Memo to a Taxpayer: Blame Canada

Canadian judges rule that stock-option cancellation payments made in the run-up to a merger aren’t deductible. They would be in the United States.
Robert WillensDecember 21, 2011

To get superior health care, Canadians have been known to go south of the border. If a case decided in November by a Canadian federal appeals court in Toronto is any indication, corporations domiciled in Canada might also think about moving to the United States to get better tax treatment.

In the case, Imperial Tobacco Canada, Ltd. v. Her Majesty The Queen, the judges ruled that stock option cancellation payments made in 2000 by Imasco Ltd. (later merged into Imperial Tobacco Canada Ltd.) are not deductible in Canada. In the United States, however, the taxpayer would have won.

At issue was whether in computing its income for income-tax purposes, Imasco, a Canadian corporation, was entitled to deduct payments made to its own employees and employees of its subsidiaries for surrendering options to acquire Imasco shares.

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In 1983 Imasco launched an employee stock-option plan. In 1999 British American Tobacco (BAT) approached Imasco to discuss a proposal for a going-private deal. Under the transaction, BAT would acquire all the Imasco shares held by public shareholders of the company. Later, the Imasco board resolved to give all option holders the right to surrender their options for cash. BAT then incorporated British American Tobacco (Canada) Ltd. (“Bidco”) as its indirect, wholly owned subsidiary to acquire the Imasco shares.

Later in 1999, the parties entered into an agreement dealing with the going-private transaction. Under the deal, Imasco agreed that its board would unanimously resolve to “encourage” all option holders to exercise the options or surrender them immediately before the completion of the reorganization.

Imasco also agreed that, subject to regulatory and stock-exchange approvals, it would ensure that all options would vest before the reorganization. The acceleration of vesting, coupled with the provision for surrender, would ensure that Imasco had taken all possible steps to ensure that Bidco could acquire all of the Imasco shares after the reorganization.

The transaction was completed on February 1, 2000. Before the closing, employees holding options to acquire 4,848,600 Imasco shares elected to surrender their options for cash. The surrender payments totaled about $118 million.

On Account of Capital
Under Canada’s Income Tax Act, “a taxpayer’s income for a taxation year from a business or property is the taxpayer’s profit from the business or property for the year.”

In determining its profit for income-tax purposes, Imasco claimed a deduction for the surrender payments. But Canada’s tax law limits or prohibits the deduction of certain amounts “on account of capital”; that is, payments made as part of capital reorganization.

In the case, Canada’s tax regulator contended that the payments at issue were expenditures on capital account because they were made in the context of a reorganization of the capital of Imasco and extinguished all of Imasco’s outstanding obligations to issue shares. By contrast, Imasco argued that the payments were best characterized as employee compensation, and therefore deductible as an ordinary business expense. The Canadian court disagreed with Imasco.

There is little doubt that in the United States, those same payments would have been fully deductible, notwithstanding that the transaction that precipitated them was unequivocally a capital transaction.

In the United States, as Revenue Rule 73-146 makes clear, the payments would have been deductible because this country employs the “origin of the claim” requiring the expense to ascertain the deductibility of expenditures. Unlike Canada, the Internal Revenue Service doesn’t focus on the transaction in which the payments were made.

Instead of addressing the origin of the claim with respect to which the disputed payments were made, the Canadian court focused exclusively on the nature of the transaction that precipitated those payments. Since the transaction was indisputably a capital transaction, the payments that stemmed from it were found to be “on capital account.”

In the United States, by contrast, the emphasis is squarely on the origin of the claim. When the claim is compensatory in nature, the payments to extinguish it would be viewed as compensation for services actually rendered. Therefore it would be deductible.

Robert Willens, founder and principal of Robert Willens LLC, writes a tax column for