“A small change to timing can have a big tax impact”
Generally, when stock options are granted, no tax benefit is recognized for Canadian tax purposes until the employee exercises the option. The benefit is begins as fully taxable employment income. If the exercise price of the options is at least equal to the value of the shares when the options were granted (or, for options of a Canadian-controlled private corporation (“CCPC”), if the shares acquired under the option are held for 24 months or more before they are sold), the full income inclusion is reduced by half. Where the employer is a CCPC and the employee deals at arm’s length with the employer, this benefit can be deferred until the shares are disposed of.
What do we mean by “disposed of”? It’s not only a sale to a third party. Transfers to a holding company, or even an exchange of shares for another class of the same company, are examples of “non-sale” events that are treated as dispositions for tax purposes. Fortunately the tax rules allow for a transfer or exchange of the shares to be ignored when certain “internal” transfers or exchanges occur. Where the exceptions are met, the income inclusion is deferred until the year in which the employee disposes of or exchanges the securities of the new company (or the securities issued to replace the original shares).
Let’s use an example. Assume Opco, a CCPC, is being sold to a new controlling group of Canadian shareholders. Often, the new controlling group will acquire its shares through a holding company (Holdco), also a CCPC. In many cases, the founding shareholders of Opco will transfer their shares of Opco to Holdco as part of the transaction. To the extent the shares the founding shareholders transfer were acquired via stock options, this transfer may trigger unintended tax. Why? The shares of Opco are technically being disposed of when they are transferred to Holdco so the employment benefit from the original stock options will become taxable unless certain deferral conditions are apply.
In particular, the benefit will be deferred until there is a sale of the new Holdco shares if Opco does not deal at arm’s length with Holdco immediately after the transaction. If the new shareholders control Holdco before the founding shareholders transfer their option shares, Holdco may not be arm’s length with Opco immediately after the transfer. This conclusion would trigger the realization of the taxable benefit by the original shareholders on their stock option shares.
In order to avoid this problem, the Opco shareholders should sell their option shares to Holdco before the new shareholders take control of Holdco. This ordering ensures that Holdco will be owned only by the previous Opco shareholders immediately after the transfer of the stock option shares. As such, Holdco and Opco would not deal at arm’s length with each other immediately after the transfer and the stock option benefit will be deferred. The new shareholders can then subscribe for their new shares of Holdco.
A small change to timing can have a big tax impact.
TAX TIP is provided as a free service to clients and friends of Cadesky Tax.
The material provided in Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.
On June 12, the Federal Court of Appeal issued its decision on a motion brought by Cameco in an ongoing transfer pricing case.
The Federal Court of Appeal ordered the Crown to communicate to Cameco “its position as to the arm’s length price or prices at which Cameco and CEL ought to have purchased/sold uranium transacted between them during the 2003 taxation year or a formula which allows Cameco to identify this price or these prices”. One would normally assume that in a transfer pricing dispute, the positions of CRA and the taxpayer on the price of the transaction in question would include an indication of the price each side believes is arm’s length. The Cameco case shows that in the topsy-turvy world of Canadian transfer pricing, this cannot be assumed.
The CRA reassessed Cameco under paragraph 247(2)(a), paragraph 247(2)(b), Section 56(2), and by alleging the Cameco transaction structure was a “sham intended to conceal the fact that all income earning activities were performed in Canada”.
Section 247(2) allows the CRA to make an income or capital adjustment where paragraph (a) or paragraph (b) applies. Paragraph (a) applies where the terms and conditions of the transaction or series are non-arm’s length. Paragraph (b) applies where the transaction or series meets two conditions, namely: (i) the transaction or series would not have been entered into between persons dealing at arm’s length and (ii) the transaction or series “can reasonably be considered not to have been entered into primarily for bona fide purposes other than to obtain a tax benefit”
Where only paragraph (a) applies, the terms and conditions made or imposed, paragraph (c) then applies to re-price the transaction or series. Where paragraph (b) applies, paragraph (d) then applies to replace the original transaction or series with a different transaction or series that would have been carried on between arm’s length parties, and then use the price from that different transaction or series to price the related-party transaction.
We could just describe the relationship between paragraphs (a) through (d) as follows:
If (a) implies (c) and (a) is true, then (c) is true
If (b) implies (d) and (b) is true, then (d) is true
If (b) implies (d) and both (a) and (b) are true, then (d) is true
But if a company or partnership were to follow the logic above, it may be out of step with the Tax Court of Canada in General Electric Canada and current CRA assessing practice as evidenced in a July 6 proposed reassessment of 2005 to 2010 taxation years of Silver Wheaton. These interpretations of Section 247(2) suggest that both (a) and (b) can be true in a certain circumstance or that the distinction between them is blurred, opening what appears to be a route to replace a mispriced transaction with a different transaction as opposed to changing the price of the original transaction as follows:
If (b) implies (d), and either both (a) and (b) are true or (a) is the same as (b), then (a) implies (d)
Meeting the two-part test of paragraph 247(2)(b) is difficult, as is making the argument for an arm’s length price under 247(2)(c). A logical bypass of paragraphs 247(2)(b) and (c) (or at least 247(2)(b)) is therefore a solution that CRA may find worthwhile to attempt. This may be an attractive option when compared with a legislative amendment to include a rule with two ‘ors’ – (a) or (b) or ((a) and (b)) – that sets out the consequences to taxpayers of meeting these conditions.
Cameco is defending its position vigorously through uncertain territory. In fairness, the CRA and the Tax Court are not alone in experiencing difficulty reasoning through the distinction between substituting an arm’s length price and substituting an arm’s length transaction when non-arm’s length conditions are found to have been used to determine taxable income. This issue is the subject of the hotly debated and incomplete BEPS Actions 8, 9 and 10.
As we wait for the Cameco trial and decision, companies should treat Section 247(2) transfer pricing proposals of zero adjusted price, zero adjusted profit, and claims about what arm’s length parties would or would not do with professional skepticism, and consult a transfer pricing advisor.
THE NON-ARM’S LENGTH NEWS is provided as a free service to clients and friends of Cadesky Tax. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing a tax planning arrangement or taking an uncertain tax filing position. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.