Elizabeth Boyd, Jeremy J. Herbert, "Trusts Holding Shares For Employees", draft 2023 CTF Annual Conference paper

Use of phantom plans as EPBs (pp. 9 – 14)

• An employee benefit plan (EBP) can be used to acquire employer or parent company shares on the open market in order to settle phantom share awards (payable in cash or in shares), such as restricted or performance share units (RSUs or PSUs).
• An EBP trust is not subject to the corporate law constraints on a corporation acquiring its own shares and the employer is not subject to s. 7(3)(b) and generally may deduct contributions when there is an income inclusion to the employee.
• A typical phantom plan will not be a retirement compensation arrangement (cessation of employment typically is not a requirement to receive a benefit) and is usually structured to access the para. (k) exemption from being a salary deferral arrangement.
• The employer generally provides the trust with enough cash to purchase the shares that are expected to be needed to settle the awards that vest (unless the awards are subject to a multiplier).
• Withholding regarding distributions to an employee can be handled by providing for awards to be partly settled in cash, or providing for sale by the trust of a portion of the shares for cash immediately before the distribution.
• Ss. 104(19) and (21) designations are not permitted.
• As paying dividends on trust shares to employees would be inconsistent with the unvested nature of the awards, the dividends may instead be paid to the employer.
• However, per 9526615 (see also 2000-0010723) where the terms of an EBP provide for both the payment of dividend income earned by the EBP trust to the employer and the contribution by the employer of an equivalent amount in the same or a subsequent year, no deduction will be permitted to the EBP trust for the amount distributed to the employer.
• The carve-out in s. 12(1)(n.1) for amounts included in an employer’s income under s. 12(1)(n) is an implicit acknowledgement that an employer can be a beneficiary – which can facilitate liquidation of the trust.

Non-taxable distribution contrasts with EBP (p. 16)

• In the case of an EPSP used to acquire employer shares, s. 144(7.1) permits it to distribute shares to an employee on non-taxable basis at the employee’s cost base reflecting taxable allocations to the employee under the EPSP and the employee’s own contributions to which the shares can be attributed. This contrasts with distributions to an employee from an EBP trust, which is fully taxable and creates an FMV cost base in the distributed shares.

Use of EPSPs for open market share purchases for small amounts “out of profits” (pp. 17-18)

• EPSPs seem to be used quite frequently to facilitate employee share purchase plans to which both the employees (by way of payroll deduction) and employers contribute on the open market.
• When so used, advantages of the EPSP over an EBP trust include that the increase in the shares’ value from their acquisition can be received by the employee as a capital gain (in contrast to employment income under an EBP) and dividends and capital gains generated by the EPSP can retain that character when allocated to an employee – and the employer’s deduction of contributions to an EPSP is more immediate and straightforward (i.e., no need for the trustee to determine the employer’s deduction nor is it offset by income earned in the trust).
• The taxation of participants in the year in which contributions are made to an EPSP (in contrast to an EBP trust whose participants are not taxable regarding contributions to or earnings of the trust until they receive a distribution, assuming there is no SDA) means that EPSPs will usually be most useful in connection with employee share plans under which the contributions are relatively small.
• Most EPSP employee share purchase plans seem to be “out of profit” EPSPs under which the employer can base contributions on a percentage of employee earnings or a dollar amount.

Use of s. 7(2) trusts predominantly by CCPC employers (p. 22)

• S. 7(2) trusts are not common where the employer is not a CCPC, since the employee will be required to recognize the employment benefit in the year in which the share is transferred to the s. 7(2) trust (since s. 7(2) deems the employee to have acquired the share at the time of its acquisition by the trust).

Advantages of s. 7(2) trust over traditional s. 7 stock option (pp. 22-23)

• Assuming an increasing share price, a s. 7(2) trust arrangement reduces the employment benefit, and increases the economic gain potentially taxed as a capital gain, as compared to a traditional stock option arrangement, given that the employment benefit is limited to the in-the-money amount recognized at the time the shares are transferred to the trust, whereas for the latter, the employment benefit will be based on the value of the shares at the time of vesting.
• A s. 7(2) trust arrangement also avoids the potential whipsaw result (employment income coupled with a capital loss) that could occur where under a stock option arrangement the employee immediately exercises the option so as to acquire the shares (thereby triggering s. 7 income) but is subject to what is effectively a vesting requirement pursuant to a unanimous shareholder agreement.

Requirement for a specific agreement with an identifiable employee (pp. 25-26)

• CRA considers (see 2016-0641841I7) that a discretionary trust established to hold shares of the corporation for the benefit of its employees will not fall within s. 7 but will instead be an EBP, and that s. 7(2) cannot apply any earlier than when a specific number of shares have been allocated to an identifiable employee pursuant to a legally binding agreement to issue or sell shares.
• This position seems correct (so that such a trust would be an EBP), as s. 7(2) merely deems the shares to have been acquired by the employee when they began to be held by the trust for the employee and the shares to have been exchanged or disposed of at the time the trust exchanged or disposed of it to any person other than the employee, and it is difficult to see how the acquisition of securities by the trust constitutes an agreement between the corporate employer and a specific employee.

Implications of Chrysler No. 3 regarding overriding EBP rules (pp. 28-29)

• A s. 7(2) trust would come within the wording of an EBP assuming that there were contributions, in the form of shares of the employer corporation, made by the employer to a trust for the benefit of employees.
• Based on Chrysler No. 3 ([1992] 2 C.T.C. 95), CRA has accepted (in 2010-0373561C6) that where s. 7 applies to an arrangement, it takes priority over the application of the EBP rules, so that those rules do not apply, including rules dealing with the distribution of shares from the trust.
• This is a generous interpretation since it would not be inconsistent with Chrysler No. 3 to consider that the EBP rules could apply to the transactions contemplated by the arrangement to which s. 7 is inapplicable, e.g., the distribution of shares from the trust to the employee upon the vesting conditions having been satisfied, and the sale of shares by the s. 7(2) trust and the distribution of the resulting proceeds.

Example of s. 7(2) trust for employees of CCPC and potential interaction with EBP rules (pp. 26-35)

• As an example of the interplay of the various rules, a resident employer corporation settles shares of its capital on a trust for the benefit of specific employees, who are not required to pay anything for the shares, but there is a vesting provision whereby the employees must remain employed by the corporation for a period of at least three years before being entitled to direct ownership of the shares. It is intended that the trustee either distribute the shares acquired by the trust to the specific employees once the vesting period is met or, if the shares are sold by the trust prior to the expiry of the vesting period, distribute to the employees their share of the cash proceeds.
• Since this trust (the “7(2) Trust”) is not a fully discretionary trust and allocations to the 7(2) Trust are for specific employees, it is expected that the requirement in s. 7(1) for there to be an agreement to issue securities is met.
• In the CCPC context this type of arrangement can be beneficial in that the clock starts running once the trust acquires the shares regarding both the s. 110(1)(d.1) 50% deduction and the hold period required to access the employee’s lifetime capital gains deduction for qualified small business corporation shares. Furthermore, with a CCPC employer with whom the employee deals at arm’s length, taxation of the employment benefit is deferred under s. 7(1.1) until the shares are sold. Conversely, if the vesting conditions are not met and the shares are forfeited back to the corporation, the s. 8(12) deduction to offset the s. 7 inclusion is available in the same year such employment benefit is recognized.
• Since the arrangement provides for a trust to be established to hold shares of an employer corporation for the benefit of its employees, the requirements for a Reg. 4800.1 trust should be met, so that distributions of shares to the employee beneficiaries may occur on a s. 107(2) rollover basis.
• The transfer of shares from treasury to the 7(2) Trust could be completed after a corporate freeze transaction or during the start up phase of operations, so that the shares acquired by the 7(2) Trust (through a fair market value share subscription, or through a contribution of the shares by the employer corporation for no consideration) would have a nominal value – so that the employment benefit to the employees also could be nominal.
• If there was a significant benefit, then per the Chrysler No. 3 case, its amount and timing would be governed by the s. 7 rather than the EBP rules.
• Under the s. 7 rules, the 7(2) Trust would realize a capital gain or loss on a sale to a third party of the shares. The s. 53(1)(j) addition for the s. 7 benefit realized by the employee should be available as the employee would be deemed by s. 251(1)(b) to not to deal at arm’s length with the trust. If the share sale occurred after the 7(2) Trust held the shares for the required two-year period, both the 110(1)(d.1), and capital gains deduction for qualified small business corporation shares, would be available to the employee.
• If the arrangement is also considered an EBP, there would no s. 53(1)(j) ACB addition to the 7(2) Trust for the employment benefit to the employee, as s. 251(1)(b) does not apply to an EBP. Under those rules, the distribution by the trust of the taxable capital gain would be deductible to the trust under s. 104(6)(a.1) and the amount received would be taxed to the employee under s. 6(1)(g). However, it is possible to conclude, based on the priority of the s. 7 over the EBP rules, that no amounts would be included in beneficiary’s income under s. 6(1)(g) with the result that neither the 7(2) Trust nor the employee would be taxed on the gain amount.
• If the arrangement was not an EBP, there could be a tax-deferred rollout of the trust property pursuant to s. 107(2). If an EBP, the s. 107.1 rule would apply, with the result that there would be no gain on the distributed shares to the trust, the employee would acquire the shares at a cost equal to the greater of their ACB and FMV, and the employee would realize no gain on the disposition of the employee’s interest in the trust.
• This favourable result is premised on there being a full income inclusion to the employee under s. 6(1)(g), yet the arguable precedence of the s. 7 rules could avoid this result.

Considerations for structuring a market maker trust (pp. 40-43)

• Given the specified employee rules, market maker trusts are commonly used in larger organizations with extensive share ownership by employees, rather than more closely-held entities.
• In situations where employees are employed by an Opco that is held by a Holdco, it should be Opco that makes the loan to the market maker trust to facilitate the purchase of shares from departing employees rather than the Holdco, even though the shares purchased and sold by the market maker trust are Holdco shares.
• The bona fide loan repayment requirement means that if, after a reasonable passage of time, the trust cannot secure a purchaser for the shares acquired from departed employees, it must repay the loans under a repayment plan.
• If the trust is unable to sell the shares at the end of the trading period, it generally will exchange those common shares for redeemable preferred shares in order to protect against fluctuations in value - with those shares being “unthawed” at the beginning of the following trading period.