2020-0850281I7 Formula-based incentive plan

Principal Issues: Whether it can be reasonably determined if any given formula-based incentive plan is not a SDA over the duration covered by a proposed ruling.

Position: No.

Reasons: Whether a formula-based incentive plan is a SDA requires a full review of all relevant facts and circumstances pertaining to the plan itself and the participants individually. In addition, the review must take place on an annual basis, and only after all the relevant facts are known. Since such information will not be available at the outset, we are unable to reasonably determine if any given formula-based incentive plan is not a SDA over the duration covered by a proposed ruling.

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, Natalie Boyer

                                                                          2020-085028

Withdrawn request for an advance income tax ruling by XXXXXXXXXX (“EmployerCo”)

An Advance Income Tax Ruling request was received on behalf of EmployerCo involving a performance bonus plan (the “Proposed Plan”) that was based on future variations in retained earnings.  The relevant employees’ entitlement under the Proposed Plan was determined using a formula that differed from what we typically see for appreciation rights plans offered by private corporations in situations where share prices are not readily available.  The Income Tax Rulings Directorate (“ITRD”) was asked to provide a ruling that the Proposed Plan is not a salary deferral arrangement (“SDA”), as defined in subsection 248(1) (footnote 1).

We concluded that we were unable to provide a favourable ruling, and EmployerCo withdrew its ruling request.  Nevertheless, the issues raised during the course of examining EmployerCo’s ruling request have caused us to revisit our willingness to consider rulings requests on most incentive plans that rely on formulas to determine the relevant employees’ entitlement under such plans (“formula-based appreciation plans”).

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 2020-084196.

Description of the Proposed Plan and ITRD’s Disposition of the Ruling Request

In general terms, participants under the Proposed Plan would have been granted units, the value of which at the redemption date would have been essentially based on changes in EmployerCo’s cumulative retained earnings (i.e. retained earnings on redemption date minus retained earning on grant date) over the period, plus dividends paid over the same period. EmployerCo’s representative took the view that the proposed plan was akin to a share appreciation rights (“SAR”) plan, and that the proposed formula was a reasonable approximation of the FMV of the shares of EmployerCo.

Nevertheless, ITRD concluded that we could not provide a favourable ruling that the Proposed Plan was not a SDA, because the formula in the Proposed Plan was such that the units’ value would have increased over the duration of the vesting period even if EmployerCo’s net earnings did not increase and remained stable over this period.  Given the stability of EmployerCo’s positive net earnings in previous years, we concluded that the formula in the Proposed Plan would very likely result in an increase in the value of the units held by participants at a year end after the issuance of the units up to the redemption date.  Thus, on the first year end in which the units have a positive value, the participants in the Proposed 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.  More importantly, in our view, this history of stable positive net earnings and the fact that the formula ensured that the units would increase in value over the years even if annual earnings remained stable were sufficient to demonstrate that one of the main purposes of the Proposed Plan was the deferral of tax.

The representative of EmployerCo appreciated the rationale for our conclusion and we have no indication that EmployerCo intends to proceed with the Proposed Plan.  However, as mentioned, the issues raised during the course of examining EmployerCo’s ruling request have caused us to change our administrative policy with respect to whether ITRD should consider ruling requests on formula-based appreciation plans.

Rulings on Formula-Based Appreciation Plans will no Longer be Considered (footnote 2)

ITRD will no longer consider any ruling requests pertaining to whether any given formula-based appreciation plan is a SDA, unless:

i) the plan is of a type described in ATR-45 – “Share Appreciation Rights Plan” (discussed later in this memorandum); or

ii)   the ruling request pertains to whether one of the enumerated exceptions listed in the definition of SDA apply to the plan.

It should be noted that this change in administrative policy does not mean that ITRD considers all formula-based appreciation plans to be SDAs.  On the contrary, we accept that it is quite possible that many such plans will not be a SDA where the underlying formula closely approximates the fair market value (“FMV”) (footnote 3) of the relevant shares of the corporate employer over the duration of the plan.  However, ITRD will no longer make such a determination in the context of a ruling request.

Reasons for Change

ITRD has previously provided favourable rulings that certain formula-based appreciation plans were not SDAs.  Many of these rulings were effective or covered a lengthy or indefinite period of time.  The formulas in these plans were based on a variety of future-oriented financial metrics, most commonly earnings before interest, taxes, depreciation, and amortization (“EBITDA”).

In general, it has become clear that it is not possible to be reasonably certain, at the time of a ruling request, that a formula-based appreciation plan would never become a SDA at some point in the future due to changes in the facts and circumstances specific to the employer or the business environment in which it operates.

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 4) The SDA definition references a plan or arrangement under which any person has a right in a particular taxation year to receive an amount after that particular taxation 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 the right to receive a deferred amount under the plan or arrangement is tax deferral in respect of salary or wages attributable to past services.

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 (collectively, the “SDA Purpose Test”).

The determination of whether an incentive plan satisfies the SDA Purpose Test 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.  As a result, the facts and circumstances required for the SDA Purpose Test would only be gradually known over the duration of the plan, rather than at the time in which a ruling request is being examined.

Finally, ITRD is increasingly concerned that the financial metrics that underlie formula-based appreciation plans may be susceptible to manipulation.  This manipulation can be used to obfuscate the fact that a formula-based appreciation plan’s underlying purpose is to defer tax, rather than a tool to incentivize employees by rewarding future performance.  ITRD does not believe that it can reasonably account for such risk in the context of a ruling request and believes this question would be more appropriately examined at the audit stage.

ATR-45 SAR Plans

Any reference to formula-based appreciation plans in this memorandum excludes share appreciation rights (“SAR”) plans of the type described in ATR-45 – “Share Appreciation Rights Plan”, which 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 FMV of a share of the employer at the date of grant from the FMV of a share of the employer at that particular time.

We will continue to consider ruling requests on such SAR plans.

The CRA's longstanding position remains that a unit issued under a SAR plan with the above characteristics will generally not be considered to be a SDA.  This is because we consider such plans to be significantly less susceptible to manipulation, since the FMV of the shares of the corporate employer that underpins the value of the units of such plans generally depends on factors over which the relevant corporate employer has limited control.  As a result, where a right to a deferred amount arises - after the date of grant but before the date of vesting - under such plans, we are prepared to accept that none of the main purposes for the existence or creation of this right is to defer tax on an amount attributable to past services.

In closing, we want to reiterate that our decision to no longer consider ruling requests for formula-based appreciation plans does not mean that the CRA now considers all such plans to be SDAs.  It simply means that ITRD is not confident that it can obtain sufficient comfort in the context, and confines, of a ruling request to determine if the formula-based appreciation plan at issue will not become a SDA over the duration of the ruling.

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  Whether an incentive plan is a SDA has to be determined from the perspective of each employee participating in the plan, and in the context of the specific awards granted to that employee. In other words, it is possible that an award from an incentive plan may be a SDA from the perspective of one employee, but not from the perspective of another employee.  Any reference or discussion about whether an incentive plan is a SDA in this memorandum should be understood in this context.

3  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.  Although the definition of a SDA in subsection 248(1) does not refer to “FMV”, the focus on FMV in this discussion is due to our view that provided that (i) the units of an incentive plan has no intrinsic value at the date of grant, (ii) any subsequent increase in the value of the unit of an incentive plan at any particular time after the date of grant is due to increases in the FMV of shares of the relevant corporate employer from the date of grant to the particular time, and (iii) this FMV is not susceptible to manipulation by the corporate employer, it would generally be reasonable to conclude that none of the main purposes of the plan is the deferral of tax and therefore the plan falls outside of the preamble of the SDA definition.

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

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