2017-0692931E5 Employee stock options - Bankruptcy

Principal Issues: Whether the deemed disposition rules in subsection 50(1) for shares of bankrupt corporations result in a disposition for purposes of section 7?

Position: No.

Reasons: The preamble to subsection 50(1) restricts its application to the rules for determining capital gains and capital losses in subdivision c. It does not apply for the purposes of the Act as a whole.

Author: Schnitzer, Irina
Section: 7(1), 7(1.1), 50(1), 39(1)

XXXXXXXXXX                                                                                                              2017-069293
                                                                                                                                       I. Schnitzer
May 28, 2018

Dear XXXXXXXXXX:

Re:  Section 7 Stock Option Benefit - Bankruptcy

We are writing in reply to your email sent March 6, 2017, on the application of the employee stock option rules to the following hypothetical scenario:

*     Opco is a Canadian controlled private corporation (“CCPC”);

*     Opco enters into a stock option agreement with an employee (the “Employee”). The stock option agreement gives the Employee the right to acquire common shares of Opco at an exercise price below the fair market value (“FMV”) of the shares on the date of grant;

*     The Employee and Opco are at all relevant times dealing at arm’s length;

*     The Employee exercises the stock options in Year 1. The aggregate FMV of the Opco shares acquired by the Employee is $200,000 and exercise price paid by the Employee on the stock options is $50,000;

*     During Year 3 Opco has become a bankrupt; and

*     In Year 4 the shares of Opco have nil value and Opco is wound up and all its issued and outstanding shares are cancelled.

In particular, you have asked whether the deemed disposition under paragraph 50(1)(b), due to the bankruptcy of Opco, results in the Employee being required to include in income a stock option benefit of $150,000 (the “Benefit”) pursuant to paragraph 7(1)(a) in Year 3. In addition, you have asked whether there is any forgiveness of the income inclusion of the Benefit to the Employee.

This technical interpretation provides general comments about the provisions of the Income Tax Act (the “Act”) and related legislation (all references herein are made to the Act unless otherwise indicated).  It does not confirm the income tax treatment of a particular situation involving a specific taxpayer but is intended to assist you in making that determination.  The income tax treatment of particular transactions proposed by a specific taxpayer will only be confirmed by this Directorate in the context of an advance income tax ruling request submitted in the manner set out in Information Circular IC 70-6R7, Advance Income Tax Rulings and Technical Interpretations.

Comments

Generally, pursuant to paragraph 7(1)(a) if an employee has acquired securities under a stock option agreement granted by the employer, then the employee is deemed to have received a benefit equal to the amount by which the value of the securities of the employer, at the time the employee acquired them, exceeds the exercise price of the option. If the employer is a CCPC and the employee is dealing at arm’s length with the employer immediately after the stock option agreement was made, then, pursuant to subsection 7(1.1), the value of the benefit, determined under paragraph 7(1)(a), is not included in income of the employee until the taxation year in which the security is disposed of or exchanged.

In the situation you have described, the conditions of subsection 7(1.1) appear to have been met and the Employee does not have to include the Benefit in income until the shares of Opco are disposed of or exchanged.

The term “disposition” is defined in subsection 248(1) and includes any transaction or event by which a share is redeemed, acquired or cancelled. A corporation’s bankruptcy does not result in the issued and outstanding shares of the capital stock of the corporation being redeemed, acquired or cancelled.

Pursuant to paragraph 50(1)(b) where a share of the capital stock of a corporation is owned by the taxpayer at the end of the taxation year, the corporation has during the year become a bankrupt and the taxpayer files a valid election, the taxpayer is deemed to have disposed of the share for proceeds equal to nil and to have reacquired it at a cost equal to nil, which could result in a capital loss. However, this deemed disposition is only applicable for the purpose of subdivision c of Division B of Part I of the Act and section 7 is found in subdivision a of Division B of Part I of the Act and consequently, the deemed disposition under paragraph 50(1)(b) does not result in a disposition for purposes of section 7.

In the situation you have described, a disposition for purposes of section 7 will occur when all of the issued and outstanding shares of Opco are disposed of in Year 4, the year that Opco is wound up and all of its issued and outstanding shares are cancelled. Consequently, the Employee will have to include the Benefit in income in Year 4; however, the Employee may be entitled to a deduction pursuant to paragraph 110(1)(d.1).

If the conditions of paragraph 50(1)(b) are met and the Employee makes a valid election, then the Employee is deemed to have disposed of the shares of Opco for nil proceeds in that year. If the Employee does not make an election under paragraph 50(1)(b), then the Employee disposed of the shares of Opco in Year 4, the year Opco is wound-up and all of the issued and outstanding shares are cancelled.

Pursuant to paragraph 53(1)(j), the amount of the Benefit is added to the adjusted cost base (“ACB”) to the Employee of the shares of Opco in Year 1, the year that the Employee exercised the option and acquired the shares of Opco. As such, the ACB to the Employee of the shares of Opco is $200,000 and a capital loss of $200,000 will result either in the year the Employee makes a valid election under paragraph 50(1)(b) or in Year 4, the year Opco is wound up and all of its issued and outstanding shares are cancelled.

Where Opco is a small business corporation and the disposition of the shares of Opco is to an arm’s length person or deemed to have occurred under subsection 50(1), the capital loss should qualify as a business investment loss (“BIL”) and ½ of the BIL is an allowable business investment loss (“ABIL”) which can be applied against income from sources other than against taxable capital gains. Information concerning BIL can be found in Income Tax Folio Business Investment Losses at: http://www.cra-arc.gc.ca/tx/tchncl/ncmtx/fls/s4/f8/s4-f8-c1-eng.html.

There is no provision in the Act that permits the forgiveness of the income inclusion as a result of the employment benefit deemed to be received by an employee under section 7, in the circumstances described in your email.

We trust that our comments will be of assistance to you.

Yours truly,

Mary Pat Baldwin, CPA, CA
Section Manager
for Division Director
Financial Industries and Trusts Division
Income Tax Rulings Directorate
Legislative Policy and Regulatory Affairs Branch

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