“A small change to timing can have a big tax impact”
Generally, when stock options are granted, no tax benefit is recognized for Canadian tax purposes until the employee exercises the option. The benefit is begins as fully taxable employment income. If the exercise price of the options is at least equal to the value of the shares when the options were granted (or, for options of a Canadian-controlled private corporation (“CCPC”), if the shares acquired under the option are held for 24 months or more before they are sold), the full income inclusion is reduced by half. Where the employer is a CCPC and the employee deals at arm’s length with the employer, this benefit can be deferred until the shares are disposed of.
What do we mean by “disposed of”? It’s not only a sale to a third party. Transfers to a holding company, or even an exchange of shares for another class of the same company, are examples of “non-sale” events that are treated as dispositions for tax purposes. Fortunately the tax rules allow for a transfer or exchange of the shares to be ignored when certain “internal” transfers or exchanges occur. Where the exceptions are met, the income inclusion is deferred until the year in which the employee disposes of or exchanges the securities of the new company (or the securities issued to replace the original shares).
Let’s use an example. Assume Opco, a CCPC, is being sold to a new controlling group of Canadian shareholders. Often, the new controlling group will acquire its shares through a holding company (Holdco), also a CCPC. In many cases, the founding shareholders of Opco will transfer their shares of Opco to Holdco as part of the transaction. To the extent the shares the founding shareholders transfer were acquired via stock options, this transfer may trigger unintended tax. Why? The shares of Opco are technically being disposed of when they are transferred to Holdco so the employment benefit from the original stock options will become taxable unless certain deferral conditions are apply.
In particular, the benefit will be deferred until there is a sale of the new Holdco shares if Opco does not deal at arm’s length with Holdco immediately after the transaction. If the new shareholders control Holdco before the founding shareholders transfer their option shares, Holdco may not be arm’s length with Opco immediately after the transfer. This conclusion would trigger the realization of the taxable benefit by the original shareholders on their stock option shares.
In order to avoid this problem, the Opco shareholders should sell their option shares to Holdco before the new shareholders take control of Holdco. This ordering ensures that Holdco will be owned only by the previous Opco shareholders immediately after the transfer of the stock option shares. As such, Holdco and Opco would not deal at arm’s length with each other immediately after the transfer and the stock option benefit will be deferred. The new shareholders can then subscribe for their new shares of Holdco.
A small change to timing can have a big tax impact.
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The material provided in Tax Tip is believed to be accurate and reliable as of the date of posting. Tax laws are complex and are subject to frequent change. Professional advice should always be sought before implementing any tax planning arrangements. Cadesky Tax cannot accept any liability for the tax consequences that may result from acting based on the contents hereof.