6 July 2012 Internal T.I. 2012-0440741I7 - stock option benefit derived by US resident

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: 1. Whether a stock option benefit realized by a US resident individual who performs part of his duties in Canada is subject to Canadian tax? 2. Whether, pursuant to paragraph 153(1)(a) of the Act, the non-resident employer of the US resident individual is required to withhold and remit Canadian tax on account of the US resident individual?

Position: 1. Not in this case. 2. Yes, unless a waiver from Canadian tax is obtained pursuant to section 102 of the Regulations. .

Reasons: 1. The stock option benefit is exempt from Canadian tax pursuant to the provisions of Article XV of the Canada-United States Income Tax Convention. 2. Even if pursuant to Article XV of the Treaty, the US resident employee’s remuneration (which includes the stock option benefit in respect of services provided in Canada) is only taxable in the U.S., paragraph 153(1)(a) of the Act and sections 101 and 102 of the Regulations, provide that the employer is required to withhold and remit Canadian tax on account of the US resident employee.

July 6, 2012

XXXXXXXXXX
Information Officer Angelina Argento
Income Tax Technical Interpretation Services
XXXXXXXXXX
2012-044074

Stock Option Benefit Realized by US Resident Individual

This is in reply to your email of March 19, 2012, in which you requested our views with respect to whether there is an obligation to withhold under subsection 153(1) of the Income Tax Act (the “Act”) in respect of stock option benefits derived by a resident of the United States from employment exercised in Canada.

Unless otherwise stated, all references to sections, subsections and paragraphs are references to the Act.

This opinion is based on the following facts and assumptions:

• USCo is a corporation which is resident in the United States (“U.S.”) for the purposes of the Canada-US Income Tax Convention (“Treaty”).
• USCo is also a “qualifying person” as defined in paragraph 2 of Article XXIX-A of the Treaty.
• USCo does not currently and will not at any future time carry on business in Canada or have a permanent establishment (“PE”) in Canada within the meaning of Article V of the Treaty.
• Canco is a corporation incorporated in and resident in Canada and its shares are listed on the XXXXXXXXXX Stock Exchange.
• Canco carries on business in Canada.
• Canco owns 100% of the issued and outstanding shares of USCo.
• In the years 2009, 2010 and 2011, a US resident individual who is an employee of USCo (“US Employee”) was temporarily sent to Canada to perform services for Canco.
• In particular, in the calendar years ending 2009, 2010 and 2011, US Employee was present in Canada to perform employment duties for 55, 100 and 75 days, respectively. The US employee did not spend any other time in Canada.
• The Employee was not a resident of Canada at any time during 2009, 2010 or 2011.
• The US Employee at all times remained on the payroll of USCo and was remunerated by USCo for the services performed during the period US Employee was in Canada;
• The US Employee, at all times, remained an employee of USCo and was not an employee of Canco in substance or in form;
• On January 1, 2009, the US Employee was granted options to purchase shares of Canco in consideration for his duties of employment performed for USCo. The options vest immediately.

USCo paid Canco a sum equal to the benefit realized by the US Employee on the exercise of the stock options. Assume, for example, that the fair market value of the shares of Canco at the time of the exercise of the options was $125 and that the option price was $100, a benefit of $25 would be realized by the US Employee; thus, USCo would make a $25 payment to Canco.

You asked firstly, whether the US Employee is subject to Canadian tax on the benefit realized on the exercise of the stock options and secondly, whether Canadian source deductions must be made by USCo in respect of such benefit.

Our Comments

Stock Option Benefit

Pursuant to subsection 2(3) and subparagraph 115(1)(a)(i), a non-resident’s income from employment exercised in Canada is subject to Canadian taxation under Part I of the Act. The stock option benefit is part of the non-resident’s remuneration. In particular, when an option to acquire shares of a public corporation is issued to a non-resident individual as consideration for employment services that are performed in Canada, the benefit received by the individual from the exercise of the option will, by virtue of section 7 and subparagraph 115(1)(a)(i), be included in the non-resident individual’s “taxable income earned in Canada” in the year in which the shares are acquired. The amount of the benefit is equal to the fair market value of the shares at the time they were acquired less the total of the amount paid by the individual to acquire the options and the amount paid to acquire the shares. However, only the portion of the stock option benefit that is allocable to employment services performed in Canada using our domestic rules, is taxable in Canada under subsection 2(3) and subparagraph 115(1)(a)(i). Canada’s default position regarding the allocation of the stock option benefit is that a stock option benefit is allocable to the services rendered in the year of grant, unless it is clear from the circumstances that some other period is more appropriate, and vesting is not relevant (footnote 1) .

Since the US Employee exercised employment in Canada in the year in which the options were granted (2009), the portion of the benefit that relates to services rendered in Canada in 2009 is taxable in Canada under the domestic rules, regardless of when the options are exercised. Assume in your situation that on January 1, 2009, the US Employee was granted options to acquire 1000 shares of the capital stock of Canco. On December 31, 2010, the US Employee exercises the option, and realizes a benefit of $20,000. As you mentioned, during the 2009 calendar year, the US Employee worked in Canada for 55 days. Assume, further that during the 2009 calendar year, the US Employee worked 260 days in the United States for USCo. In this situation, regardless of the number of days worked in Canada in the year of the exercise of the option, we will consider that $3492.06 (i.e., 55/315 x $20,000) of the stock option benefit is derived from employment exercised in Canada (and therefore taxable in Canada in 2010 pursuant to subparagraph 115(1)(a)(i)) and that $16,507.94 (i.e., 260/315 x $20,000) is derived from employment exercised in the United States.

Stock Option Deduction

Paragraph 115(1)(d) allows the deduction under paragraph 110(1)(d) (of 50% of the amount of the benefit) to be taken into account in computing the non-resident’s taxable income earned in Canada that is subject to tax under Part I of the Act.

Treaty

Paragraph 1 of Article XV of the Treaty provides that the benefit is taxable only in the U.S., except that the portion of the benefit that is derived from employment exercised in Canada may also be taxed in Canada. Where the US Employee’s services are partly performed in Canada and partly performed in the U.S. (which is your case), the amount of the benefit sourced to Canada for the purposes of the Treaty will be based on the allocation method set out in Annex B to the Fifth Protocol to the Treaty.

When applying the Fifth Protocol to employee stock option benefits, we generally will apportion the stock option benefit over the period between the grant and exercise of the option using the following fraction:

Number of days on which an employee is physically present in a
Contracting State while exercising the employment in the period
Total number of days exercising the employment in the period

Assume the same example as above, (i.e. on January 1, 2009, the US Employee was granted an option to acquire 1000 shares of the capital stock of Canco. On December 31, 2010, the US Employee exercises the option, and realizes a benefit of $20,000). As you mentioned, during the 2010 calendar year, the US Employee worked in Canada for 100 days. Assume, further that during the 2010 calendar year, the US Employee worked 200 days in the United States for USCo. The numerator of the formula in Annex B represents the number of days of employment exercised in Canada between the grant of the option in 2009 and the exercise of the option in 2010 and the denominator represents the total number of days of employment between the grant of the option in 2009 and the exercise of the option in 2010. Thus, in this situation, for the purposes of the Treaty we will consider that $5040.65 (i.e., 155/615 x $20,000) of the stock option benefit is derived from employment exercised in Canada and that $14,959.35 (i.e., 460/615 x $20,000) is derived from employment exercised in the United States.

Since the Canadian domestic allocation rule provides for a benefit of $3492.06 to be taxed in Canada, whereas, the Treaty provides for a benefit of $5040.65 to be taxed in Canada, the domestic rule prevails as the Treaty cannot give Canada the right to tax an amount that it cannot tax under its domestic tax law. The Treaty can only provide relief. Therefore, absent any Treaty relief, a benefit of $3492.06 will be subject to tax in Canada in 2010.

Similar calculations should be made to determine what portion of any stock option benefit realized by the US Employee in the 2011 calendar year is considered as being derived from employment exercised in Canada in that year.

The portion of the benefit realized by the US Employee which relates to employment exercised in Canada is taxable in Canada, as the country of source. In order not to be taxable in Canada, either the conditions of subparagraph 2(a) of Article 15 of the Treaty must be met or all three conditions in subparagraph 2(b) of Article 15 of the Treaty must be met.

Paragraph 2 of Article XV of the Treaty states the following:

“2. Notwithstanding the provisions of paragraph 1, remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if:
(a) Such remuneration does not exceed ten thousand dollars ($10,000) in the currency of that other State; or
(b) The recipient is present in that other State for a period or periods not exceeding in the aggregate 183 days in any twelve-month period commencing or ending in the fiscal year concerned, and the remuneration is not paid by, or on behalf of, a person who is a resident of that other State and is not borne by a permanent establishment in that other State.”

Thus, pursuant to subparagraph (2)(a) of Article XV of the Treaty, the stock option derived by the US Employee (that is included in the computation of the US Employee’s income under the Act for a taxation year) will be exempt from tax in Canada if the remuneration (which includes the stock option benefit) for the services performed in Canada in a particular year is less than $10,000 (in Canadian currency). If this is not the case, then such remuneration may still be exempt from Canadian tax if all the conditions in subparagraph (2)(b) of Article XV are satisfied. Pursuant to subparagraph 2(b) of Article XV of the Treaty, the stock option remuneration derived by the US Employee (that is included in the computation of the US Employee’s taxable income earned in Canada under the Act for a taxation year) will be exempt from tax in Canada only if:

(i) the US Employee is not present in Canada for more than 183 days in any twelve-month period commencing or ending in the particular taxation year,
(ii) the stock option remuneration is not paid by, or on behalf of, a person who is a resident of Canada under the Treaty, and
(iii) the stock option remuneration is not borne by (i.e. allowable as a deduction in computing taxable income) a permanent establishment in Canada.

From the information you provided, it seems that for the 2009, 2010 and 2011 taxation years, the first condition in subparagraph 2(b) of Article XV of the Treaty is satisfied (since the US Employee could not possibly have been present in Canada for more than 183 days in any 12 month period commencing or ending in any of the years 2009, 2010 and 2011 based on the above facts). In addition, the last condition in subparagraph 2(b) of Article XV is satisfied in all of those years, since USCo did not have a permanent establishment in Canada in any of those years.

The only issue is whether the remaining condition in subparagraph 2(b) of Article XV is satisfied. That condition is whether the remuneration received by the US Employee is paid by or on behalf of a “person” who is a resident of the other Contracting State, as opposed to an “employer”. Whether the word “person” or “employer” is used, Canada, in determining whether this condition is met, will refer to principles developed under Canadian jurisprudence and the Quebec Civil Code to determine who, in fact, is exercising the functions of employer. As noted below, we consider that the stock option benefit was paid to US Employee by USCo. Since the facts presented state that the true and only employer of the US Employee is USCo and not Canco, the remaining condition in subparagraph 2(b)of Article XV of the Treaty is also satisfied. Accordingly, the US Employee’s remuneration from employment exercised in Canada is exempt from Canadian tax pursuant to Article XV of the Treaty.

Canadian Withholding Tax Obligation

Paragraph 153(1)(a) requires that every person “paying” at any time in a taxation year, salary, wages or other remuneration in respect of an office or employment shall withhold from the payment, the amount determined in accordance with prescribed rules and remit that amount to the Receiver General on account of the payee’s tax for the year under Part I of the Act. The amount of the required withholding is based on graduated rates calculated on the combined amount of the salary and the benefit, pursuant to paragraph 153(1)(a) and section 102 of the Income Tax Regulations. This obligation to withhold extends to non-residents of Canada employing non-residents for services performed in Canada.

We have expressed the view many times that firstly, paragraph 153(1)(a) applies to stock option benefits because the individual enjoyed the economic benefit flowing therefrom and secondly, we consider a “payment” to have been made for purposes of paragraph 153(1)(a) when a stock option is exercised and a share is issued (see 1983 Canadian Tax Foundation Conference Report XXXXXXXXXX, 9233476, XXXXXXXXXX, 1997 Tax Executives Institute Conference XXXXXXXXXX). However, although subsection 7(1) provides for the computation and timing of the stock option benefit, it does not deem such a benefit to have been paid by the employer. Accordingly, for purposes of paragraph 153(1)(a), it must be determined who in fact made the "payment". In our view, the corporation that has agreed to sell or issue the shares to the employee (in this case, Canco) will be considered to be the “payer” of the stock option benefit for purposes of paragraph 153(1)(a) (and will be responsible for the normal withholding), unless it receives reimbursement, in whole or in part, either directly or indirectly, in respect of the benefit. Since, in this case, Canco is reimbursed by USCo for the amount of the benefit conferred on the US Employee, it is our view that USCo is in substance making the actual payment and therefore is required to make the withholdings required under paragraph 153(1)(a) in respect of the remuneration paid to the US Employee for services rendered in Canada.

Note that paragraph 153(1.01)(a) clarifies, that for the purpose of paragraph 153(1)(a), a deduction available to the employee under paragraph 110(1)(d) will be taken into account in applying the withholding rules. As such, withholding will not apply in respect of the one-half of the benefit that is deductible where the US Employee is entitled to a deduction under paragraph 110(1)(d).

Waiver from Canadian withholding tax

Pursuant to subsection 153(1.1), the Canada Revenue Agency (“CRA”) may grant a waiver from withholding if a non-resident employee can provide evidence that the payments will be exempt from Canadian tax under the Treaty (footnote 2) .

Note that, following the introduction of subsection 153(1.31) of the Act (which is applicable after 2010), the Minister does not have the discretion to waive a withholding requirement in respect of a stock option benefit solely because it is received in non-cash form or is the only remuneration paid to the employee in the taxation year, or because the remuneration or other cash benefits paid to the employee during the taxation year are less than the amount of the required withholding.

Interest and Penalties

Even if pursuant to Article XV of the Treaty, the US Employee’s remuneration (which includes the stock option benefit in respect of services provided in Canada) is exempt from Canadian tax, in the absence of a waiver from Canadian tax issued by the CRA, USCo is required, pursuant to paragraph 153(1)(a) and sections 101 and 102 of the Regulations, to withhold Canadian tax on the amount of the remuneration paid to the US Employee for the services provided in Canada. In particular, USCo is required, pursuant to paragraph 153(1)(a), to withhold Canadian tax on the amount of any stock option benefit realized by the US Employee in 2009, 2010 and 2011.

Thus, where the US Employee has not obtained a waiver from Canadian tax from the CRA, USCo (as the employer) will be liable for the amount of tax that should have been withheld from the stock option benefit realized by the US Employee in accordance with paragraph 153(1)(a) and sections 101 and 102 of the Regulations. Where USCo has failed to withhold in accordance with paragraph 153(1)(a) and section 102 of the Regulations, such a failure would generally give rise to an assessment of a penalty and interest under subsections 227(8) (footnote 3) and 227(8.3) (footnote 4) , respectively, for failure to do so.

We trust that these comments will be of assistance.

Yours Truly,

Olli Laurikainen
Section Manager
For Division Director
International and Trusts 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 CRA Document No. 2003-0037271I7 dated February 6, 2004.
2 Paragraphs 86 to 96 and Appendix B of Information Circular IC 75-6R2 "Required Withholding from Amounts Paid to Non-Residents Providing Services in Canada", dated February 24, 2005 ("IC 75-6R2") describe CRA's guidelines with respect to the granting of a Regulation 102 Waiver. Form R102-J, "Regulation 102 Waiver Application - Joint Employer/Employee" is an alternative application for a Regulation 102 waiver which may be made, provided the specific conditions required thereunder are satisfied.
3 Subsection 227(8) provides that every person who in a calendar year has failed to deduct or withhold any amount as required by subsection 153(1) is liable to a penalty of 10% of the amount not deducted or withheld. A second or further occurrence penalty will be 20% of that amount not deducted or withheld. This 20% penalty will apply only where another penalty has previously been assessed under subsection 227(8) against the same person during the same calendar year.
4 Subsection 227(8.3) provides that every person who in a calendar year has failed to deduct or withhold any amount as required by subsection 153(1) is liable for interest with respect to the amount that person failed to deduct or withhold. Pursuant to subsection 227(8.1), where a taxpayer failed to deduct or withhold from a non-resident person in contravention of subsection 153(1), the non-resident person is jointly and severally liable with the taxpayer to pay any interest payable by the taxpayer under subsection 227(8.3).