http://decision.tcc-cci.gc.ca/tcc-cci/decisions/en/item/111111/index.do
Fettes v. The Queen (August 6, 2015 – 2015 TCC 198, C. Miller J.).
Précis: Mr. Fettes was an employee of the Culligan Group and in 2004 he was granted an option to acquire shares of Culligan Ltd. at $10.00 each, the then fair market value of the shares. In 2008 he exercised his option but the strike price was reduced to $2.02 for some reason. This was below the then fair market value of $8.05. The Minister assessed a benefit on the difference between $8.05 and $2.02. Mr. Fettes appealed on the basis that he was entitled to a reduction of 50% of the amount of the benefit as a result of the application of paragraph 110.1(1)(d) of the Income Tax Act (the “Act”). CRA denied the deduction since the strike price in 2008 was less than the fair market value of the shares at that date.
The Tax Court held that the inexplicable reduction of the strike price in 2008 disqualified Mr. Fettes from the benefit of paragraph 110.1(1)(d) of the Act and dismissed his appeal with costs.
Decision: This is an odd case factually:
[1] Mr. Donald Fettes was an employee of USFWatergroup, Inc., later known as Watergroup Companies Inc. He was granted stock options for shares in a related company, Culligan Ltd., on December 30, 2004 and February 10, 2005. In these two Option Agreements the option price was $10 per share for 10,000 shares and 45,000 shares respectively, valued at that time at the same $10 per share. In 2008, Mr. Fettes exercised options for 41,250 shares that had vested at an exercise or strike price of $2.02 per share: the shares had a fair market value at that time of $8.05. The Minister of National Revenue (the “Minister”) applied section 7 of the Income Tax Act (the “Act”) to bring into Mr. Fettes’ 2008 income, as a benefit of employment, an amount substantially equal to the value of the shares less the amount paid for them ($8.05 - $2.02). No amount was deducted from income pursuant to paragraph 110(1)(d) of the Act. Mr. Fettes appeals on the basis that he is entitled to a deduction, pursuant to paragraph 110(1)(d) of the Act in 2008 of half the benefit brought into income, because he met the three requirements of that paragraph:
i. The shares were common shares.
ii. He was at arm’s length with his employer and the issuer of the shares.
iii. The amount payable under the option agreement was not less than the fair market value of the shares at the time the agreements were made.
[2] The Respondent concedes the first two points but argues that because the exercise or strike price was reduced to $2.02 from $10.00, Mr. Fettes does not meet this third requirement.
There is no indication of why the strike price was reduced to $2.02 apart from somewhat cryptic evidence of the payment of a bonus, which Mr. Fettes seemed unable to explain:
[9] In considering exercising the options, Mr. Fettes requested some information from Culligan and was provided with a sheet called Culligan Ltd. Stock Incentive Plan – Equity Summary – Example, which I attach as Schedule A to these Reasons.
[10] I note in the bottom chart of the attached Schedule A that on May 28, 2007, the strike price was shown as $2.02, presumably having fallen to that amount due to the effect of what the chart shows as a cash bonus paid on that date. Mr. Fettes, the only witness, could offer no explanation regarding the circumstances surrounding this reduction in the exercise price established in the original Stock Option Agreements. He paid the $46,866.02 U.S. requested, exercising his options.
Quite simply, the Court found that Mr. Fettes could not meet the requirement of subparagraph 110.1(1)(d) of the Act that the amount payable under the option agreement was not less than the fair market value of the shares at the time the agreement was made, i.e., the 2008 agreement at a reduced strike price:
[23] It makes no sense to me from a policy perspective that an option agreement set at a price equal to fair market value can willy-nilly be altered to a price less than the fair market value and still claim it reflects a policy to provide an incentive to an employee: there is no future incentive - the employee is receiving an immediate benefit. To suggest treating it otherwise would open the floodgates to abusive tax planning with a written agreement stipulating one thing and reality dictating another. I am not for an instant suggesting that is the case with Mr. Fettes. He presented as an honest, straightforward individual caught in the tangled web of complicated tax legislation.
[24] In summary, I interpret the term “agreement” in clause 110(1)(d)(ii) of the Act to refer to the agreement Mr. Fettes had to acquire shares at $2.02 per share, a price less than the fair market value of the shares at the time of the original agreement, at the time of the repricing and at the time of the exercise. In these circumstances, the benefit Mr. Fettes realized pursuant to subsection 7(1) of the Act is not the type of benefit contemplated by paragraph 110(1)(d) of the Act that effectively provides capital gains treatment to the recipient of the benefit. It was simply an employment benefit to be brought into income.
[25] The Appellant goes on to argue that if I find Mr. Fettes has an employment benefit then the amount has been incorrectly calculated by CRA. CRA relied on the amended T4 filed by Watergroup, which indicated additional income of $233,765 with an increase in tax deducted of $102,250. Yet, the withholding analysis by Culligan (see paragraph 8 of these Reasons) suggests the withholding of US $108,830. There was no evidence of what Culligan actually remitted to the CRA. While I agree with the Appellant that this raises some question as to the accuracy of the numbers relied upon by the Respondent, the Appellant has not been able to provide me with any accurate alternative. In these circumstances, I am not prepared to accept the Appellant has demolished the Minister’s assumptions.
As a result the appeal was dismissed with costs.