Translation disclaimer
This translation was prepared by Tax Interpretations Inc. The CRA did not issue this document in the language in which it now appears, and is not responsible for any errors in its translation that might impact a reader’s understanding of it or the position(s) taken therein. See also the general Disclaimer below.
Principal Issues:
Whether any portion of a dividend paid by a corporation, after the corporation has issued an option to acquire a share from its capital stock but before the underlying share has been acquired, is considered in the computation of the safe income on hand in respect of a share that is acquired on the exercise of the option?
Position:
Generally yes.
Reasons:
In accordance with the CCRA's general position.
XXXXXXXXXX 1999-001169
Fouad Daaboul
Attention: XXXXXXXXXX
May 17, 2000
Dear Sir/Madam,
Subject: Attribution of income earned or realized (the “safe income”)
This is in response to your letter of November 19, 1999, in which you asked for our opinion on the above subject in relation to the situation described below. We apologize for the delay in responding to your request.
SITUATION
1. Pubco is a taxable Canadian corporation and a public corporation.
2. Pubco's issued and paid-up share capital consists of 2,500,000 common shares, of which 500,000 shares are held by a corporation resident in Canada, Holdco.
3. On June 1, 1999, Pubco granted 150,000 options to Holdco to acquire 150,000 Pubco common shares (the “new shares”). The exercisability of those options expired on June 1, 2002.
4. Holdco received no benefit from Pubco or any other person in respect of the grant of the 150,000 Pubco options. Holdco is not related to, deals at arm's length with, and is not considered to have a significant influence over, Pubco.
5. The exercise price of each of those options corresponded to the market price of a Pubco share on the stock exchange on June 1, 1999, i.e. $20. Furthermore, the market price of a share at a particular time corresponded to the fair market value of the share at that time.
6. On September 1, 1999, Pubco declared and paid a dividend of $0.15 per common share to all its shareholders on record at that date, for a total of $375,000. At that date, no stock options had been exercised by Holdco.
7. Holdco exercised the 150,000 stock options in question on November 1, 1999, and received 150,000 “new shares” of Pubco, while the fair market value of a Pubco common share was $25. Immediately after the options were exercised, Pubco's issued and paid-up share capital consisted of 2,650,000 common shares.
QUESTIONS
Taking into account the facts stated in the situation described above, you wish confirmation that based on the 150,000 Pubco options exercised by Holdco, the “new shares” will be entitled to their proportional share of the “safe income” on hand of Pubco calculated from the time the underlying options were granted, i.e., June 1, 1999, and that the dividend paid by Pubco on September 1, 1999 will reduce the “safe income” of Pubco that can be attributed to the 150,000 “new shares”, in proportion to their share in the value of Pubco on September 1, 1999. In your opinion, this reduction would then be $21,226, i.e.: $375,000 X ($150,000/ $2,650,000).
OUR COMMENTS
As stated in paragraph 22 of Information Circular 70-6R3 dated December 30, 1996, it is the practice of the Canada Customs and Revenue Agency (the “Agency”) not to issue written opinions regarding proposed transactions otherwise than by way of advance income tax rulings. Furthermore, when it comes to whether a completed transaction has received appropriate tax treatment, that determination rests first with our Tax Services Offices following their review of all facts and documents, which is usually performed as part of an audit engagement. However, we can offer the following general comments that we hope may be helpful to you. These comments may not, however, fully apply to the situation you have presented to us.
We would like to reiterate that the Agency's general position is that subsection 55(2) of the Income Tax Act (the “Act”) applies to a taxable dividend received by a corporation resident in Canada in respect of which it is entitled to a deduction under, among others, subsection 112(1) where one of the purposes of the dividend (or, in the case of a dividend under subsection 84(3), one of the results of which) was to effect a significant reduction in the portion of the capital gain that, but for the dividend, would have been realized on a disposition at fair market value of any share of capital stock immediately before the dividend and that could reasonably be considered to be attributable to anything other than “safe income”. The “safe income” corresponds to the amount of income established under paragraphs 55(5)(b), (c) or (d), as the case may be. Consequently, in the case of a public corporation, “safe income” refers to the corporation's net income computed pursuant to section 3 of the Act, during a given period, with the additions provided for in paragraph 55(5)(b), as applicable.
Furthermore, the Agency has taken the position that a corporation's “safe income” can only contribute to a capital gain on a share if it is “on hand” and available for the payment of a dividend on the share. Since “safe income” is based on the net income calculated in section 3 of the Act as provided in paragraph 55(5)(b) in the case of a public corporation, it is therefore necessary to adjust the “safe income” to take into account certain disbursements that do not reduce the corporation's net income in order to determine the “safe income” which contributes to the capital gain on the share (the “safe income on hand”). Disbursements that generally reduce the “safe income on hand” are dividends, income taxes, charitable donations and any expenses not deductible in computing a corporation's net income.
You referred us to the Agency's administrative policy on stock options, and more specifically to the comments made by Mr. Robert J.L. Read in his document entitled “Section 55: a review of current issues”, at the 1988 Canadian Tax Foundation Conference. Here are the comments applicable to the present situation as taken from pages 18:8 and 18:9 of that document:
When a person acquires an option to purchase shares of a corporation, for the purposes of computing the income earned or realized referable to existing shares and to the shares, if any, acquired on the exercise of the option, the person is considered to have acquired the shares that are the subject of the option at the time he acquires the option. At the time of issue, options to acquire shares of an issuer will ordinarily have no value if they are exercisable at a price equal to or in excess of the fair market value of the optioned shares at that time. If the market value of the corporation's shares increases to an amount greater than the option exercise price, ... some portion of any income earned by the corporation after the option was issued will have accrued to the unexercised options rather to the existing issued shares...
When an option is exercised, a gain inherent in the acquired shares may be referable to income earned by the corporation before the option was exercised.
In view of the above comments, since, in the present situation, the holding period for the stock options extended from June 1 to November 1 1999 (the “relevant period”), we are of the view that for the purposes of calculating Pubco's “safe income”, Holdco would be deemed to have acquired the “new shares” on the date the related options were granted, i.e. June 1, 1999.
Furthermore, if it is established that the fair market value of a Pubco common share, at the time Holdco exercised its options to acquire “new shares”, exceeded $20, i.e. the exercise price of an option, in general, a portion of Pubco's “safe income” for the “relevant period” could then be allocated to the “new shares”. This would be the case to the extent that Pubco's “safe income” for the “relevant period” would exceed the dividend amount of $375,000. In that regard, we are of the view that, in general, the amount of a dividend paid while the stock options were outstanding would be considered in the calculation of the “safe income on hand” that could be attributed to a Pubco share, including a “new share”.
We hope that you find these comments useful.
Best regards,
Maurice Bisson, CGA
For the Director
Company Reorganizations and
International Operations Division
Income Tax Rulings Directorate
Policy and Legislation Branch1
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