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.
Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the CCRA.
Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle de l'ADRC.
Principal Issues:
1. For purposes of subsection 7(11), will the specified value of a share be based on the original stock option granted to an employee?
2. Can the specified value be based on the market value of the shares on a subsequent date when the option price is re-priced to reflect a significant reduction in the fair market value of the employer's shares?
Position:
1. Yes.
2. No.
Reasons:
1. The provision is clear that the fair market value at the date of grant has to be used.
2. There is no provision that allows for the use of the fair market value on another date.
February 21, 2002
EDMONTON TAX SERVICES OFFICE HEADQUARTERS
Arlene J. Morin M.P. Sarazin, CA
Technical Enquiries Officer (613) 957-2089
2001-010965
Security Options and Re-Pricing
This is in reply to your memorandum of November 7, 2001, wherein you requested our views regarding the application of subsection 7(11) of the Income Tax Act (the "Act") where an employer re-prices security options provided to its employees from the fair market value of the security on the date of grant to a lower fair market value on a date subsequent to the date of grant as a result of a significant decrease in the fair market value of the employer's shares.
The example described in your memorandum is as follows:
An employer grants an option to an arm's length employee to acquire 20,000 of its shares at an option price of $20 per share. The option price is equal to the fair market value of a share of the employer on a stock exchange at the time the option is granted. The options vest 50% on the first anniversary of the issuance of the option and 50% on the second anniversary of the issuance of the option.
Where the employee exercises his or her options, the employee will be entitled to defer the recognition of any benefit required to be included under paragraph 7(1)(a) of the Act where the acquisition is a "qualifying acquisition" as defined in subsection 7(9) of the Act and the employee files an election to defer the recognition of the benefit in accordance with subsection 7(10) of the Act. Since subsection 7(10) has a $100,000 annual vesting limit, the employee will only be able to elect in respect of 5,000 options which have a specified value of $100,000 (5,000 x $20). The vesting limit applies because the total specified value of the shares, within the meaning assigned by subsection 7(11) of the Act, acquired under the options exceeds the $100,000 limit allowed under subsection 7(10) of the Act.
In the situation where there is a significant reduction in the fair market value of the employer shares subsequent to the issuance of the options and the employer re-prices the exercise price of the options to the fair market value of the shares on that date, you have requested our views with respect to whether subsection 7(10) would be applied based on the specified value of the shares on the re-pricing date or the specified value of the shares on the date that the options were originally granted to the employee.
The Department of Finance issued a comfort letter on July 13, 2001 which included the following comments:
"As you know, we are prepared to recommend that the Act be amended to ensure that an employee is not disqualified from claiming the stock option deduction because of a reduction in the option price to an amount below the value of the underlying share when the option was granted, provided the reduction could have been accomplished by way of an exchange of options to which subsection 7(1.4) of the Act would have applied. The effect of the amendment would be to allow paragraph 110(1)(d) to apply as though there had, in fact, been such an exchange of options. By requiring that the hypothetical option exchange satisfy the conditions of subsection 7(1.4), this relief would be limited to those situations in which the reduction in exercise price provides no immediate increase in the net benefit associated with the option. We will recommend that this amendment, if adopted, apply to reductions in exercise price occurring after 1998."
Finance's comfort letter only discusses the application of paragraph 110(1)(d) when there is a re-pricing of the exercise price of security options issued by an employer. The comfort letter does not discuss the application of subsection 7(11) of the Act. Consequently, we are unable to conclude that the position expressed in the comfort letter will be extended to the application of subsection 7(11) of the Act.
Where an acquisition of securities under a securities option is a qualifying acquisition within the meaning assigned by subsection 7(9) of the Act and the taxpayer elects in accordance with subsection 7(10) of the Act, the taxpayer will be entitled to defer the recognition of some or all of the benefit computed under paragraph 7(1)(a) of the Act. In order to qualify as a qualifying acquisition, paragraph 7(9)(b) requires that the acquisition of securities qualify for the deduction under paragraph 110(1)(d) of the Act. Based on the comfort letter, this condition may be satisfied where securities have been acquired subsequent to the re-pricing of the exercise price of security options. Since Finance has indicated that paragraph 110(1)(d) will be changed to accommodate re-pricing, we understand that CCRA will not make any reassessments based on the current wording when this deduction is claimed in a pricing reduction situation.
The election under subsection 7(10) of the Act is limited to the value computed under paragraph 7(10)(c) of the Act. Under paragraph 7(10)(c) of the Act, the specified value cannot exceed the amount by which $100,000 exceeds amounts previously claimed under subsection 7(8) of the Act in respect of security options that vested in the same year as the particular security options that were exercised and are being considered for the current deduction under subsection 7(8) of the Act. Subsection 7(11) of the Act is the relevant provision for determining the "specified value" of option shares for purposes of the limit imposed under paragraph 7(10)(c). Under subsection 7(11), the specified value is defined as the amount determined by the formula A/B where A is the fair market value of the security that could be acquired under the option at the time the option was granted and B is the number of securities that it is reasonable to consider that the employee could acquire in lieu of one security under the original option at the time the option was granted. The variable B will only apply where there is a modification in the number of shares that could be acquired as a result of an exchange of options, a stock split of the employer's shares or a stock consolidation of the employer's shares.
In our view, the provision clearly provides that the specified value has to be based on the fair market value of the security at the time that the securities option was granted to the employee and not on the fair market value of the security at the time that the securities option was re-priced. As noted above, we are of the view that the comfort letter does not apply to the computation of the specified value under subsection 7(11) of the Act in respect of securities acquired under a securities option. Consequently, in the above example, the employee will continue to be eligible to elect under subsection 7(10) in respect of only 5,000 shares for each vesting period (5,000 x $20).
For your information, a copy of this memorandum will be severed using the Access to Information Act criteria and placed in the Legislation Access Database (LAD) on the Canada Customs and Revenue Agency's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their databases. The severing process will remove all material that is not subject to disclosure, including information that could disclose the identity of the taxpayer. Should your client request a copy of this memorandum, they can be provided with the LAD version, or they may request a copy severed using the Privacy Act criteria, which does not remove client identity. Requests for this latter version should be made by you to Mrs. Jackie Page at (613) 994-2898. A copy will be sent to you for delivery to the client.
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Legislation Branch
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