Download Non Arms Length Stock Options Transfers

Non-Arm’s Length Stock Options Transfers
Marie-Emmanuelle Vaillancourt and Alan Shragie
“Non-Arm’s Length Stock Options Transfers”
by Marie-Emmanuelle Vaillancourt and Alan Shragie
Davies Ward Phillips & Vineberg, LLP
The tax treatment of employee stock options is principally governed by section 7 of the Income
Tax Act (Canada) (the “Act”), which sets out the timing of when the employment benefit should
be realized in various scenarios.1 For example, the assignment of an option to an arm’s length
third-party results in an immediate income inclusion for the employee.2 Furthermore, it is
generally understood that a transfer to a person with whom the employee is not dealing at arm’s
length is taxable only at the time of the exercise of the options (or the transfer of same to a thirdparty) by the non-arm’s length transferee.3
It appears, however, that certain taxpayers were filing their tax returns on the basis that section 7
did not apply in two different cash-out scenarios, which prompted confusing statements from the
Minister of Finance in the last Budget (as discussed in more detail below). The first situation
involves the cash-out of options by an employee who does not deal at arm’s length with the
employer at the time of the cash-out. In the second scenario, the options are first transferred by
the employee to a non-arm’s length person and the transfer is followed by a cash-out of the
options by the transferee.
Employee and Employer Not Dealing at Arm’s Length
Paragraph 7(1)(b) determines the tax treatment of cash-outs where the employee and the
employer deal at arm’s length and requires the amount to be included in the employee’s income
at the time of the cash-out. As for paragraph 7(1)(c), which applies to transfers between nonarm’s length persons, it requires that the rights of the employee under the stock option agreement
be “vested in a person who has acquired securities under the agreement”. On the cash-out of
options by a non-arm’s length employer, the options are cancelled and it could be argued,
therefore, that the options do not “vest in a person who has acquired securities under the
agreement”.
If section 7 does not apply to a cash-out between an employee and an employer not dealing with
each other at arm’s length, the question is whether any benefit arising from the cash-out is
taxable under another provision of the Act, for example paragraph 6(1)(a). Pursuant to
subsection 7(3), an employee is deemed not to have received or enjoyed a benefit under or
because of a stock option agreement, except as provided for in section 7. The wording of
subsection 7(3) appears to be broad enough to argue that if section 7 does not apply, any benefit
arising from a stock option is exempt from tax.
1
All statutory references herein are to the Act.
2
Paragraph 7(1)(b) of the Act.
3
Paragraphs 7(1)(c) and 7(1)(d) of the Act. It should be noted, however, that if the employee has passed away at
the time of exercise, the transferee is taxed on the employment benefit, not the estate.
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-2Cash-out By Non-Arm’s Length Transferee
As explained above, an employee who has transferred his or her options to a non-arm’s length
person is generally taxable on any benefit arising therefrom at the time of the exercise of the
options by the transferee (or transfer of the options by the transferee) under paragraph 7(1)(c) or
(d), as the case may be. However, for paragraph 7(1)(c) to apply, the transferee must acquire
“securities”, which is not the case where the transferee cashes-out the options. As for
paragraph 7(1)(d), it applies where the non-arm’s length transferee “disposed of rights under an
agreement to another person […]” (emphasis added). Even if one views the options as being
disposed of upon the cancellation of the options, it is arguable that the options have not been
disposed of to a person and thus, paragraph 7(1)(d) does not apply to the cash-out because the
options are not being acquired by anyone.4 If neither paragraph 7(1)(c) nor paragraph 7(1)(d)
applies, the employee can again rely on subsection 7(3) to argue that any benefit arising from the
cash-out is not taxable under the Act as a whole.
Budget 2010
The tax measure section of the 2010 federal Budget indicates that the Act will be amended “to
clarify that the disposition of rights under a stock option agreement to a non-arm’s length person
results in an employment benefit at the time of disposition (including cash-out)”. Clause 24 of
The Notice of Ways and Means Motion provides that subsection 7(1) of the Act shall be clarified
to ensure that it applies “in circumstances in which an employee […] disposes of rights […] to a
person with whom the employee does not deal at arm’s length”.
Although meant as a “clarification”, these broad statements create ambiguity. A plain reading
could lead to the conclusion that the transfer of an option by an employee to his personal holding
company, for example, would be subject to tax at the time of the transfer rather than at the time
of exercise. Yet, the current wording of paragraph 7(1)(c) of the Act is clear: the transfer of
options to a non-arm’s length person does not trigger immediate taxation. Is this a policy change
or an overly broad statement?
Discussions with representatives of the Minister of Finance indicate that the intention is not to
tax the employee on the transfer of his or her options to a non-arm’s length person and that the
Budget statements were meant for cash-out situations only. Proposed legislation confirming this
position should be released this summer.
Based on the foregoing comments from the Department of Finance, it appears that the
uncertainties created by the Budget in respect of the taxation of stock options are benign but such
lapses highlight that statements contained in a budget must be handled with care.
4
This argument is supported by the fact that there is no equivalent to subsection 7(1.7) that would deem such a
disposition to be in favour of another person. Subsection 7(1.7) provides that even if there is no disposition at law,
the cancellation of a stock option agreement is deemed to result in a disposition of the employee’s rights under the
agreement to an arm’s length person for purposes of paragraph 7(1)(b) (overruling Buccini v. The Queen, 2000 DTC
6685 (FCA)). See also, a contrario, subsection 84(9), which specifies that a shareholder is deemed to have disposed
of shares redeemed or cancelled to the corporation proceeding to the redemption or cancellation.
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