Canada: To Deduct Or Not To Deduct - The Stock Option Benefit Conundrum

Depending on how an employee stock option plan is structured, it may be possible for an employee having exercised in-the-money stock options to reduce by half the resulting employment benefit (the employment benefit being equal to the difference between the exercise price of the option and the fair market value of the shares acquired as a result of the exercise).

The employment benefit is generated at different times depending on whether the issuer of the optioned shares is a Canadian-controlled private corporation (a CCPC) or an issuer which is not a CCPC. Where the issuer is a CCPC, the employment benefit is generated on the sale of the optioned shares. Where the issuer is not a CCPC, the employment benefit is generated on the exercise of the options.

The reduction of the employment benefit is a result of a deduction provided either under paragraph 110(1)(d) or paragraph 110(1)(d.1) of the Income Tax Act (Canada) (the ITA). Under paragraph 110(1)(d.1), the optionee can deduct 50% of the employment benefit where the shares were issued by a CCPC and the optionee held the shares for two years before disposing of them. Under paragraph 110(1)(d), the optionee can deduct 50% of the employment benefit where the exercise price of the options is no less than the fair market value of the shares at the time the options were granted, and the shares qualify as "prescribed shares" when the options are exercised and the shares are issued.

The rules governing what qualifies as a "prescribed share" are found in section 6204 of the Income Tax Regulations. Until the Tax Court of Canada's decision in Montminy et al. v. The Queen1, the interaction between paragraphs 6204(1)(b) and 6204(2)(c) had not been considered by a court. The Tax Court of Canada's decision offers welcome guidance in applying these rules, although, at the same time, the decision confirms just how stringent (and some might argue overly technical) these requirements are.

Facts

In order to incent and retain its key employees, Cybectec Inc. (Cybectec), a CCPC, adopted a stock option plan on May 1, 2001 (the Plan). The Plan provided that options could be exercised only on an initial public offering or the sale of all issued shares of Cybectec, failing which they could be exercised on the 10th anniversary of the grant of options. On December 17, 2001, Cybectec granted options, with an exercise price of $0.20 per share, to ten employees who each entered into agreement with Cybectec with respect to the grant (the Agreements).2 On January 18, 2002, Cybectec granted options to an eleventh employee, for a total of 1,974,000 options granted to the eleven optionees.

In early 2007, Cybectec received an unsolicited offer for the purchase of its assets from Cooper Industrial (Electrical) Inc. (Cooper).3 In light of Cooper's offer, and because Cybectec's two directors found it unjust that the optionees should be prevented from exercising their options due to what in their view was a technical reason (i.e., that the sale of the business took the form of an asset deal rather than a share deal), Cybectec resolved on January 10, 2007 to allow the exercise of options upon the sale of all or substantially all of its assets. On the same date, Cybectec wrote to the optionees advising them of this and requiring that they agree, following the exercise of options, to immediately sell the shares, consistent with their Agreements, to 9135-8184 Québec Inc., a corporation related to Cybectec, for $1.2583 per share.

On January 26, 2007, Cybectec sold all of its assets to Cooper, and on January 28, 2007, nine optionees exercised their options and immediately sold the resulting Cybectec shares to 9135-8184 Québec Inc. The shares were acquired for a total of $325,380 and sold for a total of $2,047,128.

Seven optionees4 sought to deduct one half of the employment benefit resulting from the exercise of their options, for the 2007 taxation year. In November 2010, the Minister of National Revenue (the Minister) reassessed them and rejected their claim for a deduction. The Minister determined that the optioned shares were not prescribed shares and established the fair market value of the shares at the time of grant of the options at $0.3246. The optionees appealed the reassessment.

The Tax Court agreed with the Minister as to the nature of the shares, which is discussed below, but not with respect to the fair market value of the shares since, for reasons that we will not get into here, it preferred the appellants' valuation of the shares over the Minister's.

Findings

The Tax Court first determined that, although Cybectec, the share issuer, was a CCPC, the deduction under paragraph 110(1)(d.1) was not available to the optionees since the shares had not been held for two years after issuance.

Therefore, in order to reduce the employment benefit, the appellants had to show, not only that the exercise price was no less than the fair market value of the shares at the time the option was granted (which the Tax Court agreed they had) but also, that the shares qualified as prescribed shared when the options were exercised. However, although different than the two-year hold rule for CCPC shares, as discussed below there is also a two-year hold rule for prescribed shares, and this proved to be the crux of the issue.

For ease of reference and to better follow the Tax Court's findings summarized below, subsection 6204 is reproduced in full in Appendix A.

The Minister's main contention was that, since paragraph 6204(1)(b) had not been complied with, the shares could not qualify as prescribed shares. Pursuant to paragraph 6204(1)(b), in order for a share to be a prescribed share, it cannot reasonably be expected that the issuer of the share, or a 'Specified Person' will redeem, acquire or cancel the share within two years after the share is sold or issued. A Specified Person is defined at subsection 6204(3), in part, as any person or partnership with whom the issuer does not deal at arm's length otherwise than because of a right referred to in paragraph 251(5)(b) of the ITA that arises as a result of an offer to acquire all or substantially all of the issuer's shares. Obviously, given the agreement with the optionees that they immediately sell the shares to a corporation related to Cybectec, it could not be said that it could reasonably be expected that the issuer or a Specified Person would not acquire them within two years.

The optionees argued that paragraph 6204(2)(c) exempted them from that requirement since they met all the conditions set out in subparagraphs 6204(2)(c)(i), (ii)(B) and (iii). In addition, the Plan was put in place in order to incent Cybectec employees, not to provide disguised remuneration.

The Tax Court's main findings are as follows:

  • Subsection 6204(1) describes what constitutes a prescribed share and as of when the determination as to whether a share is a prescribed share takes place, while subsection 6204(2) applies only to certain provisions of subsection 6204(1).
  • Subparagraphs 6204(1)(a)(i), (ii), (iii), (iv), (v) and (vi) require that a share not be subject to conditions or restrictions (i.e., it be a "plain-vanilla share").
  • Paragraph 6204(1)(b) requires that it be reasonable to expect that a share will be held for two years except where there is an amalgamation, a winding-up under subsection 88(1) of the ITA, or a distribution under subsection 84(2) of the ITA.
  • Paragraph 6204(1)(c) prevents paragraph 6204(1)(a) from being by-passed by modifying the terms of the shares within two years after their issuance.
  • Paragraph 6204(2)(a), in deeming that the dividend entitlement of a share is not limited to a maximum amount or fixed at a minimum amount where it may reasonably be considered that all or substantially all of the dividend entitlement is determinable by reference to the dividend entitlement of another share of the corporation that meets the requirements of subparagraph 6204(1)(a)(i), applies to subparagraph 6204(1)(a)(i).
  • Paragraph 6204(2)(b), in deeming that the liquidation entitlement of a share is not limited to a maximum amount or fixed at a minimum amount where it may reasonably be considered that all or substantially all of the liquidation entitlement is determinable by reference to the liquidation entitlement of another share of the corporation that meets the requirements of subparagraph 6204(1)(a)(ii), applies to subparagraph 6204(1)(a)(ii).
  • Paragraph 6204(2)(c), in providing that a right or obligation to redeem, acquire or cancel the share, or to cause the share to be redeemed, acquired or cancelled, is disregarded if certain criteria are met, applies to subparagraph 6204(1)(a)(iv).
  • Nothing in subsection 6204(2) applies to subparagraphs 6204(1)(a)(iii), (v) or (vi) or to paragraphs 6204(1)(b) or (c). Therefore, there is no exception to the requirement in paragraph 6204(1)(b) that it cannot reasonably be expected that the issuer of the share, or a Specified Person, will redeem, acquire or cancel the share within two years after the share is sold or issued.

As for the appellants' policy argument, the Tax Court observed that, in allowing 50% of the employment benefit to be deducted, the legislator chose to treat employees who acquire employer shares through a stock option plan in the same way as taxpayers who purchase shares outside of such a plan. Consistent with this, paragraphs 110(1)(d) and 6204(1)(b)5 are designed to prevent stock option plans from becoming disguised remuneration, and to ensure that employees who exercise options bear a certain amount of risk. Since, until exercise, the employee runs no risk, the expectation that the shares will be held for at least two years introduces that missing element.

*****

Interestingly, in its review of how the various provisions of subsections 6204(1) and 6204(2) relate, the Tax Court observed that:

... I would like to point out that subsections 6204(1) and 6204(2) are technical and complex provisions. I find it difficult to conceive how anyone running a business could decipher the mechanisms of these provisions. Given the increasing popularity of stock option plans, a reform of these provisions is warranted.6

Certainly, the prescribed share rules are complex, and the two-year hold rule, whether for CCPC shares or for prescribed shares, is, in some cases, an overly inflexible policy instrument. There are many more potential corporate transactions than the rules accommodate, which puts these at odds with the legislator's main intention that employees be encouraged to own employer shares by providing capital gains-like treatment on the exercise of options.

Had Cooper's original offer for shares been retained, the 50% deduction might have been preserved assuming the amendment of the stock option plan to allow the exercise of the options and the sale of the optioned shares to Cooper before it became a Specified Person. However, we are not given enough facts about Cybectec and its employees after the sale of assets occurred to be able to tell whether and how the deduction could have been preserved. It may be that there was no way of doing so, in which case, Cybectec could simply have cashed out the optionees and, if the deduction could not be preserved, compensating them for the loss of the deduction if doing so was a priority.

Whether a company is contemplating a sale of shares or assets, it should seek legal advice on how to deal with its stock option plan. We at McCarthy Tétrault can help.

Please do not hesitate to contact Lorraine Allard at 416-601-7948 or any member of our Pensions, Benefits & Executive Compensation Group with any questions you may have concerning this decision or other questions or issues related to pensions, benefits or executive compensation.

Appendix A

6204(1) For the purposes of subparagraph 110(1)(d)(i) of the Act, a share is a prescribed share of the capital stock of a corporation at the time of its sale or issue, as the case may be, if, at that time,

(a) under the terms or conditions of the share or any agreement in respect of the share or its issue,

(i) the amount of the dividends (in this section referred to as the "dividend entitlement") that the corporation may declare or pay on the share is not limited to a maximum amount or fixed at a minimum amount at that time or at any time thereafter by way of a formula or otherwise,

(ii) the amount (in this section referred to as the "liquidation entitlement") that the holder of the share is entitled to receive on the share on the dissolution, liquidation or winding-up of the corporation is not limited to a maximum amount or fixed at a minimum amount by way of a formula or otherwise,

(iii) the share cannot be converted into any other security, other than into another security of the corporation or of another corporation with which it does not deal at arm's length that is, or would be at the date of conversion, a prescribed share,

(iv) the holder of the share cannot at that time or at any time thereafter cause the share to be redeemed, acquired or cancelled by the corporation or any specified person in relation to the corporation, except where the redemption, acquisition or cancellation is required pursuant to a conversion that is not prohibited by subparagraph (iii),

(v) no person or partnership has, either absolutely or contingently, an obligation to reduce, or to cause the corporation to reduce, at that time or at any time thereafter, the paid-up capital in respect of the share, except where the reduction is required pursuant to a conversion that is not prohibited by subparagraph (iii), and

(vi) neither the corporation nor any specified person in relation to the corporation has, either absolutely or contingently, the right or obligation to redeem, acquire or cancel, at that time or any later time, the share in whole or in part other than for an amount that approximates the fair market value of the share (determined without reference to any such right or obligation) or a lesser amount;

(b) the corporation or a specified person in relation to the corporation cannot reasonably be expected to, within two years after the time the share is sold or issued, as the case may be, redeem, acquire or cancel the share in whole or in part, or reduce the paid-up capital of the corporation in respect of the share, otherwise than as a consequence of

(i) an amalgamation of a subsidiary wholly-owned corporation,

(ii) a winding-up to which subsection 88(1) of the Act applies, or

(iii) a distribution or appropriation to which subsection 84(2) of the Act applies; and

(c) it cannot reasonably be expected that any of the terms or conditions of the share or any existing agreement in respect of the share or its sale or issue will be modified or amended, or that any new agreement in respect of the share, its sale or issue will be entered into, within two years after the time the share is sold or issued, in such a manner that the share would not be a prescribed share if it had been sold or issued at the time of such modification or amendment or at the time the new agreement is entered into.

(2) For the purposes of subsection (1),

(a) the dividend entitlement of a share of the capital stock of a corporation shall be deemed not to be limited to a maximum amount or fixed at a minimum amount where it may reasonably be considered that all or substantially all of the dividend entitlement is determinable by reference to the dividend entitlement of another share of the capital stock of the corporation that meets the requirements of subparagraph (1)(a)(i);

(b) the liquidation entitlement of a share of the capital stock of a corporation shall be deemed not to be limited to a maximum amount or fixed at a minimum amount where it may reasonably be considered that all or substantially all of the liquidation entitlement is determinable by reference to the liquidation entitlement of another share of the capital stock of the corporation that meets the requirements of subparagraph (1)(a)(ii); and

(c) the determination of whether a share of the capital stock of a particular corporation is a prescribed share shall be made without reference to a right or obligation to redeem, acquire or cancel the share, or to cause the share to be redeemed, acquired or cancelled, where

(i) the person (in this paragraph referred to as the "holder") to whom the share is sold or issued is, at the time the share is sold or issued, dealing at arm's length with the particular corporation and with each corporation with which the particular corporation is not dealing at arm's length,

(ii) the right or obligation is provided for in the terms or conditions of the share or in an agreement in respect of the share or its issue and, having regard to all the circumstances, it can reasonably be considered that

(A) the principal purpose of providing for the right or obligation is to protect the holder against any loss in respect of the share, and the amount payable on the redemption, acquisition or cancellation (in this subparagraph and in subparagraph (iii) referred to as the "acquisition") of the share will not exceed the adjusted cost base of the share to the holder immediately before the acquisition, or

(B) the principal purpose of providing for the right or obligation is to provide the holder with a market for the share, and the amount payable on the acquisition of the share will not exceed the fair market value of the share immediately before the acquisition, and

(iii) having regard to all the circumstances, it can reasonably be considered that no portion of the amount payable on the acquisition of the share is directly determinable by reference to the profits of the particular corporation, or of another corporation with which the particular corporation does not deal at arm's length, for all or any part of the period during which the holder owns the share or has a right to acquire the share, unless the reference to the profits of the particular corporation or the other corporation is only for the purpose of determining the fair market value of the share pursuant to a formula set out in the terms or conditions of the share or the agreement in respect of the share or its issue, as the case may be.

(3) For the purposes of subsection (1), "specified person", in relation to a corporation, means

(a) any person or partnership with whom the corporation does not deal at arm's length otherwise than because of a right referred to in paragraph 251(5)(b) of the Act that arises as a result of an offer by the person or partnership to acquire all or substantially all of the shares of the capital stock of the corporation, or

(b) any partnership or trust of which the corporation (or a person or partnership with whom the corporation does not deal at arm's length) is a member or beneficiary, respectively.

Footnotes

1 2012-2142(IT)G, 2012-21443(IT)G, 2012-2145(IT)G, 2012-2146(IT)G, 2012-2147(IT)G, 2012-2148(IT)G, 2012-2150(IT)G, 2015 CCI 110, 2016 TCC 110. As of the writing of this e-alert, this decision is available only in French.

2 We are not told what the Agreements provided.

3 The offer had originally been for Cybectec's shares but, unfortunately for the optionees, Cooper revised its offer to purchase assets.

4 It is not clear whether only those seven optionees sought to take advantage of the deduction or whether nine optionees did so but only seven chose to pursue the matter,

5 The decision refers to paragraph 6204(2)(b) but we believe this to be an error.

6 Paragraph 105. Our translation.

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