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Docket: 2003-748(IT)G |
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BETWEEN: |
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ALCATEL CANADA INC., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
____________________________________________________________________
Appeal heard on November 16, 2004 at Toronto, Ontario
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Before: The Honourable Justice Michael J. Bonner |
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Appearances: |
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Counsel for the Appellant: |
Al Meghji Peter MacDonald |
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Counsel for the Respondent: |
Alexandra Brown Brent Cuddy |
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JUDGMENT
The appeal from the assessment under the Income Tax Act for the Appellant's 1994 taxation year is allowed with costs and the assessment is referred back to the Minister of National Revenue for reassessment to permit the deduction of the investment tax credit as claimed.
Signed at Toronto, Ontario, this 24th day of February 2005.
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"Michael J. Bonner" |
Bonner, J.
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Citation: 2005TCC149 |
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Date: 20050224 |
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Docket: 2003-748(IT)G |
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BETWEEN: |
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ALCATEL CANADA INC., |
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Appellant, |
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and |
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HER MAJESTY THE QUEEN, |
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Respondent. |
REASONS FOR JUDGMENT
Bonner, J.
[1] This is an appeal from an assessment of income tax for the Appellant's 1994 taxation year. It raises the question whether the Appellant is entitled to an investment tax credit in respect of the value of stock option benefits conferred by it on certain of its employees who were engaged in scientific research and experimental development ("SRED").
[2] The essential facts are not in dispute. Many of the allegations set out in the Notice of Appeal were admitted in the Amended Reply. Further facts were established by the Agreed Statement of Facts filed. No witnesses were called at the hearing.
[3] At all material times the Appellant, a corporation formerly known as Newbridge Networks Corporation, engaged in scientific research and experimental development ("SRED") in Canada.
[4] The Appellant maintained an employee stock option program. Under the program employees were granted the right to purchase a specified number of the Appellant's common shares at an exercise price not lower than the market price of the shares on the Toronto Stock Exchange ("TSX") at the time when the options were granted. The options were exercisable in equal one-third instalments on each of the first, second and third anniversaries of the date of the grant and expired four years from the date of grant or following termination of employment.
[5] The option plan permitted the employees to exercise their options in one or the other of two ways, the regular method and the cashless method. Under both the cashless and regular methods, 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 exercise price. It was not suggested that the method chosen by the employee for exercise of the option had any bearing on the outcome of this appeal.
[6] The dispute over the investment tax credit arose in the following way. In its 1994 income tax return, the Appellant elected in accordance with subsection 37(10) of the Income Tax Act (the "Act") to use the proxy method, as set out in clause 37(8)(a)(ii)(B) of the Act, to calculate its SRED expenditures. In calculating its 1994 SRED expenditures the Appellant included the value of stock option benefits derived by those employees who were directly engaged in the prosecution of SRED in the amount of $23,344,318 pursuant to subclause 37(8)(a)(ii)(B)(IV). Accordingly, the Appellant claimed an investment tax credit ("ITC") of $4,668,864 with respect to the stock option benefits for its 1994 taxation year pursuant to section 127 of the Act.
[7] The Minister reassessed the Appellant on November 27, 2002. He disallowed the ITC claim and reduced the balance of the ITC pool on the basis that the stock option benefits derived by the employees of the Appellant were not "expenditures incurred" within the meaning of clause 37(8)(a)(ii)(B). The appeal is brought from that reassessment.
[8] The main issue is whether the benefits conferred on the employees by way of stock option constituted "... expenditures made in respect of an expense incurred in the year for salary or wages ..." within the meaning of subclause 37(8)(a)(ii)(B)(IV) of the Act. The position of the Appellant is that the benefits did so qualify.
[9] The issue arises in the context of a chain of statutory provisions intended to provide taxpayers with an incentive to carry out SRED by providing investment tax credits based on the taxpayer's expenditures for SRED. In construing the statutory language the objective which the legislature sought to attain in creating the incentive program must be kept in mind.[1]
[10] It is convenient at this point to review the chain of statutory provisions relied on by the Appellant in support of its claim.
[11] The right to deduct an investment tax credit from tax otherwise payable arises under subparagraph 127(5)(a)(i) of the Act:
"(5) There may be deducted from the tax otherwise payable by a taxpayer under this Part for a taxation year an amount not exceeding the lesser of
(a) the total of
(i) the taxpayer's investment tax credit at the end of the year in respect of property acquired, or an expenditure made, before the end of the year, and"
[12] The term "investment tax credit" is defined in subsection 127(9) of the Act:
"127. In this section
(9) "investment tax credit" of a taxpayer at the end of a taxation year means the amount, if any, by which the total of
(a) the total of all amounts each of which is the specified percentage of
...
(ii) a qualified expenditure made by the taxpayer in the year, or,"
[13] The term "qualified expenditure" is also defined in subsection 127(9):
""qualified expenditure" - "qualified expenditure" means an expenditure in respect of scientific research and experimental development incurred by a taxpayer that is ... an expenditure described in paragraph 37(1)(a) or subparagraph 37(1)(b)(i) and includes an amount that is a prescribed proxy amount of a taxpayer, but does not include ..."
[14] Expenditures are "described" in paragraph 37(1)(a) of the Act as follows:
"37.(1) Where a taxpayer carried on a business in Canada in a taxation year and files with the taxpayer's return of income under this Part for the year a prescribed form containing prescribed information, there may be deducted in computing the taxpayer's income from the business for the year such amount as the taxpayer may claim not exceeding the amount, if any, by which the total of
(a) the total of all amounts each of which is an expenditure of a current nature made by the taxpayer in the year or in a preceding taxation year ending after 1973
(i) on scientific research and experimental development carried on in Canada, directly undertaken by or on behalf of the taxpayer, and related to a business of the taxpayer,"
I note in passing that the reference in paragraph 37(1)(a) to expenditure "of a current nature" is the foundation of the second of the Respondent's two main arguments.
[15] Subsection 37(8) of the Act imposes limits on the ambit of references in section 37 to expenditures on or in respect of SRED:
"(8) In this section,
(a) references to expenditures on or in respect of scientific research and experimental development ...
(ii) where the references occur other than in subsection (2), include only
...
(B) where a taxpayer has elected in prescribed form and in accordance with subsection (10) for a taxation year, expenditures incurred by the taxpayer in the year each of which is
...
(IV) that portion of an expenditure made in respect of an expense incurred in the year for salary or wages of an employee who is directly engaged in scientific research and experimental development in Canada that can reasonably be considered to relate to such work having regard to the time spent by the employee thereon, and, for this purpose, where that portion is all or substantially all of the expenditure, that portion shall be deemed to be the amount of the expenditure."
[16] The Appellant did elect in accordance with subsection (10) and thus it is necessary to consider whether the benefits constitute expenditures incurred, each of which is a portion of an expenditure made in respect of an expense incurred for salary or wages of an employee within the meaning of the statutory language set out immediately above. The term "salary" or "wages" is so defined in section 248 of the Act as to include the benefits in issue.
[17] The raising of capital was an incidental result of the operation of the stock option program. It was not, however, the objective. The goal was the securing of the services of a contented and productive work force by permitting employees to reap the benefit of increases in the market value of the Appellant's shares.
[18] The goal is clear from a letter delivered by management to an employee advising her of the grant to her of options. It reads in part:
"I am pleased to advise you that you have been granted an option by our Board of Directors to purchase 600 common shares of Newbridge Networks Corporation. This stock option will allow you to share in the success of the company. Your participation in this round of options was determined by management review and is based on your overall performance. This is an encouragement to you to contribute good ideas, hard work and enthusiasm.
I would like to thank you for helping me to make our company highly motivated and also for helping to maintain Newbridge at a leadership position in our industry. I believe that Newbridge will grow substantially over the next few years. It is in working together as a team that we can gain business success. Success that we can all share!"
I take the letter to be representative of communications from management to all employees who benefited under the plan. It is evident that the stock options were a form of benefit from employment different in form but not in function from salary or wages.
[19] As noted above, the employees derived a benefit upon the exercise of their options equal to the difference between the exercise price and the market value of the shares at the time of exercise. The amount of the difference was required to be included in the employee's income under section 7 of the Act. The amount now in issue is equal to the aggregate of the option benefits.
[20] The advantage to the Appellant of the stock option program generally was that it enabled the Appellant to reward its employees without making any cash outlay.
[21] The Appellant did not record the amount in issue as an expense on its income statement for the 1994 taxation year. The Appellant's financial statements for 1994 reflected only the increase in the number of shares and the increase in share capital equal to the aggregate of the exercise price of all the shares acquired under the program (plus the corresponding increase in cash). No amount was recorded as an expense on the income statement of the Appellant in years preceding the 1994 taxation year at the time when the options which were exercised in 1994 were granted to the Appellant's employees.
[22] As I understand the Appellant's position with regard to subsection 37(8), it is that:
a) the Appellant "incurred" an expense in 1994 for salary and wages within subclause 37(8)(a)(ii)(B)(IV) when its employees exercised their rights rendering it liable to issue the shares for a price less than market value;
b) the Appellant made the "expenditure" by issuing the shares at the option price.
[23] There was no dispute with regard to the time when the expense was incurred and the expenditure, if any, was made. The Respondent took the position in paragraph 11 of the Amended Reply to the Notice of Appeal:
"The granting of an option under the terms of a stock option program has no consequences until the option is exercised and shares are acquired by the employee for less than the fair market value prevailing at the time of exercise."
[24] The Respondent argued that the Appellant, in allowing its employees to buy shares for less than market value as contemplated by the option program, conferred a benefit on them without making any outlay and therefore did so without making any expenditure. The premise on which this argument rests is that legislation which requires that an expenditure be made can be satisfied only by making an outlay or payment. Because the Appellant made no outlay it therefore made no expenditure as required by subclause 37(8)(a)(ii)(B)(IV). Secondly, the Respondent argued, the transactions whereby the Appellant's employees were permitted to acquire shares at less than market value related not to the Appellant's income earning process but rather to the Appellant's share capital structure. The outlays, if any, were therefore not "expenditures of a current nature made by the taxpayer" within paragraph 37(1)(a) of the Act.
[25] In respect of both arguments, the Respondent relied on the decision of the House of Lords in Lowry v. Consolidated African Selection Trust, [1940] A.C. 648. There, a corporate taxpayer, with a view to expressing gratitude for services rendered by its employees, granted to them the right to purchase its shares at par. At the time the market value of the shares was in excess of par. The taxpayer sought to deduct in computing its profit the premium which it would have received if the shares allotted to the employee had been issued in the open market. The House of Lords rejected the taxpayer's claim by a majority of 3 to 2. In doing so, it reversed the unanimous decision of the Court of Appeal which, in turn, had reversed the decision at trial against the taxpayer's claim. This decision, in which more judges found in favour of the taxpayer's claim than against it was said to be "the cornerstone of the Crown's case".
[26] The Respondent relied on Lowry for the proposition that the word "expenditure" necessarily involves outlay and, as well, for the proposition that any outlays involved in the operation of the stock option program were on capital account.
[27] In Lowry the majority of the Law Lords held that the course of action adopted by the taxpayer did not involve any expenditure of its money. That question is very much at the centre of the present case. The following passages from the speeches of the majority were among those relied on by counsel for the Respondent in this case. At page 653 Viscount Caldecote noted that the taxpayer could have sold its shares in the open market to raise funds necessary to pay to the employees an amount equivalent to the benefit in cash. Had it done so and paid cash to the employees the payment would have been a deductible trading expense. He noted, however, that:
"...The company chose to take another course which did not involve any expenditure of its money, or realization of any of its assets."
After a review of the case law he continued at p. 656:
"...I come back to the facts of this case, and I ask whether the issue of these shares in the manner adopted involved the respondent in any "disbursements or expenses .... wholly "and exclusively laid out or expended for the purposes of" its trade. Its capital was intact after the issue of the shares : not a penny was in fact disbursed or expended. Its trading receipts were not diminished, nor do I think it is a right view of the facts to say that the respondent gave away money's worth to its own pecuniary detriment. The company was entitled to issue its shares at par. It did so, and the company never received, and never elected to receive, anything more than the par value of the shares."
At p. 658 he concluded:
"...The plain fact as it appears to me is that the cost to the company of earning its trading receipts was not increased by the issue of these shares at less than their full market value."
[28] Viscount Maugham also was influenced by the view that (at p. 660): "We are invited to consider something which did not take place; ...". On the facts, he characterized the suggestion that conferring the right to buy at par was a present of money or money's worth as a 'false view' of the transaction. Moreover, he noted at page 661: "Indeed the issue of shares by a limited company is not a trading transaction at all." This analysis of the facts of the case led him to conclude at page 662:
"...There is here in my opinion no transaction of trade at all, nor an item of any kind that ought to be carried to either side of the profit and loss account."
[29] Lord Russell was of like mind. At pp. 671-672, he stated:
"...I am of the opinion that the first basis of the judgment of the Court of Appeal fails because the respondents transferred neither money nor money's worth to their servants; they merely elected not to obtain more than the nominal value of the shares in order to induce the servants to become shareholders in the company. I cannot hold (apart from compelling authority) that such action by the respondents is, or may be treated as, a disbursement or an expense ; or that the premium which the servants could, if they wished, obtain from purchasers of their shares, is or may be treated as money laid out or expended by the respondents for the purposes of the respondents' trade."
[30] Obviously, the decision in Lowry, although entitled to great respect, is not binding on the courts in Canada. More importantly, it does not involve the construction of the word "expenditure" in the context of a statutory scheme intended to encourage, by the granting of a tax credit, activity of the very sort in which the Appellant's employees were engaged. Finally, it is distinguishable on the basis that the facts in the present case cannot support a conclusion that the costs of compensating the employees by the stock option program was on capital account.
[31] Black's Law Dictionary, Eighth Edition, defines "expenditure" as follows:
"1. The act of process of paying out; disbursement. 2. A sum paid out."
I take that to be the ordinary meaning of the word. Expenditure is not confined to outlays of cash. Nothing in the definition excludes the disbursement of assets by mechanisms adopted for that purpose which do not involve payouts of cash. The Respondent's argument fails to recognize that a very real expenditure is accomplished when shares having an established market value are sold for less than that value in the context of a scheme for the compensation of the employees who buy them. The benefit realized by the employees is real. It is not conjured up by magic. It flows from the Appellant to the employees by the mechanism of the stock option. The expenditure consists of the consideration which the Appellant foregoes when it issues its shares for less than market value. The encouragement of scientific research which is the object of the legislation would be greatly diminished by the adoption of the narrow construction for which the Respondent contends.
[32] The meaning of the word "expenditure" which is implicit in the language used by the majority in Lowry is not the same as the meaning of the word in ordinary usage in Canada today. For example the word "expenditure" is employed by the Department of Finance of the Government of Canada in the term "tax expenditure". The term is used, without in any way extending its ordinary meaning, to describe tax revenues foregone due to exemptions, deductions, rate reductions, rebates, etc. that reduce the amount of the tax that would otherwise be payable.[2]
[33] Finally, I note that the stock option benefits in issue fall within the meaning of salary or wages as defined in section 248 of the Act. It is hard to see how salary or wages can flow from employer to employee without expenditure on the part of the employer. The section 248 definition forms part of the statutory context in which section 37 is found. Accordingly I reject the Respondent's first argument for it imposes a constraint on the meaning of the word 'expenditure' which is not justified having regard to the purpose of the legislation.
[34] I turn now to the Respondent's second argument, namely, that the expenditure in issue is on capital account. The argument rests on the proposition that consideration received by the Appellant for the shares which it issued was an addition to the capital of the company and not a trading receipt. So far, I agree. The argument continued that the expenditure, if any was made, arose from a distribution of shares which generated capital and not from the conduct of the Appellant's ordinary day-to-day revenue generating activities. Here, I disagree.
[35] As already noted, on the facts as I see them, the primary purpose of the program was to compensate the Appellant's employees for their services and to encourage future effort. There was no suggestion that the work on which the employees were engaged was aimed in any way at increasing or otherwise altering the Appellant's capital structure. The mere fact that a capital asset, in this case the share capital generated by the issue of shares pursuant to the options, may be the incidental result of activity undertaken with a different objective in view does not warrant a conclusion that the cost of the activity is on capital account.[3]
[36] The Respondent, in reliance on a passage from the reasons of the Federal Court of Appeal in The Queen v. Kaiser Petroleum Ltd. v., 90 DTC 6603 argued that though employee compensation was a factor motivating the Appellant the means adopted involved the reshaping of the capital structure of the Appellant's organization. In my opinion there is nothing in the evidence here which could conceivably justify an assertion that the issuance of the shares pursuant to the options could be described as a "reshaping" of the Appellant's capital structure as was the case in Kaiser. Here, the options were issued to satisfy a recurrent need to compensate employees engaged in the day-to-day operations of the business. The cost of the option program was an ordinary current expense.
[37] The Respondent also argued that generally accepted accounting principles did not, at the time, require that the Appellant's financial statements reflect any expense in connection with the options. If non-cash expenditure could be ignored in the preparation of a profit and loss statement it might consistently be ignored in the computation of a 'qualified expenditure'. That sort of accounting may well have prevailed in 1994 but the argument raises the question whether accounts which did not reflect the cost to the Appellant of the options accurately disclosed the expenditures made to earn its income. If the Appellant's accounts were up to current 1994 standards, then the standards required change (and, I note, they have been changed). As I see it, disclosure of the expenditure is necessary to reflect reality both for present purposes and for domestic accounting purposes.
[38] Finally, the Respondent argues that even if the amount in issue does satisfy the terms of subclause 37(8)(a)(ii)(B)(IV) it cannot be added to the expenditures described in paragraph 37(1)(a) without contravening the prohibition in paragraph 7(3)(b). The short answer to this contention is that the deeming provision in paragraph 7(3)(b) by its clear language applies to the computation of income only. It does not affect the computation of ITCs.
[39] The appeal will be allowed with costs and the assessment referred to the Minister for reassessment to allow the credit in issue.
Signed at Toronto, Ontario, this 24th day of February 2005.
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"Michael J. Bonner" |
Bonner, J.
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CITATION: |
2005TCC149 |
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COURT FILE NO.: |
2003-748(IT)G |
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STYLE OF CAUSE: |
Alcatel Canada Inc. and H.M.Q. |
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PLACE OF HEARING: |
Toronto, Ontario |
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DATE OF HEARING: |
November 16, 2004 |
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REASONS FOR JUDGMENT BY: |
The Honourable Justice Michael J. Bonner |
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DATE OF JUDGMENT: |
February 24, 2005 |
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APPEARANCES: |
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Counsel for the Appellant: |
Al Meghji Peter MacDonald |
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Counsel for the Respondent: |
Alexandra Brown Brent Cuddy |
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COUNSEL OF RECORD: |
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For the Appellant: |
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Name: |
Al Meghji Osler, Hoskin & Harcourt LLP |
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Firm: |
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For the Respondent: |
John H. Sims, Q.C. Deputy Attorney General of Canada Ottawa, Canada |