial Tobacco Canada Limited v. The Queen, released just before Christmas, represents a troubling development.
The background can be summarized as follows. Where an employee exercises stock options and acquires shares, the Income Tax Act expressly prohibits a corporate tax deduction. By contrast, where an employee surrenders stock options in exchange for a cash payment, it has usually been possible for the payor corporation to claim a tax deduction for this out-of-pocket payment as a cost of doing business.
The large Montreal-based conglomerate Imasco Ltd. operated a stock option plan for its employees and for employees of several of its subsidiaries, including Imperial Tobacco and Shoppers Drug Mart. In 2000, Imasco was acquired by a British corporation, BAT plc.
In order to minimize the number of options that would be exercised for shares, which would then immediately be tendered into the BAT bid, Imasco amended its stock option plan at the time of the takeover to allow optionholders to instead surrender their options to Imasco for cash. Virtually all Imasco, Shoppers Drug Mart and other participating employees surrendered their options for cash rather than exercising them for shares.
The Canada Revenue Agency challenged the deductibility of the cash payments made by Shoppers Drug Mart and Imasco. Back in 2007, the Tax Court upheld the deductibility of the payments by Shoppers. Surprisingly, however, in this latest decision rendered last month, the corresponding payments made by Imasco to its employees were held by a different Tax Court judge to be non-deductible. (The reason the case is called “Imperial Tobacco” rather than “Imasco” is because after the BAT takeover, the two companies merged under the Imperial Tobacco name.)
How is this unfortunate and seemingly contradictory result possible? The Tax Court in Imperial Tobacco all but ignored the 2007 Shoppers Drug Mart decision, relying instead on a dubious, all-but-forgotten 1990 court decision involving the takeover of a company called Kaiser Petroleum. In the Kaiser Petroleum case, the conclusion was that a payment associated with the surrender of stock options which was coincident with a corporate takeover constituted a payment on account of capital rather than a cost of doing business, and was hence not deductible.
For many years, the reasoning in Kaiser Petroleum was broadly considered in the tax community to apply only to its own facts. But that reasoning has now been given new life in Imperial Tobacco.
As a result of changes to the stock option rules announced in the March 2010 federal budget, it is no longer possible for stock option surrenders to generate both favourable tax treatment for optionholders (i.e. the half rate of tax pursuant to paragraph 110(1)(d) of the Income Tax Act) and a corporate deduction for the employer. Rather, the parties must henceforth choose one or the other.
On the theory that most employers will wish to optimize their employees’ tax treatment, this means that many fewer corporate tax deductions will be claimed in connection with option surrender payments anyways. Accordingly, the Imperial Tobacco decision may have relatively limited impact even if it is not reversed on appeal.
However, to the extent that there are any stock option surrender payments under review by Revenue Canada in connection with past takeovers, the deductibility of those payments (which are often quite large) may be at serious risk.
If there are any future takeovers in which the favourable personal tax treatment would not otherwise be available for one reason or another, the effect may be to put a damper on option surrender arrangements of this nature and make the process of sorting out stock options in the takeover context much more cumbersome.