24 July 1997 External T.I. 9716015 - SWAP 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.

Please note that the following document, although believed to be correct at the time of issue, may not represent the current position of the Department.

Prenez note que ce document, bien qu'exact au moment émis, peut ne pas représenter la position actuelle du ministère.

Principal Issues:

  	Whether formula to determine number of new options and exercise price of same 	(which will be granted to employees in exchange for old options) can use average 	trading value of the old and new shares for a period of 5 consecutive business day ending on the date of the reorganization such that subsection 7(1.4) will apply.

Position:

Fair market value is question of fact - referred to Audit position and gave them contact's name and phone number.

Reasons:

	 7(1.4) refers to "value" of shares "immediately after" the exchange of options.  	Whether this formula will arrive at fair market value cannot be verified by Rulings.

XXXXXXXXXX 971601

Attention: XXXXXXXXXX

July 24, 1997

Dear Sirs:

Re: Subsection 7(1.4) of the Income Tax Act (the "Act")

This is in reply to your letter of June 11, 1997, and your facsimile transmission of July 7, 1997, in which you ask for a technical interpretation concerning the application of the above-noted provision to an exchange of employee stock options. We also acknowledge receipt of your deposit of $481.50 which will be returned to you under separate cover.

Although we are unable to provide a technical interpretation with respect to an actual fact situation except in the context of an advance income tax ruling, we can provide the following general comments which we trust will assist.

Subsection 7(1) applies where an employer agrees to sell (hereinafter referred to as an "exchanged option") its shares or shares of a corporation with which it does not deal at arm's length (hereinafter referred to as the "old shares") to an employee or an employee of a corporation with which the employer does not deal at arm's length .

Where the employee disposes of the exchanged option and acquires only rights under another option (the "new option"), the rules in paragraph 7(1.4)(d) through (f) of the Act apply if the conditions in paragraphs 7(1.4)(a) through (c) of the Act are satisfied.

You are particularly concerned with the condition in paragraph 7(1.4)(c) of the Act. This condition will prevent the application of subsection 7(1.4) where the economic benefit to the employee of the new option (as determined under that paragraph) exceeds the economic benefit of the exchanged option at the time of the exchange.

In your example, the exchanged option provides that the employee may acquire 1000 shares at an exercise price of $15.00 per share and each old share has a fair market value immediately before the exchange of $38.50. The benefit under the exchanged option as determined under subparagraphs 7(1.4)(c)(iii) and (iv) of the Act is $23,500.

The new option provides that the employee may acquire 1100 new shares at an exercise price of $13.63 and each new share has a fair market value immediately after the exchange of $35.00. The benefit under the new option as determined under subparagraphs 7(1.4)(c)(i) and (ii) is $23,507.00. Therefore, the condition in paragraph 7(1.4)(c) of the Act is not satisfied and the employee will be subject to an income inclusion at the time of the exchange in accordance with paragraph 7(1)(b) of the Act and may be eligible to claim a deduction under paragraph 110(1)(d) of the Act.

In applying subsection 7(1.4) of the Act note that the provision requires that the "value" (which means fair market value) of both the new shares and the old shares must be determined immediately after the disposition of the old option and the acquisition of the new option. You have referred to adjusting the exercise price and the number of options so that paragraph 7(1.4)(c) of the Act is satisfied by relying on the average closing prices of the relative stocks for a period of five consecutive business days during a two week period preceding the spin-off of the new corporation, the shares of which are the subject of the new option.

We have confirmed the Department's position concerning the determination of the fair market value of a share with the Department's Audit Directorate which follows:

The fair market value of publicly-traded shares at any point in time should be the price established on the appropriate stock exchange on the particular date. It is the Department's view that the following criteria should be considered in determining a price which is representative of fair market value:

- The closing price on the particular day (in this case the day the options are exchanged),
- The average of the high and low prices for the particular day,
- The simple average of a stock's daily trading price, calculated as the total value of the stock traded during the particular day divided by the total number of shares traded,
- The closing price for the most recent, previous day on which there was active trading, or
- The average closing price of the stock over a limited number of trading days immediately before the valuation date.

Further information concerning valuations may be addressed to the Tax Services Office serving the region in which your client resides. For Toronto residents, this service is provided by the Toronto Centre Tax Services Office, and you may contact Mr. Murray Game of that office at 613-973-9211. Although our comments are not binding on the Department we trust they will be of assistance to you.

Yours truly,

for Director
Financial Industries Division
Income Tax Rulings and
Interpretations Directorate
Policy and Legislation Branch