2023-0964391C6 stock based compensation and transfer pricing

Principal Issues: Do recent changes affecting deductions for stock based compensation have transfer pricing implications?

Position: Probably no material impact.

Reasons: para. 7(3)(b) is unchanged and the new deduction under para. 110(1)(e) has significant limitations.

Author: Taylor, Charles
Section: 7(3)(b), 110(1)(e), 247

2023 International Fiscal Association Conference
CRA Roundtable

Question 1 – section 247 & recent changes regarding stock-based compensation

CRA has traditionally not allowed inbound charges for stock option expenses incurred by related parties to be deducted by a Canadian taxpayer when the cost of such stock options is included in the cost of services provided by the related non-resident person. There are revised rules in Canada allowing, in certain situations, deductions of non-qualified stock option expenses. In this context, will CRA now expect that Canadian taxpayers will include stock option expenses in the cost base for services charged to related non residents, where the employees providing the services to the related non-residents received employer-deductible stock options? If "Yes", will CRA provide reciprocity on inbound stock-based compensation charges if the circumstances are similar?

CRA Response

In paragraph 44 of TPM-15, the CRA explains that:

If a charge includes non-deductible items [e.g., pursuant to paragraph 7(3)(b)], but the amount is an arm's length amount, the Income Tax Act does not prevent the taxpayer from paying the amount [i.e., no adjustment under 247(2)]; however, it will prevent its deduction for tax purposes [e.g., pursuant to paragraph 7(3)(b)].

The new rules in paragraph 110(1)(e) allow an employer that is a qualifying person to claim a deduction equal to the value of the benefit that is deemed by subsection 7(1) to have been received by an employee in respect of non-qualified securities, provided certain conditions are met.

Some have implied that the introduction of paragraph 110(1)(e) to provide a deduction in computing taxable income in situations in which an employee no longer benefits from a deduction in respect of stock-based compensation as something which suggests a change to CRA’s approach regarding the application of paragraph 7(3)(b) is appropriate.

Paragraph 110(1)(e) contemplates its application in cross-border situations. In particular, subparagraph 110(1)(e)(v) as recently amended limits the deduction where the benefit associated with the stock-based compensation is received by an employee who is a non-resident of Canada. The deduction for the employer will apply only if:

(v) in the case of an individual who is not resident in Canada throughout the year, the benefit deemed by subsection 7(1) to have been received by the individual was included in computing the taxable income earned in Canada of the individual for the year.

A Canadian taxpayer receiving consideration for providing goods or services to related non-residents (“Outbound Charges”) is expected to comply with the arm’s length standard.

Conversely, a Canadian taxpayer might pay consideration to related non-residents (“Inbound Charges”). The CRA distinguishes two types of Inbound Charges. The first type of Inbound Charge involves payments by a Canadian resident or non-resident person that is liable to pay Canadian tax (“Canadian Taxpayer”) for goods or services provided by a foreign related party to the Canadian Taxpayer.  

The second type of Inbound Charge to a Canadian Taxpayer is for its portion of costs incurred by a related foreign party on its behalf. As an example of the latter situation, a foreign public company might offer stock-based compensation to qualifying employees in the corporate group, and charge the cost of providing these benefits to the Canadian Taxpayer and other employers of qualifying employees within the group.

In the evaluation of whether subsection 247(2) might apply to adjust an Outbound Charge or an Inbound Charge, all relevant circumstances are to be considered in order to determine the appropriate arm’s length price. Consistent with commentary on OECD transfer pricing principles, the CRA is of the view that stock-based compensation may be relevant in establishing an appropriate arm’s length price. That was the case before the recent changes in paragraph 110(1)(e) affecting the deductibility of stock-based compensation and those changes have not altered CRA’s views on how Outbound Charges affected by stock option expenses should be treated for purposes of subsection 247(2).

However, even though the Inbound Charge satisfies the transfer pricing standard under 247(2), the reimbursement of the cost of providing stock-based compensation to the Canadian Taxpayer’s employees may not be deductible in computing income in Canada. In particular, stock-based compensation expenses are generally not deductible in Canada for income tax purposes under paragraph 7(3)(b) and the language therein is broad.

With respect to the first type of Inbound Charge, it is a question of fact as to whether the Canadian Taxpayer receiving the service can deduct all of the Inbound Charge in computing its income. A stock-based compensation component of the Inbound Charge will not be deductible in computing income if, in the absence of paragraph 7(3)(b), the income of the Canadian Taxpayer would be “less than [it] would have been had a benefit not been conferred on the employee by the sale or issue of the securities.”

For the second type of Inbound Charge, paragraph 7(3)(b) should apply to prevent the Canadian Taxpayer from deducting in computing its income, the stock-based compensation element of the Inbound Charge. However, paragraph 110(1)(e) may allow the Canadian Taxpayer to deduct an amount from its taxable income.

The CRA will continue to assess the impact of changes to the Act on its approach to transfer pricing adjustments.  

Charles Taylor
2023-096439|
May 17, 2023  

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