7 May 2001 Internal T.I. 2001-0079677 - STOCK OPTIONS PAPER TEI

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: Prepare a paper on the recent amendments to the stock option provisions in the Act.

Position: Paper drafted.

Reasons: Paper discusses old provisions, proposed amendments and effects on the recent administrative positions taken in respect of stock options.

Stock Options

History

• Stock options are used by corporations to attract and retain key employees. Through stock options, the increase in the value of the corporate employer's shares rewards employees for their contribution to the attainment of corporate goals. Many corporations have used stock options to encourage employees to take an ownership stake in the corporation, most notably in the fast-growing high-technology industries. In addition, for cash strapped start-up companies, stock options may represent the primary source of employment revenues for its employees.
• Other than in the case of stock options granted by Canadian-controlled private corporations, stock option benefits were generally taxed in the year that an employee acquired a share of the employer or a corporation related to the employer under a stock option agreement. The taxable employment benefit is equal to the difference between the fair market value of the share at the time the option was exercised and the aggregate of the amount paid by the employee to acquire the share and the amount paid to acquire the stock option. This amount has to be included in the employee's income in the year the option is exercised. Consequently, employees with insufficient cash to pay the income taxes resulting from the stock option benefit income inclusion were forced to sell some of their shares. In the case of CCPCs, the inclusion of the taxable employment benefit is generally deferred until the year of disposition of the share acquired under the stock option.
• For qualified stock options in the United States, employees may be taxed on their stock option benefits in the year that they dispose of the shares that they acquired under their stock options. The preferential tax treatment of stock option benefits in the United States made it very difficult for Canadian companies to attract and retain their key employees. Canadian corporations argued that the preferential U.S. tax treatment given to qualified stock options contributed to an increase in the emigration of key executives and highly qualified University graduates from Canada.

Proposed Amendments

• To assist Canadian corporations in attracting and retaining high-caliber workers and to make our tax treatment of employee stock options more competitive with the United States, the Minister of Finance announced in The Budget Plan Tabled in the House of Commons on February 28, 2000 that, subject to an annual $100,000 limit, the employee income inclusion from exercising stock options after February 27, 2000 for publicly listed shares will be deferred, under proposed provision subsection 7(8), until the earlier of the employee's death, the employee's ceasing to be a resident of Canada or the employee's disposition of the shares acquired under a stock option agreement. These proposed amendments are included in the Bill C-22 tabled on March 13, 2001. The Bill passed first reading in March as well.
• In order to be eligible for the new stock option benefit treatment, the following conditions have to be satisfied:
• The employee must be a Canadian resident.
• The share that may be acquired under the stock option agreement will be eligible only if the share is of a class of shares listed on a Canadian or foreign prescribed stock exchange.
• The deferral is only available if the employee is entitled to a deduction under paragraph 110(1)(d) of the Act. Generally speaking, an employee is entitled to a deduction under paragraph 110(1)(d) when the following conditions are satisfied:
• the amount paid by the employee to acquire the security was not less than the fair market value of the security when the option was granted;
• the employee was dealing at arm's length, immediately after the option was granted, with the employer, the entity that granted the option and the entity whose securities could be acquired under the option. These entities will be referred to generally as `the employer' throughout; and
• the share is an ordinary common share.
• Immediately after the option was granted, the employee was not a specified shareholder of the employer. (Also includes the corporation that granted the option or the corporation whose shares could be acquired under the option.). A specified shareholder is a person who owns, directly or indirectly, not less than 10% of the issued shares of any class of the capital stock of the corporation. In determining whether a person is a specified shareholder, the person is deemed to own each share that is owned by a related person.
• An employee must file an election by January 15th of the following year to have the new deferral provisions apply with respect to options exercised in the year with the entity involved in the stock option agreement defined earlier as the employer. A February 15, 2001 deadline for filing an election to defer the taxation of employee stock options exercised in 2000 was indicated in the backgrounder to Finance press release 2000-101 dated December 21, 2000. In response to public concerns, the Finance Minister will extend this deadline to 60 days after the day on which the legislation providing for the deferral receives Royal Assent.
• The deferral is subject to an annual limit of $100,000. The limit is based on the year in which the options vest and on the fair market value of the underlying shares when the options were granted. For options vesting in a given year, an employee will be able to defer taxation on the acquisition of securities having a total fair market value (determined at the time the options were granted) not exceeding $100,000.
• The deferred amount will be reported as a special item on the employee's T4 slip in the year that the employee acquired the shares under the stock option. The employer is only responsible for the reporting of the deferred amount. The employee is responsible for reporting any dispositions or deemed dispositions that would trigger the inclusion of the deferred amount in his or her income.
• In order to ensure that deferred employment benefits that relate to the acquisition of employer shares are not taxed prematurely, proposed subsection 7(1.3) provides rules for the order of disposition where identical securities are disposed of by a taxpayer. The deferral of the recognition of an employment benefit will occur where an employee acquires securities under an option granted by a CCPC, acquires securities under proposed subsection 7(8) described above or acquires securities that are distributed by a deferred profit sharing plan and the employee elected in accordance with subsection 147(10.2) of the Act. We will refer to these securities as deferral securities. Where a taxpayer holds deferral securities and the taxpayer acquires identical securities that are not deferral securities, the new securities will be deemed to have been acquired immediately before the earliest acquisition of the deferral securities. Consequently, a taxpayer holding both deferral and non-deferral securities will be considered to have disposed of the non-deferral securities first. When a taxpayer acquires a number of identical deferral securities at one time, the securities will be deemed to have been acquired in the order in which the options under which the securities are acquired were granted.
• In the year that the employee disposes of the shares associated with the deferred stock option benefit, the deferred amount in respect of those shares has to be included in the employee's income for that year. When an employee dies or ceases to be a resident of Canada, the employee will be deemed to have disposed of the shares associated with any deferred stock benefits and the deferred amounts will be included in the employee's income at that time.

Disposition Issues

• Historically, the disposition of deferral securities by a taxpayer resulted in adverse tax consequences where the taxpayer owned significant identical properties. The disposition of the deferral security resulted in the inclusion of the deferred stock option benefit and the disposition resulted in capital gains because the stock option benefit addition to the adjusted cost base of the shares acquired under the stock option were, indirectly, averaged over all of the identical properties owned at that time. The averaging occurred because the partial disposition of identical properties were considered to be prorata from the identical properties with the 53(1)(j) bump and the identical properties without the 53(1)(j) bump.
• In Income Tax Technical News No. 19, the Agency revised its earlier position to allow for the specific identification of securities where there was a direct correlation between a particular acquisition of securities and a disposition of the securities. Under this new position, subsection 47(1) applied to average the adjusted cost base of the identical securities previously held with the cost amount of the identical securities acquired under the stock option and the 53(1)(j) bump in respect of the securities option benefit was added to this average cost computed for the newly acquired securities under subsection 47(1) of the Act. In computing the capital gain realized on the disposition of the securities, the employee could specifically identify the identical securities with the 53(1)(j) bump as being the securities disposed of under the Act. This would reduce the capital gain that would have to be recognized in respect of the disposition of the securities acquired under the particular stock option.
• Under proposed subsection 7(1.31), a taxpayer is entitled to designate which particular security that he or she is disposing of at that time. In order to qualify for the proposed subsection 7(1.31) designation, the following conditions have to be satisfied:
• the particular security must have been acquired under an employee securities option agreement described in subsection 7(1) of the Act;
• the disposition of the security must occur no later than 30 days after the taxpayer acquired the particular security;
• the taxpayer must not acquire or dispose of identical securities in the intervening period;
• the taxpayer must make a designation in the return of income that is filed for the year in which the disposition occurs; and
• the taxpayer could not have designated the particular security in connection with the disposition of any other security.
• Proposed subsection 47(3) will exempt certain securities acquired after February 27, 2000 from the cost-averaging rule by deeming such securities not to be identical to any other securities acquired by the taxpayer for the purposes of subsection 47(1) of the Act. This new provision will apply to deferral securities and to securities that are designated under proposed subsection 7(1.31) by the taxpayer. This exemption will result in the capital gain or capital loss on the disposition of these securities not being affected by the adjusted cost base of identical securities already owned by the taxpayer.
• It should be noted that proposed subsection 7(1.31) is intended to legislate the practice of specific identification that was adopted by the Agency in Income Tax Technical News No. 19. With the enactment of proposed subsection 7(1.31), the administrative position described in Technical News No. 19 will only apply to pre-February 28, 2000 dispositions, provided that the taxation year in question is still open for the taxpayer.

Stock Option Benefits and Subsequent Decrease in Fair Market Value

• Unless the security acquisition is eligible for the benefit deferral described above, the stock option benefit is computed as of the date the security is acquired by the employee. The computation of the benefit is as described above. We have been advised that many taxpayers acquired securities in 2000 and their employers reported significant benefits in respect of such acquisitions. The fair market value of many of the shares acquired by these taxpayers has dropped significantly as a result of the recent decline in the markets. In many cases, the income taxes owing in respect of the reported stock option benefits exceed the fair market value of the shares that were acquired under the stock option agreement.
• Because the application of the Act is very clear, CCRA has been unable to provide any administrative relief in these cases. However, many taxpayers and many corporate employers have brought the matter to the attention of CCRA and the Department of Finance.
• A review of the matter will by necessity take some time. Anyone in this situation should file their return for 2000 in accordance with existing law. If taxpayers cannot pay the taxes due on filing without hardship they should contact their local tax services office to discuss the matter. When a final determination is made by Finance, taxpayers will be informed.