28 November 2001 Internal T.I. 2001-0091247 - Employer Stock Opt. & Section 116116(5)

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:

(i)Does the exercising of an employee stock option constitute a disposition of property?

(ii)Would subsection 116(5) apply where the employee is a non-resident person and the stock option is a taxable Canadian property?

Position:

(i) Yes.

(ii) Probably not.

Reasons:

(i) An option is a property and the exercise of it constitutes a factual disposition of property.

(ii) It may be difficult to say that the Canadian employer is the purchaser of the option.

		November 28, 2001

	Louise Green, A/Manager	International and Trusts Section	Policy and Program Division	S. Leung
	International Tax Directorate	957-2115

	Attention: Ved Arora
		2001-009124

Employee Stock Options and Section 116 of the Income Tax Act

We are writing in reply to your memorandum of July 17, 2001 in which you requested our views on the above-noted subject matter with respect to XXXXXXXXXX. The fact situation is outlined below.

The Situation

XXXXXXXXXX is a former employee of XXXXXXXXXX ("Canco"), a subsidiary company incorporated in XXXXXXXXXX ("Parentco"). Parentco is a U.S. corporation. On XXXXXXXXXX, a non-resident of Canada, exercised employee stock options ("Canco stock options") which had been granted to him while he was a resident of Canada to purchase XXXXXXXXXX Shares and XXXXXXXXXX Shares of Canco. These shares were retractable by XXXXXXXXXX at any time.

Coincident with the exercise of the XXXXXXXXXX Shares stock option, XXXXXXXXXX also exercised additional stock options ("Parentco Stock options") which had been granted to him by Parentco (presumably in respect of his performance of duty in Canada in Canco). The fair market value of the Parentco shares exceeded the option exercise price by about CAN$XXXXXXXXXX.

Upon exercise of the Canco and Parentco stock options, Canco issued a T4 to XXXXXXXXXX reporting the benefit under subsection 7(1) of the Income Tax Act (the "Act"). The total stock option benefit (including the benefits from the Canco stock options and the Parentco stock options), after an amendment made to the T4, was about CAN$XXXXXXXXXX. The benefit from the Canco stock options was approximately US$XXXXXXXXXX and thus the aggregated adjusted cost base of the Canco XXXXXXXXXX Shares to XXXXXXXXXX was approximately US$XXXXXXXXXX.

Later on the same day of XXXXXXXXXX decided to retract all the XXXXXXXXXX Shares of Canco and, pursuant to the right of first refusal owned by Parentco, Parentco issued XXXXXXXXXX of its common shares to XXXXXXXXXX for all the XXXXXXXXXX Shares of Canco.

An application for a clearance certificate was filed under subsection 116(3) of the Act. Parentco did not withhold any amount on the purchase of the Canco XXXXXXXXXX Shares from XXXXXXXXXX as the proceeds of disposition of the Canco XXXXXXXXXX Shares equaled the adjusted cost base to XXXXXXXXXX of those shares as the consequence of the application of paragraph 53(1)(j) of the Act.

The CCRA has refused to issue the clearance certificate on the basis that income taxes were still owing with respect to the employee stock option benefits realized by XXXXXXXXXX from the exercise of the Canco and Parentco stock options.

Your Request

You requested our view on the following:

1. Is the exercise of employee stock options a disposition of property for income tax purposes?

2. If it is a disposition, is it subject to the reporting requirements of section 116 of the Act?

3. Is Canco a purchaser for the purposes of subsection 116(5) of the Act when its employee stock options are exercised? If so, what would be the cost to Canco of the Canco stock options?

4. What is the cost to Parentco of Canco XXXXXXXXXX Shares that it acquired from XXXXXXXXXX?

Our Comments

The question of whether a disposition occurs when an employee stock option is exercised to acquire shares of the employer or a company with which the employer does not deal at arm's length is seldom addressed in the courts or in tax publications because the tax treatment of the stock option benefit is governed by section 7 of the Act and not by the capital gain provisions in subdivision c of division B of Part I of the Act. Subsections 49(3) and 49(3.1) of the Act deem the granting and the exercise of options not to be dispositions of property. However, both subsections 49(3) and 49(3.1) of the Act are under subdivision c which only deals with capital gains and capital losses. As benefits from employee stock options are dealt with in section 7 of the Act and are treated as employment income, neither subsection 49(3) nor 49(3.1) of the Act would apply.

An option to acquire shares of a corporation is a right owned by the option holder. The definition of "property" in subsection 248(1) of the Act includes a right of any kind whatever, a share or a chose in action. Therefore, a stock option is clearly a property. Pursuant to the definition of "taxable Canadian property" ("TCP") in subsection 248(1) of the Act, an option to acquire a TCP is also a TCP. The issue is whether the exercise of an employee stock option constitutes a disposition of TCP.

The definition of the word "disposition" can be found both in subsections 13(21) and 248(1) of the Act. In the former subsection, the word "disposition" is defined in relation to the disposition of depreciable property which may generate recapture of depreciation or terminal loss and is, therefore, not applicable to our case on hand. The definition of "disposition" in subsection 248(1) of the Act used to be found in section 54 of the Act. Where section 54 is under subdivision c and is only applicable to matters relating to capital gains and capital losses, subsection 248(1) of the Act is for the purposes of the whole Act. Therefore, it states in the Technical Notes issued by the Department of Finance in December 1998 in part as follows:

"The proposed new definition of "disposition" in subsection 248(1) replaces a definition of the same expression in section 54. The proposed new definition applies for the purposes of the entire Act.

...

Except as indicated otherwise above, these amendments apply to transactions and events that occur after December 23, 1998."

The definition of "disposition" of a property in subsection 248(1) of the Act includes any transaction or event entitling a taxpayer to proceeds of disposition of the property. It is not clear whether XXXXXXXXXX was entitled to proceeds of disposition (e.g., do the XXXXXXXXXX Shares of Canco constitute proceeds of disposition upon the exercise of the Canco stock options?). However, since the definition of "disposition" in subsection 248(1) of the Act is not all inclusive, it is a question of fact whether a particular property has been disposed of. Our initial reaction is that when an option (property) has been exercised, there is a factual disposition of that property. For example, it would not be necessary for subsection 49(3) of the Act to deem the granting and the exercise of the option not to be dispositions of property (for purposes of the capital gains rules) if it was not considered a disposition of property to begin with. Furthermore, the word "disposition" in subparagraph (b)(iv) of the definition of "disposition" in subsection 248(1) of the Act also includes any transaction or event by which, where the property is an option to acquire or dispose of property, the option expires. It would be strange to say that when an option expires it is a disposition, but when the option is exercised it is not a disposition.

In further support of our above opinion, we found several court cases dealing with the surrender of employee stock options. Where the right to acquire shares still exists when such stock options are surrendered or cancelled, Canadian courts of law generally ruled that there was a disposition of property to which subsection 7(1)(b) of the Act would apply.¹ Although these court cases do not deal with the exercise of the stock options, they indirectly confirmed that the giving up of the right to acquire shares by a taxpayer through an employee stock option is a disposition of property. Where such a right is exercised, there is no reason to say that there is no disposition of property as the right to acquire shares (a separate and distinct property) is extinguished and shares of the employer (a different kind of property) are acquired.

Even though we are of the view that the exercise of the employee stock options is a disposition of taxable Canadian property by a non-resident of Canada and that generally section 116 of the Act would apply, it does not appear that Canco (or any other person for that matter) is the purchaser for the purpose of subsection 116(5) of the Act. This is because the employee stock option would not exist immediately after it was exercised. This is analogous to a situation where a debtor repaid his debt and the debt ceased to exist. That is, the CCRA would generally recognize the settlement or extinguishment of the debt as a disposition of property by the creditor but not an acquisition of property by the debtor.

If it could be argued that Canco acquired the employee stock options from XXXXXXXXXX (which we do not think so), the cost to Canco would likely be equal to the stated capital of the shares issued by Canco under the option agreement as described below.

With respect to the cost to Parentco of Canco XXXXXXXXXX Shares as a result of the exercise of the right of first refusal by Parentco, we are of the opinion that such cost would be equal to the stated capital or paid-up capital of the common shares of Parentco issued to XXXXXXXXXX in consideration for the transferring of the Canco XXXXXXXXXX Shares to Parentco by XXXXXXXXXX. As indicated by the taxpayer's representative, there are several court cases in the past that dealt with this issue. For example, see Teleglobe Canada Inc. v. The Queen, 2000 DTC 2493; King Rental Limited v. The Queen, 96 DTC 1132, Hotel Talbot v. M.N.R., 62 DTC 180; and Tuxedo Holding Co. Ltd. v. M.N.R., 59 DTC 1102. Although all the cases cited above dealt with Canadian companies issuing shares to acquire property, we feel that from the Canadian perspective for Canadian tax purposes, there is no reason why the same principle would not apply in this case to Parentco. As a result, we feel that the cost to Parentco for the purposes of subsection 116(5) of the Act of Canco XXXXXXXXXX Shares is the stated or paid-up capital of the common shares of Parentco so issued to XXXXXXXXXX for those Canco XXXXXXXXXX Shares.

XXXXXXXXXX

We trust you will find the above to be of assistance. If you have any questions regarding the above, please do not hesitate to contact us.

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 CCRA's mainframe computer. A severed copy will also be distributed to the commercial tax publishers for inclusion in their database. 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. Request for this latter version should be made by you to Jackie Page at (819)994-2898. The severed copy will be sent to you for delivery to the client.

for Director
International and Trusts Division
Income Tax Rulings Directorate
Policy and Legislation Branch

FOOTNOTES :

¹ See, for examples, Joseph R. Dundas v. The Queen, 95DTC 5116; Raymond Geiner v. The Queen, 84 DTC 6073 and The Queen v. William T. Harvey, 83 DTC 5098. See also Marie Bernier, 99DTC 5656.

² XXXXXXXXXX.

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