15 June 2022 STEP Roundtable Q. 18, 2022-0924791C6 - McNeeley et al v. The Queen

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ARC.

Principal Issues: Can CRA provide comments on the McNeeley decision.

Position: Comments provided.

Reasons: See below.

2022 STEP CRA Roundtable – June 15, 2022

Question 18. McNeeley et al v. The Queen

The Federal Court of Appeal recently confirmed the decision of the Tax Court of Canada in McNeeley et al v. The Queen (2021 FCA 218 affirming 2020 TCC 90) and the Supreme Court of Canada dismissed the taxpayer’s application for leave to appeal (2022 CanLII 42894). A key issue before the Courts was whether a trust established for the benefit of employees was an employee benefit plan (“EBP”), as defined in subsection 248(1) of the Income Tax Act (the “Act”) (footnote 1) , or a prescribed trust pursuant to paragraph (a) of Income Tax Regulation (“Regulation”) 4800.1.

The Federal Court of Appeal’s decision seems to demonstrate the need for employers and their tax advisors to exercise care in structuring employee trust arrangements as the tax outcome for the employees who are beneficiaries of such a trust can be very significantly impacted, depending on how the arrangement is structured. Could the CRA provide comments?

CRA Response

The decisions rendered by the Federal Court of Appeal and Tax Court in this case were in respect of the appeals by three appellants, which were heard on common evidence. Each of the three individuals appealed reassessments by CRA of their 2012 personal returns, in which amounts were included in their income in respect of the shares that they received from a trust that held shares of their employer. The assessments were made on the basis that CRA had concluded that the Stock Trust was an EBP under the Act.

In general terms, an EBP, as defined in subsection 248(1), is an arrangement in which contributions are made by an employer, or by a person not dealing at arm’s length with the employer, to a custodian and under which payments are to be made to or for the benefit of employees or former employees of the employer, or for persons not at arm’s length with the employees/former employees. Under paragraph 6(1)(g), amounts received by an employee from an EBP are included in income as a benefit from employment.

In contrast, a prescribed trust under paragraph (a) of Regulation 4800.1 is a trust maintained primarily for the benefit of employees of a corporation, where one of the main purposes of the trust is to hold interests in the shares of the corporation. Such trusts are prescribed for the purposes of specific provisions of the Act, namely paragraph 107(1)(a) and subsections 107(1.1), (2) and (4.1).

The relevant facts

The facts in this case are relatively straightforward and not uncommon, and can be briefly summarized as follows:

One of the appellants was the founder (“Founder”) and president of a Canadian company (“Employer”), as well as its sole shareholder until 2006. The other two appellants were employees.

In 2005 the Founder’s mother contributed cash to settle a trust established to acquire and hold securities of the Employer for the benefit of certain full-time employees of the Employer and its affiliates (the “Stock Trust”).

The trustees of Stock Trust were required to allocate and distribute shares to the beneficiaries in any manner and proportion as they, in their absolute and sole discretion, might determine.

In 2006 the Stock Trust subscribed for common shares of Employer for a nominal cash amount. Between that time and 2012, the shares held by Stock Trust were exchanged for different shares as a result of certain reorganization and freeze transactions.

In 2012, the Stock Trust distributed the shares it held, which by that time had significant accrued gains, to various beneficiaries including Founder, in two tranches. An election was made pursuant to subsection 107(2.001) to apply subsection 107(2.1) in respect of the share distributions to beneficiaries other than the first share distribution to Founder, and tax filings were made on the basis that a subsection 107(2) rollover applied to the first share distribution made to him. The resulting taxable capital gains realized by the Stock Trust in respect of the distributions were allocated to the other beneficiaries on a pro-rata basis.

Founder transferred the shares he received on the first distribution, which was by far the larger of the two distributions he received, to a numbered corporation owned by him on a subsection 85(1) rollover basis, but reported a taxable capital gain in respect of the second smaller distribution to him. The other two appellants claimed the capital gains deduction in respect of the taxable capital gains that were allocated to them and also sold the shares they received to the numbered corporation owned by Founder.

The issues considered in the case

The issues which the Tax Court had to consider included the following:

1. Was the Stock Trust an EBP or a prescribed trust pursuant to paragraph (a) of Regulation 4800.1?

2. If the Stock Trust was both an EBP and a prescribed trust, did the prescribed trust rules take precedence over the EBP rules?

The appellants asserted that the amounts they received from Stock Trust were trust capital distributions from a prescribed trust, and that a rollover pursuant to subsection 107(2) applied to the first distribution to the Founder. In addition, based on that assertion that the Stock Trust had realized taxable capital gains in respect of the other share distributions, it flowed those gains out to the beneficiaries, who in turn claimed capital gains deductions pursuant to subsection 110.6(2.1) of the Act, if they were eligible to.

The Crown argued on behalf of the CRA that the appellants had received the shares as EBP distributions and not from a prescribed trust, so the fair market value of what was received had to be included as income from an office or employment pursuant to paragraph 6(1)(g) of the Act. Furthermore, pursuant to subparagraph 107.1(b)(i), the Stock Trust would be deemed to have disposed of the shares at cost amount, thus realizing no capital gains at the trust level. This would preclude capital gains treatment in regard to the shares distributed, and by extension, claims for the capital gains deduction by the employees.

Federal Court of Appeal

The Federal Court of Appeal agreed with the Tax Court that the arrangement was an EBP but noted that it also satisfied the requirements for a prescribed trust. On behalf of a unanimous Court, Mr. Justice Wyman Webb noted that while the definitions of EBP and prescribed trust overlapped in this case, they do not always overlap and that it is possible to create an EBP which is not a prescribed trust and vice versa.

Since the Stock Trust was an EBP and also met the requirements to be a prescribed trust, it was necessary to determine which set of rules governed the tax treatment of shares distributed to the employees. The employees reported their income on the basis that the Stock Trust was a trust for purposes of section 107. Under the “trust” definition in subsection 108(1), however, a trust for purposes of various sections of the Act, including section 107, does not include an EBP. Since the Stock Trust was an EBP, it could not be a trust for purposes of section 107 and therefore the capital gains treatment reported by the employees was unavailable.

The Court acknowledged that there was a clear conflict between the provisions of the Act governing EBPs and the prescribed trust rules which could not be reconciled as the tax consequences were significantly different depending on how the arrangement was characterized. However, since the EBP definition was set out in the Act and the prescribed trust definition is set out in the Regulations, the paramountcy doctrine required that the EBP rules governed.

Some key considerations from the decision:

When contemplating the establishment of a trust which will acquire securities of an employer to be held for the benefit of employees, consideration of the EBP rules is advised. If the intent is that the trust be governed by section 7 of the Act, so as not to be treated as an EBP, then care must be taken to ensure that the requirements to be a section 7 trust are met. As noted in CRA technical interpretation 2016-0641841I7, a trust arrangement that provides for allocations and distributions of employer shares on a fully discretionary basis would not be governed by section 7.

If the arrangement is found to be an EBP, any distributions of shares to the employee beneficiaries will be included in their income at their fair market value as income from an office or employment pursuant to paragraph 6(1)(g), with no rollover available, and the employee beneficiaries will not be able to claim a capital gains deduction in respect of the growth in the value of the shares up to the time they are received.

Phil Kohnen
2022-092479

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 Unless otherwise expressly stated, every statutory reference herein is a reference to the relevant provision of the Act.