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Paying with equity – an illustration of the importance of form

Consider, if you will, the tax treatment of two simple transactions.

Under the first transaction, an employing company pays a salary which the employee uses to purchase shares in the company.  In the second transaction the employer company simply issues shares to an employee in compensation for his services.  These transactions result in the same net economic outcome but radically different tax outcomes.

In the first transaction, the payment of salary will be a deductible expense of the company and taxable to the employee as employment income.  The employee’s subscription for shares in the company is not a taxable transaction (provided the shares are acquired for fair market value).

In the second transaction, the direct issue of shares by an employer to an employee will also be taxable as employment income (as the provision of a benefit under a share purchase agreement, see s CE 7 of the Act) however there will be no corresponding tax deduction for the employer company. The Act does not treat the issue of shares in a company as expenditure incurred by the company.

This stark difference between tax and economic outcomes is both intentional and rational.  The Income Tax Act is not being capricious.  A company that issues shares does not incur any additional obligations to its shareholders.  The issue of shares is simply a reorganisation of the equity in the company, the aggregate obligations the company owes to its equity holders remain the same.  The real detriment, of course, has been suffered by the existing shareholders who have had their ownership interest in the company diluted.  However, for tax purposes, this equity dilution is a mere economic loss and it does not constitute a tax event for shareholders either.  Thus we have a situation where the employee received consideration for their services (taxable as employment income) but no expenditure was incurred by anyone in providing that consideration.

The implications of this simple example are interesting.  It is a neat illustration of how consideration can be provided without expenditure being incurred.  This distinction helps explain how a company can buy property in exchange for shares and still take a market value base cost for tax purposes while a bonus issue of shares is not taxable as a dividend (unless the company elects to treat it as taxable).

The example is also an illustration of the fact that, at the level of fundamental tax concepts, the form of the transaction is its substance (or perhaps, more clearly, the Act is simply blind to the substance of the transaction) and of how the Act taxes transactions rather than economic outcomes.

The example may also help clarify your thinking about avoidance.  In the first transaction, the payment of a salary is surely an unnecessary step that was inserted to achieve a tax advantage – but is it avoidance?

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