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...