Black v. The King

Black v. The King
Court (s) Database
Tax Court of Canada Judgments
Date
2024-07-11
Neutral citation
2024 TCC 96
File numbers
2019-4444(IT)G, 2019-4445(IT)G, 2019‑4446(IT)G, 2019-4447(IT)G
Judges and Taxing Officers
David E. Spiro
Subjects
Income Tax Act
Decision Content
Docket: 2019-4444(IT)G
BETWEEN:
RONALD KARY BLACK,
Appellant,
and
HIS MAJESTY THE KING,
Respondent.
Appeals heard on common evidence with the appeals of Murphy Pettypiece (2019-4445(IT)G), Rebecca Ford (2019-4446(IT)G) and Jason Murphy (2019-4447(IT)G) on September 18, 19, and 20, 2023 and February 8 and 9, 2024 at Toronto, Ontario
Before: The Honourable Justice David E. Spiro
Appearances:
Counsel for the Appellant:
Daniel Sandler and Selena Ing
Counsel for the Respondent:
Arnold H. Bornstein and Tigra Bailey
JUDGMENT
The appeals of reassessments under the Income Tax Act dated February 28, 2019 for the Appellant’s 2015, 2016, and 2017 taxation years are dismissed, with costs.
The parties shall have 30 days from the date of Judgment to reach an agreement on costs, failing which the Respondent shall then have 30 days to serve and file written submissions on costs of 15 pages or less. The Appellant in this appeal and the Appellants in the three related appeals shall then have 30 days to serve and file written submissions of 15 pages or less. The Respondent may serve and file a response of 10 pages or less within 15 days of service of those submissions.
If the parties do not advise the Court that they have reached an agreement and no submissions are received within the foregoing time limits, the Respondent is entitled to four sets of costs for all four appeals as set out in the Tariff.
Signed at Toronto, Ontario, this 11th day of July 2024.
“David E. Spiro”
Spiro J.
Docket: 2019-4445(IT)G
BETWEEN:
MURPHY PETTYPIECE,
Appellant,
and
HIS MAJESTY THE KING,
Respondent.
Appeals heard on common evidence with the appeals of Ronald Kary Black (2019-4444(IT)G), Rebecca Ford (2019-4446(IT)G) and Jason Murphy (2019-4447(IT)G) on September 18, 19, and 20, 2023 and February 8 and 9, 2024 at Toronto, Ontario
Before: The Honourable Justice David E. Spiro
Appearances:
Counsel for the Appellant:
Daniel Sandler and Selena Ing
Counsel for the Respondent:
Arnold H. Bornstein and Tigra Bailey
JUDGMENT
The appeals of reassessments under the Income Tax Act dated March 14, 2019 for the Appellant’s 2015, 2016, and 2017 taxation years are dismissed, with costs.
The parties shall have 30 days from the date of Judgment to reach an agreement on costs, failing which the Respondent shall then have 30 days to serve and file written submissions on costs of 15 pages or less. The Appellant in this appeal and the Appellants in the three related appeals shall then have 30 days to serve and file written submissions of 15 pages or less. The Respondent may serve and file a response of 10 pages or less within 15 days of service of those submissions.
If the parties do not advise the Court that they have reached an agreement and no submissions are received within the foregoing time limits, the Respondent is entitled to four sets of costs for all four appeals as set out in the Tariff.
Signed at Toronto, Ontario, this 11th day of July 2024.
“David E. Spiro”
Spiro J.
Docket: 2019-4446(IT)G
BETWEEN:
REBECCA FORD,
Appellant,
and
HIS MAJESTY THE KING,
Respondent.
Appeals heard on common evidence with the appeals of Ronald Kary Black (2019-4444(IT)G), Murphy Pettypiece (2019‑4445(IT)G) and Jason Murphy (2019-4447(IT)G) on September 18, 19, and 20, 2023 and February 8 and 9, 2024 at Toronto, Ontario
Before: The Honourable Justice David E. Spiro
Appearances:
Counsel for the Appellant:
Daniel Sandler and Selena Ing
Counsel for the Respondent:
Arnold H. Bornstein and Tigra Bailey
JUDGMENT
The appeals of reassessments under the Income Tax Act dated March 25, 2019 for the Appellant’s 2015, 2016, and 2017 taxation years are dismissed, with costs.
The parties shall have 30 days from the date of Judgment to reach an agreement on costs, failing which the Respondent shall then have 30 days to serve and file written submissions on costs of 15 pages or less. The Appellant in this appeal and the Appellants in the three related appeals shall then have 30 days to serve and file written submissions of 15 pages or less. The Respondent may serve and file a response of 10 pages or less within 15 days of service of those submissions.
If the parties do not advise the Court that they have reached an agreement and no submissions are received within the foregoing time limits, the Respondent is entitled to four sets of costs for all four appeals as set out in the Tariff.
Signed at Toronto, Ontario, this 11th day of July 2024.
“David E. Spiro”
Spiro J.
Docket: 2019-4447(IT)G
BETWEEN:
JASON MURPHY,
Appellant,
and
HIS MAJESTY THE KING,
Respondent.
Appeals heard on common evidence with the appeals of Ronald Kary Black (2019-4444(IT)G), Murphy Pettypiece (2019‑4445(IT)G) and Rebecca Ford (2019-4446(IT)G) on September 18, 19, and 20, 2023 and February 8 and 9, 2024 at Toronto, Ontario
Before: The Honourable Justice David E. Spiro
Appearances:
Counsel for the Appellant:
Daniel Sandler and Selena Ing
Counsel for the Respondent:
Arnold H. Bornstein and Tigra Bailey
JUDGMENT
The appeals of reassessments under the Income Tax Act dated March 25, 2019 for the Appellant’s 2015, 2016, and 2017 taxation years are dismissed, with costs.
The parties shall have 30 days from the date of Judgment to reach an agreement on costs, failing which the Respondent shall then have 30 days to serve and file written submissions on costs of 15 pages or less. The Appellant in this appeal and the Appellants in the three related appeals shall then have 30 days to serve and file written submissions of 15 pages or less. The Respondent may serve and file a response of 10 pages or less within 15 days of service of those submissions.
If the parties do not advise the Court that they have reached an agreement and no submissions are received within the foregoing time limits, the Respondent is entitled to four sets of costs for all four appeals as set out in the Tariff.
Signed at Toronto, Ontario, this 11th day of July 2024.
“David E. Spiro”
Spiro J.
Table of Contents
I. Issue to be Decided 2
II. Representative Appellants 3
III. Overview (Law) 4
A. Paragraph 6(1)(g) of the Act 4
B. Subsections 7(1) and 7(2) of the Act 4
C. Statutory Appendix 6
IV. Overview (Facts) 6
V. Findings of Fact 8
A. The Old Stock Option Plan 8
B. The Proposed Estate Freeze and Corporate Reorganization 10
C. The Three Individual Shareholders 15
D. Termination of the Old Stock Option Plan 15
(1) Mr. James Schmalz’s Conversations with Senior Employees 18
(2) Mr. Michael Schmalz’s Conversations with Junior Employees 19
(3) Mr. Black’s Conversation with the Human Resources Department 20
(4) Summary of Conversations 21
E. Constating Documents for the New Trust Arrangement 22
(1) The Trust Deed 22
(2) The Employee Rights Plan 24
F. The Committee Granted Trust Units on a Discretionary Basis 26
(1) The Grant of Trust Units to Mr. Black 29
(2) The Grant of Trust Units to Mr. Pettypiece 29
(3) The Grant of Trust Units to Ms. Ford 31
(4) The Grant of Trust Units to Mr. McGregor 32
G. No Shares Were Allocated to Each of the Former Stock Option Holders 32
H. No Shares Were Allocated to Each of the New Employees 33
I. Email Message on Agreement to Sell 61% of the Company 33
VI. Submissions of the Parties 35
A. Submissions of the Appellants 35
B. Submissions of the Respondent 37
VII. The Jurisprudence 38
A. Chrysler No. 1 40
B. McAnulty v The Queen 46
VIII. Analysis and Conclusion 47
Statutory Appendix
Schedule “A” – Partial Agreed Statement of Facts (Global)
Schedule “B” – Partial Agreed Statement of Facts (Black)
Schedule “C” – Partial Agreed Statement of Facts (Pettypiece)
Schedule “D” – Partial Agreed Statement of Facts (Ford)
Schedule “E” – Partial Agreed Statement of Facts (Murphy)
Schedule “F” – Letter from Digital Extremes Ltd. to Mr. Black dated July 29, 2013
Schedule “G” – Settlement and Release Agreement of Mr. Black dated August 7, 2013
Schedule “H” – Email Message from James Schmalz dated October 14, 2024
Endnotes .................................................................................... 51
Citation: 2024 TCC 96
Date: 20240711
Docket: 2019-4444(IT)G
BETWEEN:
RONALD KARY BLACK,
Appellant,
and
HIS MAJESTY THE KING,
Respondent,
Docket: 2019-4445(IT)G
AND BETWEEN:
MURPHY PETTYPIECE,
Appellant,
and
HIS MAJESTY THE KING,
Respondent,
Docket: 2019-4446(IT)G
AND BETWEEN:
REBECCA FORD,
Appellant,
and
HIS MAJESTY THE KING,
Respondent,
Docket: 2019-4447(IT)G
AND BETWEEN:
JASON MURPHY,
Appellant,
and
HIS MAJESTY THE KING,
Respondent.
REASONS FOR JUDGMENT
Spiro J.
[1] In 1993, James Schmalz (“James”) established a video game business in London, Ontario that was later incorporated as Digital Extremes Limited (the “Company”).[1] The Company developed, published, and sold a popular video game called Warframe.
I. Issue to be Decided
[2] The key issue to be decided in these appeals is whether distributions made in 2015, 2016, and 2017 to each of the Appellants from a trust established by the Company are taxable:
(a) under paragraph 6(1)(g) of the Income Tax Act (the “Act”) as distributions from an “employee benefit plan” within the meaning of subsection 248(1) of the Act as reassessed by the Minister of National Revenue (the “Minister”); or
(b) under subsection 7(2) allowing the trust to make the designations necessary to characterize the distributions to the Appellants under subsection 104(19) as dividends eligible for the dividend tax credit, subsection 104(21) as taxable capital gains, and subsection 104(21.2) as taxable capital gains eligible for the lifetime capital gains exemption, as the Appellants contend.
[3] The parties agree that the distributions made to the Appellants from the trust in 2015, 2016, and 2017 were distributions from an “employee benefit plan” within the meaning of subsection 248(1) of the Act. They part company on whether those distributions are taxable under paragraph 6(1)(g) as the Respondent contends or under subsection 7(2) of the Act as the Appellants contend.
[4] For the reasons set out below, the trust is not one described in subsection 7(2) of the Act. In short, there was never any allocation of a particular number of shares to a particular employee to be held on their behalf by the trust. It is for that reason that subsections 104(19), 104(21), and 104(21.2) do not apply to characterize the distributions from the trust as dividends and taxable capital gains.
[5] I have, therefore, concluded that the Minister reassessed the Appellants correctly on the distributions from the trust in 2015, 2016, and 2017 under paragraph 6(1)(g) of the Act as distributions from an “employee benefit plan” within the meaning of subsection 248(1) of the Act.
II. Representative Appellants
[6] Although the four appeals are not “lead cases” under section 146.1 of the Tax Court of Canada Rules (General Procedure), they do reflect a set of facts shared by three groups of employees of the Company who received grants of trust units followed by distributions from the trust in 2015, 2016, and 2017. Those groups are:
(a)holders of trust units who formerly held stock options including Mr. Ronald Kary Black and Mr. Jason Murphy;
(b)members of that group who received additional trust units including Mr. Black; and
(c)holders of trust units who did not formerly hold stock options including Mr. Murphy Pettypiece and Ms. Rebecca Ford.
[7] The parties agreed on most of the relevant facts. They filed a Partial Agreed Statement of Facts that applies across all four appeals (attached as Schedule “A”) and a Partial Agreed Statement of Facts that addressed the particular facts of each Appellant (attached as Schedule “B”, “C”, “D” and “E”). Other facts adduced at the hearing came into evidence by way of witness testimony and documents tendered as exhibits. Each of the four Appellants testified as did James and his brother Michael Schmalz (“Michael”).
III. Overview (Law)
A. Paragraph 6(1)(g) of the Act
[8] Paragraph 6(1)(g) of the Act provides:
Amounts to be included as income from office or employment
6(1) There shall be included in computing the income of a taxpayer for a taxation year as income from an office or employment such of the following amounts as are applicable
…
Employee benefit plan benefits
(g) the total of all amounts each of which is an amount received by the taxpayer in the year out of or under an employee benefit plan …
[9] Subsection 248(1) of the Act defines an “employee benefit plan” as:
… an arrangement under which contributions are made by an employer … to another person … and under which one or more payments are to be made to or for the benefit of employees … of the employer …
B. Subsections 7(1) and 7(2) of the Act
[10] Subsection 7(1) of the Act provides:
Agreement to issue securities to employees
7(1) … where a particular qualifying person has agreed to sell or issue securities … to an employee of the particular qualifying person …,
(a) if the employee has acquired securities under the agreement, a benefit equal to the amount, if any, by which
(i) the value of the securities at the time the employee acquired them
exceeds the total of
(ii) the amount paid or to be paid to the particular qualifying person by the employee for the securities, and
(iii) the amount, if any, paid by the employee to acquire the right to acquire the securities
is deemed to have been received, in the taxation year in which the employee acquired the securities, by the employee because of the employee’s employment;
[11] Subsection 7(7) of the Act defines a “qualifying person” to mean a corporation or a mutual fund trust and defines “security” of a qualifying person to mean:
(a) if the person is a corporation, a share of the capital stock of the corporation; and
(b) if the person is a mutual fund trust, a unit of the trust.
[12] Subsection 7(2) of the Act provides that:
Securities held by trustee
7(2) If a security is held by a trustee in trust or otherwise, whether absolutely, conditionally or contingently, for an employee, the employee is deemed, for the purposes of this section and paragraphs 110(1)(d) to (d.1),
(a) to have acquired the security at the time the trust began to so hold it; and
(b) to have exchanged or disposed of the security at the time the trust exchanged it or disposed of it to any person other than the employee.
C. Statutory Appendix [13] A Statutory Appendix reproducing other relevant provisions of the Act including paragraph 104(13)(a), subsections 104(19), 104(21) and 104(21.2) and the definition of a “trust” in subsection 108(1) is attached to these Reasons.
[14] The key interpretive question is how to make sense of subsection 7(1) in light of subsection 7(2) and subsection 7(2) in light of subsection 7(1). Are they two ships passing in the night or do they work harmoniously in the trust context? That is the interpretive question to be resolved. Before doing so, however, the facts must be reviewed.
IV. Overview (Facts)
[15] From the founding of the business in 1993 until deciding to implement an estate freeze and corporate reorganization in 2013, James was the Company’s sole shareholder and director. After the 2013 estate freeze and corporate reorganization, he remained firmly in control of the Company with two-thirds of the votes.
[16] Early on, James set up a stock option plan to reward the employees whom he valued most highly. James designed the stock option plan to allow those employees to share in the proceeds of any sale of the Company.
[17] As part of the 2013 estate freeze and corporate reorganization, the Company terminated its stock option plan and cancelled all outstanding stock options. The Company decided to provide payment to each former stock option holder of ten cents for each of their cancelled stock options.
[18] At the same time, James spoke with the Company’s senior employees who held stock options and assured them that, notwithstanding the termination of the stock option plan and the cancellation of their stock options, they would continue to share in the proceeds of sale of the Company to the same extent as before – but this time, the arrangement would be more tax-effective. Michael conveyed the same message to the Company’s junior employees who held stock options.
[19] The new arrangement used a trust to hold 15% of the shares of the Company for all eligible employees as a group. James, along with his brother Michael and a third shareholder, decided who would receive units in the trust and how many units they would receive. This process applied to all former stock option holders except for Michael and one other senior employee, each of whom received shares of the Company rather than trust units. The same process applied to employees who joined the Company after the termination of the stock option plan.
[20] In 2014, James agreed to sell the Company to a third party. The sale occurred in two stages. The first stage, in which 61% of the shares were sold, closed in 2015. That stake was sold for $73.2 million CDN.
[21] The second stage, in which the remaining 39% of the shares were sold, closed in 2016. That stake was sold for $63 million USD.
[22] In anticipation of each of the two stages of the sale, the Company declared pre-sale dividends on the shares held by the trust. The trust designated each of those distributions as dividends eligible for the dividend tax credit and distributed those amounts to the Appellants. The Appellants reported those amounts as dividends on their returns of income for those taxation years.
[23] Immediately following the closing of each of the two stages of the sale, the Company paid to the trust the proceeds of disposition attributable to the shares sold by the trust to the third party. The trust designated each of those distributions as taxable capital gains. The Appellants reported those amounts on their returns of income as taxable capital gains for those taxation years.
[24] In addition, because the shares held by the trust were shares of a Canadian‑controlled private corporation immediately before the first stage of the sale, the Appellants claimed the lifetime capital gains exemption in respect of the taxable capital gains designated by the trust in respect of the proceeds from the first stage of the sale.
[25] Finally, the trust distributed a small amount to each of the Appellants in 2017. The Company called that distribution the “N-Space Dividend”. The Appellants claimed a dividend tax credit on their 2017 tax returns in respect of that distribution as well.[2]
V. Findings of Fact
A. The Old Stock Option Plan
[26] In 2007, the Company established a stock option plan for its most valued employees.[3] By 2013, James had granted stock options to 43 of the Company’s employees. James granted stock options only to those employees whom he considered key to the Company’s growth and development.
[27] This objective is consistent with paragraph 1.1 of the document under which the plan was established and in which James was referred to as the “Majority Shareholder”:
The purpose of the Plan is to secure for the Corporation and its shareholders the benefits of the incentive inherent in share ownership by Eligible Persons who, in the judgment of the Majority Shareholder, could have a significant impact on the future growth and success of the Corporation. It is generally recognized that share option plans aid in retaining and encouraging directors, officers and employees of exceptionable [sic] ability because of the opportunity offered to them to acquire a proprietary interest in the Corporation.
[28] James, as sole shareholder, made all the decisions regarding the stock option plan. This is reflected in several provisions of the plan document, including Article 3.2:
Powers: In administering the Plan, the Majority Shareholder shall have the power, where consistent with the general purpose and intent of the Plan and subject to the specific provisions of the Plan:
(a) to establish policies and to adopt rules and regulations for carrying out the purposes, provisions and administration of the Plan;
(b) to interpret and construe the Plan and to determine all questions arising out of the Plan and any Option granted pursuant to the Plan, and any such interpretation, construction or termination so made shall be final, binding and conclusive for all purposes;
(c) to determine which Eligible Persons are to receive Options, and to grant Options;
(d) to determine the number of Shares covered by each Option;
(e) to determine the Exercise Price;
(f) to determine the time or times when Options will be granted and exercisable;
(g) to determine, at any time, if the Shares that are subject to an Option will be subject to any restrictions upon the exercise of such Option; and
(h) to prescribe the form of the instruments relating to the grant, exercise and other terms of Options.
[29] The only aspect of the stock option plan that was not within James’ discretion was the expiration date of the options. The options were exercisable no later than seven years from the date of the grant of the option.[4] Option holders could exercise their options within seven years only if any person, or combination of persons, acquired more than 50% of the voting securities of the Company.[5] Article 11.1 provided that option holders had no rights as shareholders until they exercised their options.
[30] James was asked how he decided which employees would receive stock options. He testified that he made those decisions:
… entirely from my perceived view of their future value to the company to achieve that ultimate goal of selling the company, just people who were -- that I knew that were going to be incredibly productive over the coming years and create great video games for us.[6]
[31] After James granted stock options to a particular employee, that employee would sign a share option agreement. The agreement set out the employee’s rights and obligations under the stock option plan and incorporated the terms of the stock option plan by reference.
[32] The share option agreement began by acknowledging that James had awarded stock options to the particular employee.[7] By way of example, James testified about awarding stock options to Mr. Murphy, one of the Appellants. James decided to award Mr. Murphy 5,000 stock options under a share option agreement dated as of April 13, 2007.[8] Later on, James decided to award Mr. Murphy 10,000 additional stock options under a subsequent share option agreement.[9] On any sale of the Company, Mr. Murphy would have been entitled to exercise his options to acquire 15,000 shares at an aggregate exercise price of $2.00 ($1.00 for the first 5,000 shares and $1.00 for the next 10,000 shares).
[33] Later on, James decided to award Mr. Black another 5,000 share options under a new share option agreement dated as of November 22, 2010.[10] Under that agreement, Mr. Black was entitled to exercise his additional 5,000 options at an aggregate exercise price of $1.00. As at November 22, 2010, Mr. Black held 20,000 stock options that he could have exercised on a sale of the Company at an aggregate exercise price of $3.00, all governed by the terms of the three share option agreements he had signed.
B. The Proposed Estate Freeze and Corporate Reorganization
[34] By 2013, the Company engaged a mergers and acquisitions consultant to explore the possibility of a sale.[11]
[35] While preparing to sell the Company, James and Michael came to believe that the Company’s stock option plan was not as tax-efficient as it could have been. A 17-page letter from Ernst & Young LLP (“E&Y”) dated March 8, 2013 (the “E&Y Letter”) formed the basis for their belief.[12]
[36] Most of the E&Y Letter is devoted to the tax planning needs of James and his family and Michael and his family, including setting up a trust for each of their families[13] and incorporating a holding company for each of James and Michael.[14] This personal tax planning exercise was the focus of the 17-page E&Y Letter which ultimately proposed a plan of reorganization to accomplish the following objectives:
Freeze James’ current interest in the Company
Convert the existing after-tax retained earnings into debt owing to James
Provide an opportunity to income split with family members to the extent possible (James and Mike)
Plan to convert future after-tax retained earnings into debt owing to principal shareholders (James and Mike)
Access CGE (James and Mike)[15]
[37] Three of the fourteen steps set out at the end of the E&Y Letter are devoted to the trust arrangement at issue in these appeals.[16]
[38] The E&Y Letter does not include a meaningful analysis of section 7 of the Act but does include the following statement (emphasis added):
Securities held by a trustee are deemed, pursuant to subsection 7(2) of the Act, to be held by the employee for purposes of Section 7; further research is required to determine if this is similarly applicable for Regulation 6205[17]
[39] The E&Y Letter refers to subsection 7(2) immediately following a statement that the revised arrangements would include the use of a plan under which units of a trust are awarded to select employees. E&Y’s discussion of subsection 7(2) of the Act proceeds on the assumption that the trust was “constructed to be compliant with subsection 7(2) of the Act”:
4. … Provided the Trust is constructed to be compliant with subsection 7(2) of the Act the units are treated, for tax purposes, as shares acquired pursuant to a stock option agreement [RID 9724915 is footnoted], Furthermore subsection 7(2) deems the employee to have acquired the shares for purposes of the stock option rules at the time that the Trust begins to hold them. The use of a trustee to hold the employee option shares will not impede the employees’ access to either the CGE or the reduction of the employment benefit [Subsection 7(2) is footnoted].[18]
[40] With respect to the shares to be issued to the trust, E&Y notes that:
… [t]he Trust will own a separate class of common shares of DE which remain under the control of a trustee(s). The Trust would ensure that the employees do not have access to the financial information or voting rights.[19]
[41] E&Y’s criticized the Company’s stock option plan on the following basis:
Since the current options are only exercisable at the time of a change of control, the current stock option plan does not allow employees to access either the CGE or the 50% reduced employment benefit.[20]
[42] In order to deal with those issues (which are not explained in any further detail), E&Y suggested that the Company set up a plan and a trust along the following lines:
It is possible to modify the [current stock option] arrangement such that the employee will still receive stock option treatment, capital gain exemption eligibility and forfeit the right to the share on departure for zero proceeds. To accommodate this arrangement an Employee Stock Rights Plan (“the Plan”) is required by which units of an Employee Stock Rights Plan Trust (“the Trust”) are awarded to selected employees. The Trust will own a separate class of common shares of DE which remain under the control of a trustee(s). The Trust would ensure that the employees do not have access to the financial information or voting rights. The trustees are appointed by the corporation. One feature must be included to provide the employees with stock option treatment and that is that the shares held by the Trust must be acquired at FMV, no bargain purchase option is permitted. In the current proposed arrangements this feature is easily accommodated as James’ existing common share interest is to be frozen to permit Mike and Steve [Sinclair] a direct ownership interest. As a consequence of the freeze the value of the employee shares at the date of subscription by the Trust will be nominal and so acquired at FMV. Certain features of the Plan and Trust are described in #4 below. We believe that it is not possible to amend the existing arrangements to include these features and the existing Plan would have to be canceled.[21]
[43] E&Y went on to describe, in considerable detail, the proposed plan and trust (footnotes omitted):
4. As noted above the revised arrangements would include the use of a Plan whereby units of a Trust are awarded to select employees. Provided the Trust is constructed to be compliant with subsection 7(2) of the Act the units are treated, for tax purposes, as shares acquired pursuant to a stock option agreement. Furthermore subsection 7(2) deems the employee to have acquired the shares for purposes of the stock option rules at the time that the Trust begins to hold them. The use of a trustee to hold the employee option shares will not impede the employees’ access to either the CGE or the reduction of the employment benefit. In order for the employee to benefit from the CGE the Trust must own the shares for the full 24 month holding period. At the date of sale of DE the trustee will be permitted to distribute the shares to the beneficiaries for sale, or sell the shares and allocate the capital gains to beneficiaries so that the employee may claim the CGE. The basic features of the Trust are as follows:
a. The Trust would be settled by DE, by a contribution of cash sufficient to subscribe for the specific percentage of shares to be set aside for the employees as determined by the shareholders
b. The Trust agreement will specifically refer to subsection 7(2) of the Act
c. The Trust would manage the property settled upon the Trust including shares and all income from the property and property substituted thereof [sic] in accordance with the provisions of the Trust and the Plan
d. The trustee will make payments of cash or property out of the Trust in accordance with directions received from the Committee; the Committee administers the Plan
e. The beneficiaries of the Trust will be certain employees of DE as determined by the Committee (the Committee operates the Plan). The trustees will be empowered to, in accordance with the Trust indenture, take directions from the Committee to:
i. Grant Rights to participants, who are employees
ii. Do all things as directed by the Committee in connection with the granting, vesting or termination of Rights in accordance with the Plan
iii. Make distributions of Trust assets to the beneficiaries in cash or in kind
iv. Make all elections and designations pursuant to the Act in respect of granting, vesting or termination of the Rights or distributions from the Trust (including the allocation of income or deemed income)[22]
[44] E&Y described the provisions of the proposed plan:
5. The provisions of the Plan would include the following:
a. The Plan awards Rights to acquire units in the Trust
b. The Plan is administered by a Committee appointed by the Board of Directors
c. The Rights cannot be transferred or assigned
d. The Plan defines various events including termination for cause, retirement and other events
e. Eligibility to participate in the Plan is at the sole discretion of the Committee
f. The terms under which the Committee may grant Rights to acquire a number of units and the conditions which are required to be satisfied in [order] to permit the Rights to vest are all determined by the Committee, including the following
i. Individuals to participate
ii. Number of units granted
iii. Time or times at which Rights may be granted
iv. Price to be paid as consideration for the grant
v. Vesting provisions
vi. Restrictions on the units
vii. Acceleration of vesting, waiver of forfeiture
viii. Terms and conditions necessary to comply with the terms and conditions of any employment contract
ix. Purchase price of the Rights
g. The Committee is also empowered to interpret the provisions of the Plan and prescribe and rescind regulations in respect of the Plan
h. The units are subject to forfeiture even if vested, if the employee resigns or is terminated for cause
i. The participant does not have any right as a shareholder with respect to the units until the trustees distribute the Plan shares to the participant[23]
[45] The E&Y Letter did not mention that a particular number of shares would have to be allocated to a particular employee in order to comply with subsection 7(2) of the Act. More on that later.
[46] In his evidence, Michael described the 2013 estate freeze and corporate reorganization proposed by E&Y as including:
… the setup of an employee trust to administer the benefits to the employees in a different way than what we had conceived for the stock options.[24]
***
[E&Y] indicated that there were some tax opportunities that were not being taken advantage of under the old option plan, and that this plan would be a more advantageous plan for our employees, should we sell the company. And that was the basis for … their recommendation to move forward with the new plan.[25]
[47] At the time of the 2013 estate freeze and corporate reorganization, James understood his shares to have been worth $12,000,000.[26] By the time the 2013 estate freeze and reorganization were complete, James had reduced his equity interest in the Company from 100% to 67%. The other 33% of the Company would then belong to his brother Michael (7%), Steve Sinclair (10.1%), and the soon to be established trust (15.9%).[27]
C. The Three Individual Shareholders
[48] As part of the 2013 estate freeze and corporate reorganization, Michael subscribed for shares representing 7% of the equity in the Company. Along with the Company’s creative director, Steve Sinclair, Michael was one of two former option holders to receive shares rather than units in the trust.
[49] Following the 2013 estate freeze and corporate reorganization, the only individual shareholders were James, Michael, and Steve Sinclair.[28]
D. Termination of the Old Stock Option Plan
[50] On June 24, 2013, James, as sole director of the Company, resolved to terminate the stock option plan and cancel all outstanding options.[29] The resolution provides:
WHEREAS it has been determined that it is the best interests of Digital Extremes Ltd. (the “Corporation”) to terminate the Corporation’s 207 [sic] Stock Option Plan and the [sic] cancel all outstanding option agreements and options outstanding thereunder, effective as of the date hereof;
AND WHEREAS it has also been determined that, as a settlement for such cancellation and in consideration of the delivery of a full and final release in respect thereof in favour of the Corporation, all option holders shall be offered the sum of $0.10 per outstanding option;
THEREFORE BE IT SOLVED THAT:
The Corporation’s 2007 Stock Option Plan and all options outstanding thereunder are hereby cancelled and terminated and shall be of no further force or effect as of and from the date hereof.
As a settlement for such cancellation and in consideration of the delivery of a full and final release in respect thereof in favour of the Corporation, all option holders shall be offered the sum of $0.10 per outstanding option.[30]
…
[51] In his evidence, James described that resolution as:
… the cancellation of the 2007 Stock Option Plan completely terminating it and giving the employees compensation for that termination.[31]
[52] The Company asked each stock option holder to sign a letter and declaration (the “Declaration”) and a settlement and release agreement (the “Settlement and Release Agreement”). Read together, those documents describe what the employees agreed to give up and what the Company agreed to provide in return.
[53] The language of the Declarations and the Settlement and Release Agreements is consistent with the language of the resolution, namely, that the compensation the Company resolved to provide to each former stock option holder was “the sum of $0.10 per outstanding option”.
[54] The resolution attached templates for a letter agreement and a settlement and release agreement substantially similar to the Declarations and the Settlement and Release Agreements that were later signed by the former stock option holders. James described the letters as “outlining the cancellation of their options and what they would be paid for that.”[32]
[55] An example is the Declaration and Settlement and Release Agreement entered into by Mr. Black.[33] The Declaration signed by Mr. Black immediately follows a letter written on the Company’s stationery dated July 29, 2013. The letter is reproduced at Schedule “F” and the Settlement and Release Agreement is reproduced at Schedule “G”.
[56] The letter broadly reflects the advice received by James and Michael from E&Y. In it, the reader is cautioned that on a sale of the business the holders of stock options would receive proceeds that would:
… not qualify for an individual’s lifetime capital gains exemption and may not qualify for the 50% reduction in employment income for tax purposes.[34]
[57] In light of that, and because options would begin to expire the following year, the letter served notice to each option holder that the Company had decided to terminate the stock option plan and to cancel all outstanding stock options effective immediately. The Company notified the stock option holders that they were, effective immediately, former stock option holders.
[58] The letter went on to inform each former option holder that the Company was prepared to make a one-time payment to them of $0.10 per cancelled option in consideration of the cancellation of each option and in settlement of any claim that the former option holder may have against the Company as a result of the cancellation. They would receive that payment if they signed and returned the Declaration and Settlement and Release Agreement. In the Settlement and Release Agreement, each former option holder agreed to accept the settlement amount (a one-time payment of $0.10 per cancelled option) as:
… full and final settlement of any and all claims or demands that I now have, ever had, or can, or may have against the Company … resulting or arising from the Company’s termination of its 2007 Stock Option Plan (the “Plan”) and the cancellation of the [insert number of] options to purchase shares in the capital of the Company that were previously granted to me under the Plan.
[59] The Settlement and Release Agreement went on to provide that upon payment of the settlement amount, the former option holder would:
… irrevocably release and forever discharge the [Company] and forever compromise any and all claims and demands whatsoever by me, which I now have, ever had, or can, or may have against the [Company] with respect of the administration or termination of the Plan; the granting of the Options … under the Plan or the cancellation of the Options … or any cause, matter or thing arising out of or connected therewith.
[60] The Settlement and Release Agreement concluded with this declaration by each former option holder:
AND IT IS HEREBY DECLARED that the terms of this Settlement and Release Agreement are fully understood; that the amount stated herein is the sole consideration of this Settlement and Release and that the said consideration is accepted voluntarily with the benefit of having been afforded the opportunity of obtaining independent legal advice for the purpose of making a full and final settlement and release of all claims.
[61] Before the senior employees signed the Declaration and Settlement and Release Agreement, they met with James. Before the junior employees signed the Declaration and Settlement and Release Agreement, they met with Michael. The Company recommended that each former option holder review the Declaration and Settlement and Release Agreement with a lawyer before signing. None of them did.
(1) Mr. James Schmalz’s Conversations with Senior Employees [62] James testified that he spoke to each of the senior employees to tel