Canada: Foreign Stock Option Plans and Québec Health Services Fund Contributions

Article by Jean Gagnon, ©2005 Blake, Cassels & Graydon LLP

In a case that could have significant implications for multinational corporations operating in Québec, the recent Cour du Québec decision, Merck Frosst Canada & Co. c. Le Sous-Ministre du Revenu du Québec, concluded that foreign stock option benefits must be included in employees’ wages in calculating the employer obligation under section 34 of the Act respecting the Régie de l’assurance maladie du Québec (LRAMQ).

Generally, the LRAMQ provides that every employer shall pay to the Minister of Revenue of Québec a contribution to the Québec health services fund based on a percentage of the total wages that the employer pays or is deemed to pay to its employees who report for work at the employer’s establishment in the province of Québec. The percentage payable varies according to the amount of the total wages, from a minimum of 2.7% to a maximum of 4.26%.

At issue in this case was whether the benefit conferred upon the exercise of options to acquire stock in the U.S. parent company had to be included in the total wages upon which the employer’s contribution is computed.

Merck Frosst Canada Co. (Merck Canada) claimed that over a six-year period they had included an excess of approximately US$83 million in the gross calculation of wages before applying the percentage to be remitted by Merck Canada under the LRAMQ.

The US$83 million represented benefits received by employees of Merck Canada based in Québec under an employee incentive stock plan (the Plan) managed and offered by the parent company, Merck & Co., Inc. (Merck US). Subject to certain conditions, the Plan allowed Merck US to offer the right to acquire its stock to employees of its worldwide group.

There were two methods of exercising the rights granted by Merck US under the Plan. An employee could either exercise the right to acquire the stock, in which case he or she became the owner of the Merck US stock, or the employee could elect to acquire the stock and immediately order the sale of the stock on the market (the Sale Option). In his analysis, Justice Michel A. Pinsonnault considered all employees of Merck Canada to have effected the Sale Option.

Merck US had entered into an agreement with Merrill Lynch for the administration of the Plan. When an employee chose the Sale Option, Merrill Lynch would (a) sell the Merck US shares, (b) retain a portion of the proceeds for commission and expenses, (c) determine and remit to Merck Canada the applicable Canadian withholding taxes, (d) remit to Merck US funds representing the initial price at which the option was exercised, and (e) remit the balance of the funds to the employee. The difference between the market price and the exercise price then constituted a taxable benefit to the employee. Merck Canada forwarded the information to the tax authorities and included the amount of the benefit on the employees’ T4 and Relevé 1.

Merck Canada pleaded that the benefits from the Plan did not originate with the Canadian subsidiary and that under the provisions of the LRAMQ they should not have remitted 4.26% of the total benefits realized under the Plan by the employees based in the province of Québec. Merck Canada supported their argument by demonstrating that the shares remitted to employees were shares in the capital stock of the non-resident parent having no presence in the province of Québec and that Merck Canada was not party to the agreement between the parent, Merck US, and Merrill Lynch. Merck Canada contended that Merck US and Merrill Lynch administered complete management and control of the Plan. Once Merck Canada submitted a preliminary list of employees who were eligible under the Plan, it was Merck US that retained full discretion over the allotment of the options and administration of the Plan.

Merck Canada insisted that, under sections 34 and 33.2 of the LRAMQ, they were not a person or employer who had conferred a benefit to an employee who presented themselves at its establishment in Québec. Merck Canada contended that section 34 only governs employers that directly transmit a benefit and does not consider payments made indirectly. Merck Canada also insisted that section 34 of the LRAMQ is clear and not open to interpretation. Therefore, they maintained that the contributions were not their responsibility. Furthermore, Merck Canada maintained that Merck US, having no present establishment in Québec, was not subject to, or responsible for, the contributions.

In his decision, Justice Pinsonnault examined the economic reality of the operation of the Plan and the spirit of the LRAMQ, adopting the same approach as the Minister of Revenue of Québec. The Court echoed the Minister’s submissions that the benefit conferred on Merck Canada’s employees is a direct result of an agreement between Merck Canada and Merck US. More particularly, the Minister argued that the benefit is conferred by Merck Canada on the basis that the agreement confirmed that Merck Canada consents to participate in the Plan, establish a list of eligible employees, assume the cost of the benefit conferred and assume responsibility for compliance with the local tax authorities. The fact that Merck US initially conferred the actual benefits through its agreement with Merrill Lynch did not alter the final result of the exercise.

According to the Court, the particularities of the Plan, as well as correspondence exchanged between the Minister’s office and Merck Canada, weakened the ability of Merck Canada to assert their claim. Merck Canada provided a list to the parent corporation detailing which employees could be eligible to participate in the Plan. Merck Canada had also consented to the implementation of the Plan, which was an essential element for its employees to be eligible. Under the agreement entered into between Merck Canada and Merck US, Merck Canada reimbursed to its parent "the cost of providing the incentive awards". Finally in its pleadings and in correspondence with the Minister’s office, Merck Canada conceded that its employees did receive a taxable benefit under the Taxation Act by showing the benefits on the Relevé 1 form.

The Court also concluded that Merck US was not responsible for the contributions as the employees who received the benefits were not its employees. Further, those employees could never have presented themselves at Merck US’ business establishment in Québec as no such establishment exists.

The case is now under appeal. It will be interesting to observe whether the Québec Court of Appeal ruling will narrow the case to this particular set of facts or set out to present general guidelines as to how foreign stock option plan benefits must be considered for computing Québec taxpayers’ contributions to the Québec health services fund under the LRAMQ.

The appeal aside, the facts of the case, including the structure of the Plan and the correspondence admitted as proof, operated against the claim of Merck Canada. However, the lower court decision appears to allow considerable room to manoeuvre and could present the opportunity for other multinational corporations to properly structure the delivery of foreign stock option benefits to Québec employees.

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