In an April 28, 2017 Technical Interpretation (2017-0699741I7, Waugh, Phyllis), CRA was asked whether a reimbursement for tax advisory services obtained as a result of an employer payroll error would be a taxable benefit. The errors in question arose from the Phoenix pay system used for public service employees (see VTN 422(10)).

2017-10 EMPLOYMENT INCOME TAXABLE BENEFIT – TAX ADVISORY SERVICES

In an April 28, 2017 Technical Interpretation (2017-0699741I7, Waugh, Phyllis), CRA was asked whether a reimbursement for tax advisory services obtained as a result of an employer payroll error would be a taxable benefit. The errors in question arose from the Phoenix pay system used for public service employees (see VTN 422(10)).

The Interpretation noted that receipts were required from the employee, and only costs directly related to the payroll error would be reimbursed. CRA indicated that compensation for a financial loss resulting from the employer’s error would not be an economic benefit to the employee, so such a reimbursement would not be a taxable benefit.

STOCK OPTIONS – SALE ARRANGEMENTS

In a July 14, 2017 Federal Court of Appeal case (Montminy et al. vs. H.M.Q., A-180-16), at issue was whether the taxpayers could claim a 50% deduction of the benefit on the exercise of their stock options

(Paragraph 110(1)(d)). The taxpayers exercised their stock options due to the sale of all assets of the employer corporation. The options were exercised and then the shares sold to the parent of the employer company the same day. See Tax Court decision in VTN 419(3) (Montminy et al. vs. H.M.Q., 2012-2142(IT)G).

The exercise and sale of shares were undertaken in conjunction with the sale of the assets of the employer corporation to an unrelated third party. The option terms originally provided for exercise of the shares on the sale of the corporation’s shares but not the assets. However, the terms were amended to permit the options to be exercised in this case, in the interest of fairness to the employees.

The taxpayers reported a taxable benefit being the difference between the exercise price and the value of the shares sold to the parent. They also claimed a deduction of 50% of the taxable benefit.

The Tax Court opined that as the employees were required to sell the shares to the parent corporation on the date of issuance, there was no doubt that such a sale would occur, and therefore, the share would not be a prescribed share (defined in Regulation 6204(1)). As a result, the deduction was denied.Among other criteria, this deduction is not permitted if the issuer of the share, or certain related parties, is reasonably expected to redeem, acquire or cancel the share within two years of its issuance to the employee (Regulation 6204(1)(b)).

The Tax Court also noted that an exception which disregards the twoyear test (Regulation 6204(2)(c)) should not be applied due to the Tax Court’s statutory interpretation of the law. The Federal Court of Appeal analyzed this exception in detail.

Taxpayers win

The Court noted that the two-year test is ignored where they meet the following conditions (Regulation 6204(2)(c)):

(i)the employee to whom the share is issued was dealing at arm’s length with the employer when it was issued;

(ii)the right or obligation is provided for in an agreement or terms and conditions of the share, and it is reasonably considered that:

1. the principal purpose of providing the right or obligation is to protect the employee against any loss in the value of the share, and the amount payable to the employee under the right or obligation will not exceed the adjusted cost base of the share to the holder immediately before the acquisition (in other words, the value of the shares when issued to the employee); or 2. the principal purpose of providing the right or obligation is to provide the employee with a market for the shareand the amount payable for the share will not exceed fair market value of the share at the time; and

(iii)it can be reasonably considered that the amount payable for the share is not directly determined by the profits of the corporation, or a non-arm’s length corporation, for the period from issuance of the option to disposal of the shares (an exception allows use of profits in a formula for computing the fair market value of the shares)

As all three conditions were satisfied, the exception was met and the two-year rule was disregarded, such that the shares in question were prescribed shares, eligible for the deduction. Further, the Court noted that it is not the imposition of a holding period of the shares that ensures a risk element but, rather, the particular characteristics of the share and minimum price at which the option must be exercised. The Court found that the Tax Court neglected to consider the risk the taxpayers bore for the more than five years that they heldthe options where the value of the corporation could have fluctuated. As such, providing the deduction (Paragraph 110(1)(d)) was consistent with the broader purpose of the stock option rules.