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Federal Court of Appeal Affirms Tax Court Decision that Payment to Extinguish Employee Stock Option Plan is Capital Expenditure: Imperial Tobacco Canada Limited v. The Queen

On November 10, 2011, the Federal Court of Appeal (the “FCA”) delivered a unanimous decision in Imperial Tobacco Canada Limited v. The Queen, 2011 FCA 308. As discussed in an earlier post, the panel of Justice Marc Nadon, Justice Karen Sharlow and Justice Eleanor Dawson were asked to determine whether a one-time, lump sum payment of approximately $118 million made to employees to extinguish an employee stock option plan was a deductible expense or a payment on account of capital which is precluded from deduction by paragraph 18(1)(b) of the Income Tax Act (the “Act”).

The FCA dismissed the appeal of Imperial Tobacco Canada Limited (“Imasco”) and upheld Justice Bowie’s decision in favour of the Crown in Imperial Tobacco Canada Limited v. The Queen, 2010 TCC 648 noting that the decision of the Tax Court of Canada (the “Tax Court”) was “consistent with the evidence and the applicable legal principles.”         

Justice Sharlow found, notwithstanding the decision by Chief Justice Bowman of the Tax Court that a similar payment made in the course of the same series of transactions was fully deductible (Shoppers Drug Mart Limited v. The Queen), three factors that pointed to the conclusion that the payment was made on account of capital:

(i) the payment coincided with a reorganization of the capital of Imasco (the going private transaction and amalgamation);

(ii) the arrangements put in place for making the payment facilitated and were intended to facilitate the capital reorganization; and

(iii) the payment was intended to and did end all future obligations of Imasco to deal with its own shares, which can be described as a once and for all payment that resulted in a benefit of an enduring nature.

Justice Sharlow did acknowledge that there were two factors in favour of Imasco, namely, that (a) the employee stock option plan was entered into to provide a form of employee compensation and did make periodic cash payments for the surrender of options, and (b) the payment for the optioned shares represented only a small portion of the outstanding shares of Imasco (just over 1%).

In the end, the FCA followed its 1990 decision in Kaiser Petroleum Ltd. v. The Queen. Justice Sharlow agreed with Justice Bowie that the distinctions between the circumstances of Imasco and the facts in Kaiser were “distinctions without a difference”. Furthermore, the FCA rejected Imasco’s argument that Kaiser is not in step with current economic realities on the basis that it was decided at a time when employee stock option plans were not commonly used as part of the ordinary compensation package for employees of all levels.

In light of the significant difference in approach to the issue on substantially the same facts between the Federal Court of Appeal and Chief Justice Bowman in Shoppers, it would not be surprising if a leave application is filed with the Supreme Court of Canada.  As Justice Ian Binnie, formerly of the Supreme Court of Canada, noted in a recent interview, the function of counsel applying for leave is to kick the ball up in the air in an interesting way and the judges will grab it.”  That may very well be easier here than in many other tax disputes.

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Federal Court of Appeal Affirms Tax Court Decision that Payment to Extinguish Employee Stock Option Plan is Capital Expenditure: Imperial Tobacco Canada Limited v. The Queen

Capital Expenditure or Expenditure on Revenue Account? Judgment Reserved by FCA in Imperial Tobacco Canada Limited v. The Queen

As discussed in an earlier post, the Federal Court of Appeal (the “FCA”) heard submissions in Imperial Tobacco Canada Limited v. The Queen on October 26th, 2011. Justice Marc Nadon, Justice Karen Sharlow and Justice Eleanor Dawson heard the taxpayer’s appeal in Toronto.

The panel will determine whether a one-time, lump sum payment of approximately $118 million made to employees to extinguish an employee stock option plan was a deductible expense (as the taxpayer contends) or an outlay on account of capital which is precluded from deduction by paragraph 18(1)(b) of the Income Tax Act (as the Crown contends).

Imperial Canada Tobacco Limited (the “Appellant”) argued that the most important question that needed to be considered by the panel (and one that was not considered by the Tax Court of Canada) was whether there was an enduring benefit to the taxpayer. During argument, the panel was quite interested in why the Appellant agreed to facilitate the immediate vesting and exercise or surrender of all of the options to bring the stock option plan to an end. The Appellant maintained that “settling up” the stock option plan was a housekeeping matter that allowed it to satisfy its obligations before the completion of a going private transaction.

In addition to the 2007 decision of Chief Justice Donald Bowman in Shoppers Drug Mart Limited v. The Queen (“Shoppers”), the Appellant relied on three other cases (Boulangerie St-Augustin v. The Queen, International Colin Energy v. The Queen and BJ Services Company Canada v. The Queen) which permitted the deduction of expenditures incurred in the context of other corporate transactions.

The Crown argued that the cash payment to eliminate the stock option plan was a condition of the transaction and was not made in the ordinary course of the Appellant’s business. It was an extraordinary expense meant to facilitate the take-over transaction. The Crown also emphasized that the enduring benefit test should not be determinative. In this regard, the Crown relied on M.N.R. v. Algoma Central Railways, Johns-Manville Canada Inc. v. The Queen and Gifford v. The Queen.

The judgment will be eagerly anticipated as it remains to be seen whether the panel will follow the 1990 decision of the FCA in Kaiser Petroleum Ltd. v. The Queen, where it 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, or whether it will find persuasive the more recent decision of Chief Justice Donald Bowman of the Tax Court of Canada in Shoppers. In Shoppers, Chief Justice Bowman began with the proposition that “in the ordinary course a payment made by an employer to an employee for the surrender of his or her option under a stock option plan to acquire shares of the company is a deductible expense” and found that that did not change even in the context of a going private transaction.

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Capital Expenditure or Expenditure on Revenue Account? Judgment Reserved by FCA in Imperial Tobacco Canada Limited v. The Queen