2020-0841961I7 Salary Deferral Arrangements

Principal Issues: Clarification of certain past statements on employee incentive plans and SDAs.

Position: Comments provided.

Reasons: Additional clarification provided with respect to prior statements by the CRA on incentive plans and the conditions under which such plans may be SDAs that have been misinterpreted by, or caused confusion within, the tax community.

Author: Koh, Kah Foo
Section: 248(1) “salary deferral arrangement”

                                                                          July 10, 2020

Len Lubbers                                                       HEADQUARTERS
Director                                                              Income Tax Rulings Directorate
Tax Avoidance Division                                      Kah Foo Koh, Nathalie Boyer

                                                                            2020-084196

Clarification of Prior Statements on Salary Deferral Arrangements

The Income Tax Rulings Directorate (“ITRD”) has identified the need to clarify certain past statements made in Technical Interpretations about employee incentive plans that may have been misconstrued, and that may have been mistakenly relied upon to conclude that solely forward-looking or future-orientated incentive plans with certain characteristics are not salary deferral arrangements (“SDAs”).

This memorandum is one part of a set of two memorandums dealing with the SDA rules in the context of incentive plans.  While each memorandum can be read independently, the issues discussed in each memorandum are related.  The companion memorandum is 2020-085028.

The definition of a SDA in subsection 248(1) (footnote 1) references a plan or arrangement under which any person has a right in a taxation year to receive an amount after that year (a “deferred amount”).  It also includes a “purpose” test that would be satisfied if it can be reasonably considered that one of the main purposes for the existence or creation of that right is to defer tax on salary and wages attributable to past services.  Whether this “purpose” test is satisfied in a given situation or scenario is a question of fact that must be determined on an annual basis in respect of each participant of the relevant incentive plan, and in the context of the specific awards granted to that employee, taking into account all known facts and circumstances up to that point.

ITRD has generally accepted that share appreciation rights (“SAR”) plans of the type described in ATR-45 – “Share Appreciation Rights Plan” would not be SDAs (“ATR-45 SAR Plans”). An ATR-45 SAR Plan has the following characteristics:

-     The unit has no intrinsic value at the date of grant;

-     The value of a unit is not guaranteed and may have a negative value after the date of grant; and

-     The value of each unit at any particular time is determined by subtracting the fair market value (“FMV”) (footnote 2) of a share of the employer at the date of grant from the fair market value of a share of the employer at that particular time.

Our position with respect to ATR-45 SAR Plans remains unchanged.  We consider such plans to be significantly less susceptible to manipulation than formula-based appreciation plans and therefore we are prepared to accept that with such plans, none of the main purposes for the existence or creation of this right is to defer tax on an amount attributable to past services.

However, we are concerned that certain past statements made in the context of ATR-45 SAR Plans may have been misconstrued as general statements applicable to other types of incentive plans. The purpose of this memorandum is to clarify the scope of such statements.

Right is Exercisable

We have previously commented in the context of ATR-45 SAR Plans that it is only at the point in time where the unit is exercisable that the right referenced in the definition of a SDA is created.  For example, in Technical Interpretation 9307455, it was stated that “in the year that a SAR is exercisable, it is the Department’s position that a right is created in that year to receive an amount after the end of the year where the employee chooses not to exercise his right…”

We want to note that this statement was made strictly in the context of ATR-45 SAR Plans.  However, in the context of incentive plans and the SDA regime, we recognize that this statement may have since been misconstrued as implying that a right to receive an amount after the end of a particular year is not created until the units of any given incentive plan are exercisable, which is not consistent with our interpretation of the SDA definition.

It is our longstanding position that whether an incentive plan constitutes a SDA is a question of fact that can only be determined by a review of the incentive plan and all the relevant facts. (footnote 3) As indicated above, the definition of a SDA in subsection 248(1) references a plan or arrangement under which any person has a right to a deferred amount and it also includes a “purpose” test.

The determination of whether a participant under a given plan has a right to a deferred amount and whether the “purpose” test is met must be done on an annual basis in respect of each participant of the relevant incentive plan, and in the context of the specific awards granted to that employee, taking into account all known facts and circumstances up to that point. 

In other words, when determining whether, at a point in time, the rights of a participant under a given incentive plan give rise to a SDA or not, one must determine whether (i) the employee has, under the particular incentive plan, a right to a deferred amount; and (ii) one of the main purposes for the creation or existence of that right can be reasonably considered to be tax deferral in respect of salary or wages attributable to past services ( the “Purpose Test”). 

For a given year end, to the extent that the units of an incentive plan - including an ATR-45 SAR Plan - have a positive value, the participants under the plan would have, at that time, a right to receive an amount that is, or is on account or in lieu of, salary or wages of the relevant employee for past services, regardless of whether the units are exercisable.  Whether the incentive plan becomes a SDA would then depend solely on whether the Purpose Test is met at that particular time, which can only be determined after a review of all the relevant facts.

However, as indicated above, with respect to an ATR-45 SAR Plan as described above, the CRA's longstanding position remains that a unit issued under such a plan will generally not be considered to be a SDA throughout the duration of the plan, because we are prepared to accept that the Purpose Test would not be satisfied.  With respect to other types of incentive plans, whether the Purpose Test is satisfied remains a question of fact.

In summary, at any given year end, it is possible for a right to a deferred amount to arise under an incentive plan even before the units of that plan are exercisable.  If the Purpose Test is also satisfied at the same time, the incentive plan would give rise to a SDA, unless one of the enumerated exceptions listed in the SDA definition applies.

Nil Intrinsic Value

We wish to clarify our prior comments that the SDA rules do not apply to a SAR unit that has nil intrinsic value at the date of grant.  For example, in Technical Interpretation 2017-0737571E5, it was stated that “a unit issued under a SAR plan that entitles the employee to receive only the increase in value of the underlying share from the date the unit is granted to the date it is redeemed will generally not be considered to be an SDA.  Because the SAR unit has no intrinsic value when granted, it is considered to relate solely to the future services to be rendered by the employee and therefore falls outside of the preamble of the SDA definition.”

We want to reiterate that this comment was made strictly in the context of an ATR-45 SAR Plan, and should not be extrapolated to other types of incentive plans.  This is because we are only prepared to accept that tax deferral is not one of the main purposes for the creation or existence of any right in a particular taxation year to receive an amount after that particular year under a plan or arrangement, thereby falling outside of the preamble of the SDA definition, if that plan or arrangement is an ATR-45 SAR Plan, provided that the value of the underlying shares is not susceptible to manipulation by the corporate employer.

The fact that units in other types of incentive plans have no intrinsic value when granted is not a sufficient basis to conclude that the plan is not a SDA at inception, nor to conclude that the plan need not be tested on an annual basis.

Moreover, any prior statements to the effect that a particular incentive plan does not give rise to a SDA because it is future-oriented at time of grant should not be construed as a categorical statement that all future-oriented plans fall outside the scope of the SDA rules.  Ultimately, as indicated above, whether a plan or arrangement is a SDA is a question of fact.

Amount is Determinable

Finally, we have previously taken the view that there is no SDA until an amount is determinable.  For example, in Technical Interpretation 9711455, it was stated that “[w]ith respect to a bonus or any other amount an SDA does not arise until the employee has a "right to an amount".  Therefore, it is our view that unless the amount of the bonus can be determined, the SDA definition cannot apply.  Please note that an amount that can decrease or increase over time as is common, for example, under phantom stock plans will be subject to the SDA provisions.”

We wish to reiterate that an incentive plan can be a SDA before the final value of the units has been determined at the occurrence of the triggering event.  The fact that the value of the units of an incentive plan is subject to change prior to the occurrence of a triggering event does not, in and of itself, give rise to an indeterminable amount before the occurrence of the triggering event.  On the contrary, we expect that a deferred amount can be determined at any given year end after the issuance of the units, even if at that time the unit is not exercisable.  If the design of an incentive plan results in a positive value of the respective units at any given year end after the issuance of the units, the employee has, at that time, a right to receive an amount after that year that is attributable to services rendered by the employee, notwithstanding the fact that this amount may fluctuate from year to year.

We trust that the foregoing will be of assistance to you.  If you have any questions or if you would like to discuss any of these issues further, please do not hesitate to contact Mélanie Beaulieu at 343-543-2154 or Dave Wurtele at 613-793-2686.

Yours truly,

Stéphane Charette
Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader:  Because of our system requirements, the footnotes contained in the original document are shown below instead:

1  Unless otherwise stated, all statutory references in this note are references to the provisions of the Income Tax Act.

2  Per the definition in Information Circular IC89-3, “Policy Statement on Business Equity Valuations”, FMV is normally the highest price, expressed in dollars, that property would bring in an open and unrestricted market, between a willing buyer and a willing seller who are both knowledgeable, informed, and prudent, and who are acting independently of each other. The determination of FMV is a question of fact. 

3  For example, see 1999-0007315 and 2018-0740741E5.

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