1 May 2013 Internal T.I. 2009-0321721I7 - Stock Option Recharge on Grant Date

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: The parent company (USCo) grants employee stock options to the subsidiary's (Canco's) employees. Canco reimburses USCo an amount equal to the fair value of the option at the grant date. Would the reimbursement constitute a benefit paid by Canco to USCo, such that Part XIII applied to the payment?

Position: No, however, the method used to compute the fair value may be reviewed.

Reasons: It would not be unreasonable for USCo to recoup the portion of the stock option benefit that it has effectively provided to the employees on Canco's behalf.

May 1, 2013

XXXXXXXXXX HEADQUARTERS
International Audit Income Tax Rulings
XXXXXXXXXX TSO Directorate
S.E. Thomson
(613) 957-2122

2009-032172

XXXXXXXXXX – Employee Stock Options Recharge

This is in response to a request from XXXXXXXXXX that arose in the course of a real-time audit of a Canadian subsidiary ("Canco") of XXXXXXXXXX ("USCo"), a publicly traded company. In the year under audit (XXXXXXXXXX), Canco expensed $XXXXXXXXXX in its financial statements as employment expense in respect of stock options granted by USCo to employees of Canco, with an offset to "Due to USCo" (footnote 1) .

Under Canadian Generally Accepted Accounting Principles, Canco was required to compute the fair value of the options at the time that they were granted to the employees, and to expense this amount over the period in which the options vested. In any particular year, the amount to be expensed would be reduced for options that were forfeited before they vested (footnote 2) . The "fair value" was to be computed using an appropriate valuation technique.

The notes to USCo's XXXXXXXXXX financial statements state that the fair value of the options at the time of the grant was calculated using the Black-Scholes option pricing model, and that the options serially vested over a XXXXXXXXXX-year period, with a XXXXXXXXXX year life. Therefore, the $XXXXXXXXXX represents the value of options that were granted in XXXXXXXXXX, adjusted for options forfeited in those years. The $XXXXXXXXXX was added back in computing Canco's income for tax purposes, because paragraph 7(3)(b) of the Income Tax Act (the "Act") denies a deduction for stock option benefits.

Also in XXXXXXXXXX, Canco's employees were T4'd for $XXXXXXXXXX (footnote 3) under paragraph 7(1)(a) of the Act, which equals the difference between the fair market value of the shares at the exercise date, and the amount paid by the employees to USCo upon exercise (the "intrinsic value", or the "spread"). The auditor wanted to know if the difference between the $XXXXXXXXXX included in the employee's income, and the $XXXXXXXXXX that was paid to USCo constitutes a benefit paid to USCo by Canco under subsection 15(1) of the Act. He argues that Canco paid USCo more than USCo's cost to issue shares to Canco's employees in XXXXXXXXXX, therefore, the excess cost of $XXXXXXXXXX should be a benefit to USCo.

Canadian GAAP does not require that Canco reimburse USCo for options granted to Canco's employees, and USCo and Canco do not have a written recharge agreement in place.

Our Comments

The Income Tax Rulings Directorate has issued several rulings in which we concluded that a reimbursement made by a subsidiary to the parent company based on the intrinsic value of the options on the date of exercise would not be a benefit as contemplated by subsection 15(1) of the Act (see for example 2010-039128). We continue to believe that it would be reasonable for Canco to reimburse USCO an amount equal to the intrinsic value of the options on the day of exercise. However, in our view, it also is reasonable for Canco to reimburse USCo with an amount equal to the fair value of the options on the day of grant. We understand that in practice, both methods are used.

It appears that many companies are using the Black-Scholes model to value employee stock options for financial statement purposes, and to compute the recharge amount. The Valuations Section, Compliance Programs Branch has advised us that the Black-Scholes options pricing model is an acceptable approach to use, assuming that it is adjusted for the differences inherent in employee stock options. However, the Black-Scholes model is not the only reasonable model. Further, if the company were subject to audit, the CRA might review the inputs to the model and the adjustments made to it for attributes specific to employee stock options.

USCo and Canco do not have a written "recharge agreement" in place. If Canco is reimbursing USCo in a consistent manner from year to year, then it would appear that there is at least an implicit recharge agreement in place. Whether or not it is written should not be determinative of the issue. However, if Canco does not have a history of reimbursing USCo, then we would take the view that there is no recharge agreement in place. If an agreement is subsequently entered into, we would consider that only the portion of the fair value of the options on grant date attributable to the vesting period after the new agreement is in place could be paid to the parent company without subsection 15(1) applying.

XXXXXXXXXX has asked us whether subsection 15(1) will apply where Canco reimburses USCo $XXXXXXXXXX in XXXXXXXXXX, when the T4 benefit for options exercised in XXXXXXXXXX was only $XXXXXXXXXX.

In our view, it is not appropriate to compare the two amounts. The options vesting in the year are not the same options that are exercised in the year. That is, the $XXXXXXXXXX expense and reimbursement relates to a portion of the options that had vested in the year or the prior XXXXXXXXXX years (i.e. XXXXXXXXXX). The $XXXXXXXXXX represents stock options benefits taxable to employees on options that were exercised in the year, but that were granted in the prior XXXXXXXXXX years (i.e. since XXXXXXXXXX), and were vested (i.e. granted before XXXXXXXXXX). The employment benefit eventually realized by the employees in any particular year may be more or less than the reimbursed amount.

Conclusion

Therefore, we are of the view that subsection 15(1) and paragraph 214(3)(a) do not apply to the difference between $XXXXXXXXXX and $XXXXXXXXXX in XXXXXXXXXX.

We trust that our comments are of assistance.

Yours truly,

Olli Laurikainen, CA
For Director
International Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

FOOTNOTES

Note to reader: Because of our system requirements, the footnotes contained in the original document are shown below instead:

1 The auditor has told us that it is safe to assume that the amount will eventually be paid to USCo.
2 See paragraph 3870.48 of the CICA Handbook. However, once the options vest, no further adjustments will be made for options that are forfeited (i.e. not exercised).
3 Less a $XXXXXXXXXX deduction under paragraph 110(1)(d) of the Act