Imperial Tobacco v The Queen: A Lose-Lose Situation? Deduction for Amounts Paid to Employees for Stock Options Refused
It is not common for TheCourt.ca to comment on tax cases. Tax decisions often seem complicated and, unless you are an accountant, a corporate executive or a tax lawyer, they seem removed from your daily life. At face value, the case of Imperial Tobacco Canada Limited v The Queen, 2011 FCA 308 [Imperial Tobacco] is about whether amounts paid to employees for stock options in the course of going from a public to private company can be deducted as a corporate expenditure on income account. But it is more than that. Together with 2010 federal budget changes, the case may have far reaching consequences for employees as well as employers. Public companies often allow employees to surrender options for a cash payment instead of exercising those options. Ordinarily, when the option is surrendered, the company could obtain a deduction for the cash paid on surrender of the option. At the same time, the employee is permitted to a claim a deduction under paragraph 110(1)(d) of the Income Tax Act, RSC, 1985, c 1 (5th Supp) [ITA], which amounts to a deduction of 50 per cent. The position of the plaintiff is that the same applies to the surrender of the option in the course of a public company being acquired by a private company. In its decision in Imperial Tobacco, the Federal Court of Appeal did not accept the plaintiff’s argument. Just last month, the Supreme Court of Canada dismissed the appeal and refused to hear the case. Even though it jars with case law and seems to be at odds with tax policy, it looks like the appellate court will have the last word.
As the Court of Appeal states, the facts are not disputed in this case. Imasco, the holding company created by Imperial Tobacco in 1970, was a Canadian public corporation until 2000. Two decades earlier, in 1983, Imasco instituted an employee stock option plan under which employees of Imasco and its subsidiaries could be granted the right to purchase Imasco shares for their free market value (“FMV”) as of the date of the grant of the option. Concerning the transactions relevant to this case, options issued under the Imasco employee stock option plan represented rights to acquire only 1% of the shares outstanding.
12 years later, Imasco introduced an amendment to the stock option plan, allowing an option holder the right to surrender the option for cash equal to the amount by which the market value of the Imasco shares that could be acquired by exercising the option exceeded the exercise price. (In simpler language, the option holder who is granted this right and exercises it would be in the same position financially, as if the stock option had been exercised and the shares immediately sold, disregarding income tax consequences and transaction costs.)
What distinguishes this case from other cases (to be discussed below) is that Imasco was in the course of becoming a private holding company. In 1999, British American Tobacco (“BAT”), a large multinational tobacco company, approached Imasco to discuss a “going private transaction” under which BAT would acquire – directly or indirectly – all of Imasco shares held by public shareholders. By December 1999, BAT indirectly owned 42.5% of all outstanding shares of Imasco shares.
To facilitate the going-private transaction and to treat its option holders fairly, Imasco’s board of directors passed a resolution to amend section 10 of the employee stock option plan to give all option holders the right to surrender their options for cash. This amendment would allow each option holder the discretion to initiate the surrender of an option, instead of Imasco. In fact, Article 5.8 of the Transaction Proposal Agreement, entitled “Outstanding Stock Options and Employment Arrangements of Imasco,” was intended to encourage all holders of employee stock options to exercise or surrender them immediately prior to the completion of the reorganization. The board of directors took steps to ensure that all employee stock options would vest before the reorganization. Thus, the acceleration of the vesting of employee stock options, along with the provision for the surrender of stock options for cash at the election of options holders, would allow the soon-to-be parent company to acquire all Imasco shares by the end of 1999.
The purchase price of Imasco shares was set by BAT at $41.60 per share. With employees holding in aggregate options 4,838,600 Imasco shares, which they subsequently elected to surrender for cash equal to the difference between $41.60 per share and the exercise price, the surrender payment totaled approximately $118 million. This is the amount at issue in the case.
Issues and Submissions
The issue before the Court was straightforward: in computing its income for income tax purposes, was Imasco Limited entitled to deduct payments made to its employees and employees of its subsidiaries for surrendering options to acquire Imasco shares?
The Minister of National Revenue (“MNR”), relying on paragraphs 18(1)(b) of the ITA, disallowed deductions for Imasco on the basis that the payments were on account of capital. More specifically, the Crown argued that the cash payment to eliminate the stock option plan was not made in the ordinary course of the applicant’s business. It was an extraordinary expense intended to ease the take-over transaction by British American Tobacco. The applicant, on the other hand, argued that the most pressing question that needed to be answered in this case was whether there was an enduring benefit to the taxpayer. The applicant also marshaled case law, citing the recent decision by Chief Justice Donald Bowman in Shoppers Drug Mart Limited v The Queen, 2007 TCC 636 [Shoppers] as well as a series of other cases: Boulangerie St. Augustin v The Queen, International Colin Energy v The Queen and BJ Services Company Canada v The Queen. In these cases, deductions of expenditures incurred in the context of corporate transactions were rendered deductible.
Imasco first appealed to the Tax Court of Canada, which dismissed the case. Imasco then turned to the Federal Court of Appeal.
Justice Sharlow of the Federal Court of Appeal did not go into too much detail in his discussion of the relevant statutory provisions of the ITA. A basic understanding of tax law would tell you that Section 9(1) of the ITA is the general rule for determining a taxpayer’s income from a business or property. Section 9(1) (e.g. “subject to this part”) is supplemented by the many detailed rules in Part 1, including section 18. The Crown argues that the surrender payments are not deductible based on section 18(1)(b):
18. (1) In computing the income of a taxpayer from a business or property no deduction shall be made in respect of…
(b) an outlay, loss or replacement of capital, a payment on account of capital or an allowance in respect of depreciation, obsolescence or depletion except as expressly permitted by this Part… [italics added]
As Justice Sharlow explains, “the statutory prohibition on the deduction of a payment on account of capital requires consideration of the principles for distinguishing capital and income.” One of the most commonly cited passages on the issue of what constitutes capital arises in the case of British Insulated and Helsby Cables v Atherton,  AC 205 HL at paragraphs 213-4:
… When an expenditure is made, not only once and for all, but with a view to bringing into existence an asset or an advantage for the enduring benefit of a trade, I think there is a very good reason (in the absence of special circumstances leading to an opposite conclusion) for treating such an expenditure as property attributable not to revenue but to capital.
This is not a bright line test. It is only a useful guide, drawing our attention to the easily discernible and relatively constant part of the taxpayer’s operating costs, which would not be considered capital. The Crown puts forward the argument that “the payments in issue are expenditures on capital account because they were made in the context of a reorganization of the capital of Imasco and extinguished all of the outstanding obligations of Imasco to issue shares” (para 25).
The heart of this decision is really Justice Sharlow’s discussion of case law. The plaintiffs submit that these stock-for-cash payments are best characterized as employee compensation, and therefore deductible as ordinary business expenses. They rely primarily on Shoppers. Shoppers Drug Mart Limited (“SDM”) was a fully owned subsidiary of Imasco Limited, which, as noted earlier, was the holding company of Imperial Tobacco. Shoppers can be distinguished from the case at hand, though. It centered on the deductibility of a payment made by SDM to Imasco, as a reimbursement of payments made by Imasco upon the surrender by SDM employees of stock options issued to them under the Imasco stock option plan. In that case, the deduction in the context of corporate transactions was allowed, as it was grouped as together with employee compensation. Therefore, it counted as a cost of doing business under section 9 of the ITA (para 26).
But the Court decided to not follow the holding in Shoppers. Justice Sharlow argued that the two cases could be distinguished on the basis that Shoppers involved no capital restructuring and, thus, no enduring benefit was incurred by SDM. In the case at hand, however, we do have reorganization of capital – a going-private transaction and amalgamation – and it can be said that the arrangements put in place were supposed to facilitate this capital reorganization. The last holding is that “the payments were intended to and did end all future obligations of Imasco to deal with its own shares, which can fairly be described as once and for all payments that resulted in a benefit to Imasco of an enduring nature” (para. 29). So, it seems like Justice Sharlow was persuaded by the 1990 case of Kaiser Petroleum Ltd. v The Queen, (1990) 2 CTC 439 [Kaiser], where it was determined that a payment made to extinguish an employee stock option plan in the course of implementing a take-over transaction was a capital expenditure. Even though Shoppers is much more recent, Justice Sharlow saw the case at hand and Kaiser as virtually indistinguishable (para 31).
The debate about this case goes farther than case law. Sure, Shoppers may not be identical factually, but its focus is the same going-private transaction. To sidestep Shoppers and uphold a decision from 1990 seems to be misguided. Another concern is that, by upholding the decision in Kaiser, the Court in 2012 is neglecting the current economic realities. Today, it is much more common for a corporation to adopt an employee stop option as part of the ordinary compensation package for employees at all levels (para. 32). While that does not change the nature of the transaction, it may lead to some unfairness for the middle class taxpayer.
As I noted at the very beginning, an employee who surrenders a stock option for cash can claim a deduction under paragraph 110(1)(d) of the ITA. So long as the employer elects to not claim any deduction for the payment, the employee can enjoy a deduction of 50 per cent. With Imperial Tobacco decided the way it was by the Federal Court of Appeal, a corporation may opt to retain its option to claim the deduction open, as it would no longer be able to obtain a deduction for cash paid; it would therefore not file the election foregoing any deduction. That means that the employee would be prohibited from filing a 110(1)(d) deduction. So, the decision in Imperial Tobacco could result in a lose-lose situation for both employer and employee.