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: Determination of time securities are acquired and section 7 is applicable when the cashless method of exercising an option is used.
Position: General comments provided. A recent court case on this topic has raised some concerns and has resulted in commentary that may not be precise. This letter clarifies our position on the matter.
Reasons: The published position on the application of section 7 is that a share is acquired when the share has been paid for and has been received by the employee. However, this is a general position that may not be correct in all situations.
W. C. Harding
August 18, 2004
Re: "Cashless Exercise" of Employe Stock Option Agreements
This is in reply to your letter of April 1, 2004, in which you requested our comments in respect of the application of paragraph 7(1)(a) of the Income Tax Act (the "Act") when an employee exercises an employee stock option through a normal form of exercise as well as when an employee uses what is often referred to as the "cashless exercise" method.
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.
Our understanding of a typical situation you are considering is as follows:
An employee is provided with an option to acquire securities of an employer that are traded on an exchange, for a specified exercise price. The terms of the option provide that the employee may exercise the option, pay the exercise price in cash and acquire the securities, or may use the cashless exercise method. The cashless exercise method allows the employee to sell a portion of the securities before receiving them, use part of the proceeds to pay the exercise price and receive the balance of the proceeds in cash.
Under the cashless exercise method, the employer arranges for a broker to administer the option and to act as the agent of the employee in selling the securities acquired upon the exercise of the option. The employer and the broker also arrange that all the transactions will be processed through a common account held in the name of the employer. Thereafter, when the employee exercises the option, the following steps generally take place:
1. The employee notifies the employer and the broker that the cashless exercise method will be used.
2. The employee authorizes the broker to sell the securities that will be obtained through the exercise of the options and to pay the exercise price for the securities using the proceeds of the sale.
3. The broker sells the securities on the open market through a "short sale" on a specified "trade date". The securities are sold short because the corporation has not, and will not, actually issue the securities to the broker, as agent of the employee, until it has been paid the exercise price for the securities.
4. The broker receives the cash proceeds from the short sale of the securities and pays the employer the exercise price. The employer then issues the securities to the broker and the broker uses them to cover its position in respect of the short sale on the "settlement date" for that sale.
5. The broker remits the balance of the proceeds of the transactions to the employee, net of any fees and charges that the broker is entitled to.
Paragraph 7(1)(a) of the Act requires that any benefit under that provision must be determined on the date a taxpayer acquires the securities on the exercise of an option.
Paragraph 2 of CRA's Interpretation Bulletin IT-133, entitled Stock Exchange Transactions - Date of Disposition of Share ("IT-133"), indicates that a share traded on a stock exchange will usually be considered to have been disposed of or acquired for income tax purposes on the "settlement date", the date on or before which the vendor is required to deliver the share certificate and the purchaser is required to make payment. Paragraph 3 of the bulletin then provides an explanation of the rational for this position. In general, a disposition and an acquisition of a property is considered to occur when the property is transferred and, as a result of the transfer, the vendor is entitled to payment of the proceeds of disposition. In exchange-traded transactions, the vendor does not generally have any entitlement to the proceeds until the settlement date. Hence, an exchange-traded security is, in general, only acquired on the settlement date unless the facts, including the terms of a particular disposition, provide otherwise.
Paragraph 8 of IT-133 also states that this general rule does not apply to transactions that are not conducted through an exchange and that the treatment of such transactions will depend on the facts of the particular transactions. Accordingly, the above general position will not normally apply to the acquisition of securities by an employee from an employer through the exercise of an option agreement. In these cases, the facts of the situation, including the terms of the specific agreement, will determine when the securities are acquired. Nevertheless, it has been our experience that on the exercise of an option, an employee will normally pay for the securities at the time of the exercise of the option and will at that time also acquire the incidence of ownership of the securities. However, a determination of this in any particular situation is a question of fact and, in this respect, you may wish to consider the judicial decisions in Benham 2002 DTC 3902 (TCC); Clemiss 92 DTC 6509 (FCTD); Bell 92 DTC 2123 (TCC); Steen 88 DTC 6171 (FCA); Lintott 87 DTC 563 (TCC); and Grant 74 DTC 6252 (FCTD).
In the case of a cashless exercise of an option, it has been our understanding that an employer is only entitled to receive the proceeds from the issue of securities under an option at the time the broker receives the particular securities, the employee is entitled to the proceeds of the sale of identical securities through the exchange-based short sale and the proceeds are held in the broker's account. In other words, we understand that, in general, the settlement date of the short sale is also the date the employee acquires the securities from the employer. However, the decision by the Tax Court of Canada in Benham, referred to above and decided on the specific facts of that case, indicates that this may not always be the case. Accordingly, we cannot provide a more definitive response to your enquiry.
In your submission, you also enquired about the treatment for tax purposes of brokerage and other fees associated with the exercise of an option.
Paragraph 21 of IT Bulletin IT-113R4, entitled Benefits to Employees - Stock Options, indicates that commissions, brokerage fees or transfer taxes that would be payable on a disposition of securities are not to be taken into account in measuring the amount of any benefit under section 7 but that they do enter into the calculation of any capital gain or loss, as the case may be, on the actual disposition of the securities by an employee. Also, in our view, the transaction fees paid to a broker or other plan administrator, do not represent the cost of acquiring an option under subparagraph 7(1)(a)(iii) of the Act or an amount paid "for" a security as contemplated by subparagraph 7(1)(a)(ii) of the Act.
We trust our comments will be of assistance to you.
Roberta Albert, CA
Financial Industries Division
Income Tax Rulings Directorate
Policy and Planning Branch
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