CRA indicates that s. 7(1.3) does not preclude a gain arising on a short sale to fund an employee stock option exercise

An employee, who engages in a short sale transaction to finance the exercise of stock options on the shares of the individual’s employer, short sells identical shares borrowed from a third-party lender and uses the short sale proceeds to inter alia fund the option exercise – and then uses the shares acquired on exercise to cover the short position. The employee had previously made an s. 39(4) election and, at the time of the short sale, held other identical shares.

Regarding the shares that the employee acquired on exercise and promptly disposed of by delivering to the lender to cover the short position, s. 7(1.31) generally would oust the application of ACB averaging under s. 47(1), so that no gain would be realized on that disposition (assuming no value change subsequent to exercise).

However, s. 7(1.31) would not apply to the disposition of the shares that were borrowed and then sold, because such shares “would not have been acquired pursuant to an agreement referred to in subsection 7(1).” Accordingly, a gain would be realized on that initial disposition if the existing shareholding had a low ACB.

CRA also reiterated its position that:

Where, in a taxation year for which an election under subsection 39(4) applies, a taxpayer makes a short sale, the two dispositions of securities (both the one that occurs at the time of the short sale and the one that occurs subsequently when the borrower delivers securities to the lender to cover its short position) are deemed to be dispositions of capital property to the short seller.

Neal Armstrong. Summaries of APFF Financial Strategies and Instruments Roundtable, Q.7 under s. 7(1.31) and s. 39(4).