28 November 1986 Income Tax Severed Letter 5-1244 - [Stock Option Benefits]

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.

XXXX

N.R. Mitchell 957-2139

Dear Sirs:

Re: Stock Option Benefits

This is in reply to your letter of March 13, 1986, concerning the tax implications of a hypothetical stock option agreement. We regret the delay in replying caused by a recent review of certain issues which arise in your inquiry.

You have requested our views with respect to the following situation:

(1) In 1986, X Co., a public company, grants stock options to certain employees. The price at which a share may be acquired under the agreement (the exercise price) equals the fair market value of a share at the time the option was granted; and

(2) At a later date, before such options are exercised, the corporation effectively cancels the option. As consideration for the surrender of his right under the agreement, the employee receives an amount equal to the excess of the fair market value of the share at that time over the exercise price.

It is your view that the following income tax consequences would result:

(A) The employee will be deemed to have received a benefit equal to the value of the consideration for the disposition of his right under the agreement. This benefit is taxable as employment income in the year of disposition pursuant to paragraph 7(1)(b) of the Income Tax Act (the "Act").

(B) The employee would be entitled to claim a deduction under paragraph 110(1)(d) of the Act in respect of one-half of the deemed benefit included in income as described in (1) above. (It is understood that the shares in question would be "prescribed shares" for the purposes of subparagraph 110(1)(d)(ii) of the Act).

(C) Paragraph 7(3)(b) of the Act would not operate to deny the company a deduction from its income of the amount paid to the employee. As you see it, this paragraph is not applicable since the benefit conferred on the employee does not arise from the sale or issue of the shares to him or to a person in whom the employee's rights under the agreement have become vested.

In our view, the employee in the circumstances set out above would be deemed to have received a benefit equal to the value of the consideration received which would be included in his income under paragraph 7(1)(b) of the Act unless, having regard to the terms of the agreement and the surrounding circumstances, it was apparent that there was never any intention to have shares issued and the cash payment was merely a means of compensating the employee with a "phantom stock option plan". In such a case, we would maintain that the benefit to the employee would be taxable by virtue of subsection 5(1) or paragraph 6(1)(a) of the Act. The basis for this latter view is that the benefit to the employee could not be said to have arisen under an agreement to sell or issue shares.

With respect to your second submission (item B, above), it is our position that the deduction in paragraph 110(1)(d) of the Act is only available where the subsection 7(1) benefit received by the employee is actually in the form of shares. We note in this regard that subparagraph 110(1)(d)(ii) of the Act sets out as a requirement for the deduction that "the share is a prescribed share at the time of its sale or issue, as the case may be".

Finally, we would agree that where an employer has made a cash payment which results in the inclusion of a benefit in the employee's income under subsection 7(1) of the Act, paragraph 7(3)(b) will not apply to deny the employer a deduction from income of the amount paid to the employee.

We hope this letter will be of some assistance to you.

Yours truly,

for Director Small Business and General Division Specialty Rulings Directorate Legislative and Intergovernmental Affairs Branch