The recent Tax Court of Canada decision in Alcatel Canada Inc. v. The Queen [2005 TCC 149] provides an opportunity for companies engaged in scientific research and experimental development (SR&ED) activities that also offer employee stock option plans. Such companies may be able to increase their SR&ED tax credit claims for a portion of their employees' stock option benefits.
On Feb. 24, the Tax Court of Canada allowed Alcatel's claim for a SR&ED tax credit for the value of stock option benefits provided to its employees. The decision reverses the Canada Revenue Agency (CRA)'s long-standing position that such benefits are not eligible SR&ED Qualified Expenditures.
Under Alcatel's stock option program, employees were granted the right to purchase a specified number of common shares at an exercise price not lower than the market price of the shares on the Toronto Stock Exchange at the time when the options were granted. The employees derived a benefit upon the exercise of their stock options equal to the excess of the market value of the shares at the time the stock option was exercised over the exercise price.
The Court held that the stock option benefit represented an expenditure incurred by Alcatel. Moreover, the Court held that such expenditures were on current account, since the options were issued to satisfy a recurrent need to compensate employees engaged in the day-to-day operations of the business. As a result, the stock option benefit is an expenditure that could be eligible for the SR&ED tax credit. While the court specifically held that the benefit is an expenditure for tax credit purposes, paragraph 7(3)(b) of the Canadian Income Tax Act prohibits an employer (or non-arm's length person) from reducing its income by claiming a deduction related to the sale or issuance of its shares to employees.
The CRA is likely to appeal this decision to the Federal Court of Appeal, and consequently, there is a possibility that this beneficial treatment will be reversed. Nonetheless, it is important for companies to take action now in order to preserve the right to benefit from the Alcatel decision, should the eventual outcome be favourable.
If your compensation arrangements include the issuance of stock options, your SR&ED claims should be reviewed for possible amendment to increase your entitlement to Investment Tax Credits. You have an opportunity to amend previously filed claims that are still open, including those for fiscal year ends as far back as 18 months. Any current claims should certainly be revised to account for stock options benefits.
While this Tax Court of Canada decision relates solely to the treatment to be accorded the value of stock option benefits provided to employees in determining SR&ED tax credits, the issue is also important in the context of transfer pricing, particularly with respect to the treatment of such benefits under Qualified Cost Contribution Agreements. In response to the question whether stock-based compensation should be considered to be an economic cost that should be taken into account in establishing a transfer price, during the CRA Roundtable, International Fiscal Association Conference, in Montreal, May 7, 2001, CRA officials stated:
"No, stock-based compensation should not be considered to be an economic cost that should be taken into account in establishing a transfer price. The amount usually is not taxed until the stock option is exercised. Pursuant to paragraph 7(3)(b) of the Canadian Income Tax Act, there is no cost to the corporation granting the stock option. This makes sense because stock options are not costs at the corporate level but a shareholder level cost to the extent they dilute earnings per share."
Despite this view and the clear prohibition in paragraph 7(3)(b), as noted above, stock options were recognized as an allowable 'expenditure' for the purpose of determining investment tax credits, so it will be interesting to see the results of any appeal by CRA and whether stock option-based compensation will be required to be included in establishing transfer prices, including the determination of contributions under a Qualified Cost Contribution Arrangement.
By Paul Bertrand, Jennifer Smith and Ronald J. Holowka
Paul Bertrand, CA, CMA
Scientific Research and Experimental Development (SR&ED)
Partner, National SR&ED Team
Ernst & Young LLP
Phone: 613-598-4357
Fax: 613-232-5324
E-Mail: paul.d.bertrand@ca.ey.com
With over 25 years of progressive experience, Paul leads the Eastern SR&ED practice in process implementation, planning, compliance, and defence assistance for Federal and Provincial tax incentives programs for a variety of emerging and established businesses.
Paul has worked with the SR&ED tax credit program since 1985 and fully dedicated to the SR&ED practice since 1998. He works with clients from the time an R&D project is conceived for a contract that may include SR&ED activities, through to defending an Investment Tax Credit claim.
As a member of the Quebec SR&ED Consultative Committee, Paul represents industry in resolving issues with the SR&ED Field Service Offices of the Canada Revenue Agency in Montreal, Laval and Quebec with Industry and Practitioners.
Jennifer Smith, LL.B
Principal
Ernst & Young LLP
Phone: 613-598-4355
Fax: 613-232-5324
E-Mail: jennifer.j.smith@ca.ey.com
A lawyer with more than 15 years of tax experience, Jennifer works in Ernst & Young's Technology group in Ottawa. She has an expanding list of emerging growth clients that have generated over $1/2 billion in equity funding over the past two years. Jennifer has expertise in corporate reorganizations, Canadian-controlled private corporation status and employee stock options—experience that has contributed to her success as a tax services coordinator.
Jennifer launched her career at a major law firm and was one of a handful of private practitioners to be placed on an executive interchange with the Tax Policy Branch of the Canadian Department of Finance. Jennifer holds an Honours BA in Economics and Political Science from the University of Toronto and completed her LLB at the University of Ottawa. She has been a tax instructor for the Bar Admission Course for over 10 years and teaches both the Basic and Advanced Taxation courses to law students at the University of Ottawa. She is also a seminar leader for the CICA Group Study III course.
Ronald J. Holowka, CA
Senior Manager, Transfer Pricing
Ernst & Young LLP
Phone: 613-598-4351
Fax: 613-232-5324
E-Mail: ron.j.holowka@ca.ey.com
Ron is a senior member of Ernst & Young's National Transfer Pricing Practice. Based in Ottawa, he assists multinational clients with their Canadian and foreign transfer pricing issues, including transfer pricing documentation, planning, audit defence, Advance Pricing Arrangements and requests for competent authority assistance.
Prior to joining Ernst & Young, he held progressively senior positions with the CCRA's International Tax Directorate in the area of transfer pricing and competent authority services. In June 1993, he launched CCRA's APA program, and directed and administered the program until August 2001. He co-ordinated and co-authored the 1994 Guidelines on Bilateral Advance Pricing Arrangements for competent authorities of the PATA countries: Australia, Canada, Japan and the USA and was the principal author of CCRA's Information Circular IC94-4R on APAs issued in March 2001.
