13 May 2004 External T.I. 2004-0065251E5 - Exchange of employee stock options.

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.

Principal Issues: Tax consequences relating to the replacement of an "underwater" option.

Position: General comments provided.

Reasons: Application of the provisions.

XXXXXXXXXX 2004-006525
W. C. Harding
May 13, 2004

Dear XXXXXXXXXX:

Re: Exchange of Employee Stock Option Agreements

This is in reply to your electronic correspondence of March 1, 2004, in which you requested our comments in respect of the application of paragraph 7(1)(b) and subsection 7(1.4) of the Income Tax Act (the "Act") to the exchange of agreements that are subject to section 7 of the Act.

Written confirmation of the tax implications inherent in particular transactions can be provided by this Directorate where the transactions are proposed and are the subject matter of an advance income tax ruling request submitted in the manner set out in Information Circular 70-6R5, Advanced Income Tax Rulings, dated May 17, 2002. Where the particular transactions are completed, any inquiries should be addressed to the relevant tax services office. However, we are prepared to provide the following comments that may be of assistance to you. Please note that these comments are general in nature and are not binding on the Canada Revenue Agency ("CRA"). All publications referred to herein can be accessed on the CRA website at the following address: http://www.cra-arc.gc.ca/formspubs/menu-e.html.

In your letter, you asked for our comments with respect to the exchange of a restricted stock unit (an RSU) for an employee stock option. However, it has been our experience that the term RSU is often used in reference to a number of arrangements that may or may not be subject to section 7 of the Act. Accordingly, we will not use the term in this reply.

In general terms, section 7 of the Act applies to situations where a qualifying person agrees to sell or issue its own securities, or securities of a related qualifying person, to an employee of the qualifying person, or to an employee of a related qualifying person. As defined in subsection 7(7) of the Act, a "qualifying person" is a corporation or a mutual fund trust, and a security is, where a corporation is involved, a share of a corporation or, where a mutual fund trust is involved, a unit of a mutual fund trust. CRA takes the view that an agreement to sell or issue shares as contemplated under section 7 of the Act, includes an agreement to sell or issue securities where there is no cash consideration payable by the employee in respect to the acquisition of the securities. Accordingly, in our view, the provisions of section 7 apply to an agreement under which an employer agrees, subject to any vesting requirements, to provide a share to an employee for no cash consideration.

In general terms, paragraph 7(1)(b) of the Act provides that an employee is deemed to receive a benefit, as calculated under that provision, when the employee disposes of any rights under an agreement, to which section 7 applies, to a person that deals at arm's length with the employee. Accordingly, paragraph 7(1)(b) of the Act could apply where an agreement, that is subject to section 7 of the Act, is exchanged for another such agreement. However, as noted in your letter, subsection 7(1.4) of the Act provides an exception to the application of paragraph 7(1)(b) of the Act, in certain of these circumstances, if the conditions set out in subsection 7(1.4) of the Act are satisfied.

In basic terms, subsection 7(1.4) provides that a deemed benefit will not be included in the employee's income solely as a consequence of an exchange of agreements as long as the employee does not receive any consideration for rights to acquire securities under the old agreement, other than rights to acquire securities under the new agreement, and:

(c) the amount, if any, by which

(i) the total value of the securities that may be acquired under the new agreement immediately after the disposition

exceeds

(ii) the total amount payable by the taxpayer to acquire these securities under the new agreement

does not exceed the amount, if any, by which

(iii) the total value of the securities that could be acquired under the old agreement immediately before the disposition

exceeds

(iv) the amount payable by the taxpayer to acquire these securities under the old agreement.

Using the example provided in your letter, assume an employee has 5 agreements, which were acquired at no cost to the employee, to acquire 1 share of an employer's capital stock for an exercise price of $30.00 per share. Assume, also, that the shares have a current fair market value of $10.00 per share, so that, in order to re-establish the employee incentive, the employer proposes to replace the 5 agreements with a new agreement under which the employer will agree to issue one share of the employer's capital stock for no cash consideration, provided the employee remains with the employer for an additional 3 years. Finally, assume that the existing agreements have a fair market value of $2.00 while the new agreements will have a fair market value of $9.00, both values determined using a standard market valuation model.

In this example:

the value of the share that may be acquired under the new agreement: $10.00

exceeds the amount by which

the value of the Shares that could have been
acquired under the old agreement (5x$10.00): $ 50.00

exceeds

	the cost of those shares (5 x $30.00):	$150.00	$   NIL

by:		$10.00

Since the calculation results in a positive amount, subsection 7(1.4) of the Act will not apply to except the exchange of agreements from the provisions of paragraph 7(1)(b). Accordingly, paragraph 7(1)(b) will apply to the exchange and a benefit that is equal to the value of the new agreement ($9.00), minus the cost of the old agreement (nil) will have to be included in the income of the employee as a result of the proposed exchange.

In our view, the provisions of subsection 7(1.4) of the Act are consistent with the technical notes that have been provided in respect of the provision by the Department of Finance from time to time. In this respect, paragraph 7(1.4)(b) of the Act provides that the employee cannot receive any consideration other than rights to acquire securities and paragraph 7(1.4)(c) ensures that no economic advantage or net benefit can be acquired through an improvement in the rights received in the new agreement as consideration.

We trust our comments will be of assistance to you.

Yours truly,

Roberta Albert, CA
for Director
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch

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