15 October 1997 External T.I. 9725315 - CCPC 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:

Can a significant capital gain result where subsection 7(1.3) defers the recognition of any 7(1.1) benefit and subsection 47(1) requires the averaging of existing adjusted cost bases when dealing with identical properties?

Position:

Yes

Reasons:

The Act is clear that FIFO is used for the application of 7(1.1) and general averaging is used foe 47(1).

972531
XXXXXXXXXX M.P. Sarazin

Attention: XXXXXXXXXX

October 15, 1997

Dear Sirs:

Re: Employee Stock Options

This is in reply to your letter dated September 19, 1997, wherein you requested our views with respect to the application of section 7 of the Income Tax Act (the "Act") in each of the following general questions.

Question 1

A Canadian-controlled private corporation ("CCPC") provides its employees with stock options prior to its becoming a public company, will subsection 7(1.1) of the Act apply to any shares acquired under the options by the corporation's employees after it becomes a public corporation?

Comments

The Department's position with respect to the application of subsection 7(1.1) of the Act upon a CCPC becoming a public corporation is as outlined in paragraph 14 of Interpretation Bulletin IT-113R4.

Question 2

Where the fair market value of a public corporation's shares decline and the corporation and its employees agree to amend the option price under existing stock options to reflect the decline in value, would subsection 7(1.4) of the Act apply with respect to the amendment of the option price under the existing stock options?

Comments

Subsection 7(1.4) of the Act will only apply where certain conditions are satisfied. One of the conditions is that a taxpayer must dispose of rights under a stock option agreement referred to in subsection 7(1) or 7(1.1) of the Act. Consequently, you would have to determine whether the change in the exercise price under the stock option agreement would constitute a disposition of rights under the particular agreement.

In this regard, we would refer you to John A. Amirault v. The Minister of National Revenue (90 DTC 1330) (T.C.C.) wherein the court concluded that a retroactive change in the option or strike price under a stock option agreement, in and by itself, would not constitute a fundamental change to the particular option for the purposes of applying subparagraph 110(1)(d)(iii) of the Act. In paragraph 2 of Interpretation Bulletin IT-448, the Department states that the significance of the change in the terms of an agreement will be the determining factor in deciding whether there is a disposition. Even though IT-448 deals specifically with changes in the terms of debt obligations and shares, the general principles may be applied to changes in the terms of stock option agreements. Since the court has concluded that a change in option price is not a fundamental change to an option agreement, we can support a conclusion that the change in option price would not generally constitute a significant change in the terms of the stock option agreement and, as such, would not result in a disposition of rights under a stock option agreement. Therefore, subsection 7(1.4) should not apply in the general situation where the only change to an existing stock option agreement is a reduction in the exercise price.

Where an option price is subsequently reduced in order to reflect the subsequent market price, it would appear that the condition in subparagraph 110(1)(d)(iii) would not be satisfied because the option holder would be entitled to acquire the share(s) under the option for an amount that is less than the fair market value of the share(s) at the time the agreement was made.

Question #3

In applying subsection 7(1.1) of the Act, is the employment benefit computed by taking the fair market value on the date that the employee acquires the shares of the CCPC or on the date that the employee disposes of the shares of the CCPC?

Comments

Where a corporation has agreed to sell or issue shares of its capital stock or capital stock of a corporation with which it does not deal at arm's length to an employee, paragraph 7(1)(a) of the Act deems the employee to have received a benefit, in the taxation year in which the employee has acquired the shares, equal to the amount by which the fair market value of the shares on the acquisition date exceeds the amount paid by the employee to acquire such shares (the "Employment Benefit"). The purpose of subsection 7(1.1) of the Act is to defer, where certain conditions are satisfied, the recognition of the Employment Benefit that would have normally been recognized on the acquisition date until the taxation year in which the employee disposes or exchanges the shares. The Employment Benefit does not fluctuate because of changes in the fair market value after the date that the employee acquires the shares which are subject to subsection 7(1.1) of the Act.

Question #4

Where an employee/shareholder owns shares of a CCPC which have a nominal adjusted cost base (the "Original Shares"), the employee subsequently acquires additional shares (the "New Shares") under a stock option (an acquisition subjected to subsection 7(1.1) of the Act) and the employee subsequently disposes of a portion of his or her Original Shares, would the disposition result in a capital gain and no employment income because of the application of subsections 7(1.3) and 47(1) of the Act?

Comments

The recognition of the employment benefit related to the acquisition of the New Shares is deferred as a consequence of the application of subsection 7(1.1) of the Act. For the purposes of applying subsection 7(1.1) of the Act, subsection 7(1.3) of the Act deems the employee to dispose of identical properties in the order they were acquired. Therefore, the Employment Benefit in the above situation will continue to be deferred until all of the Original Shares are disposed of. Since paragraph 53(1)(j) of the Act will not apply until the Employment Benefit under 7(1)(a) is deemed to have been received by the employee, the adjusted cost base, as computed under subsection 47(1) of the Act, of each share (i.e. the Original Shares and the New Shares) could be significantly lower than they would otherwise be if the benefit under paragraph 7(1)(a) was not deferred. Therefore, the disposition of a portion of the Original Shares may result in a significant capital gain without the realization of any employment benefit.

We trust the above comments will be of assistance to you.

Yours truly,

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