Principal Issues: In the course of an estate freeze, Mr. X would receive preferred shares and voting shares in exchange for the common shares he held in the capital stock of Opco. The voting shares held by Mr. X would allow him to control Opco. In the course of that reorganization, Opco would grant stock options to a key employee (not related to Mr. X) giving that employee the right to acquire common shares of the capital stock of Opco for a consideration of $1. Mr. X would then transfer some of the non-voting preferred shares he holds in the capital stock of Opco to Holdco. Those non-voting preferred shares would then be redeemed by Opco, which transaction would result in a deemed dividend for Holdco pursuant to subsection 84(3), except if subsection 55(2) applies.
a) Would the granting of the stock options to the key employee be considered an event referred to in subparagraph 55(3)(a)(ii) or (v) of the Act?
b) If not, would the exercise of the stock options by the key employee be considered an event referred to in subparagraph 55(3)(a)(ii) or (v) of the Act?
c) Would the answer be different if the stock option plan was put in place before the estate freeze?
Position: a) The CRA would examine the rights, conditions and restrictions attached to the stock option to determine, inter alia, whether the exercise of the stock option is, at the time of the granting, contingent in fact and in law. Subject to subsection 245(2), the granting of an option would not generally be considered an increase in an interest as referred to in subparagraph 55(3)(a)(ii) or (v) of the Act where the right to acquire is contingent in fact and in law. However, the CRA would consider that the granting of an option is an increase in the interest of a corporation if the characteristics of the option and the price for which the option can be exercised are such that there is no real uncertainty or contingency with respect to the exercise of the said option.
b) If subparagraph 55(3)(a)(ii) and (v) does not apply at the time the stock option is granted because of the contingency of the rights, the CRA would consider that there is an increase in the interest of a corporation at the time the stock option is exercised. The exception provided by paragraph 55(3)(a) would not apply if the exercise of the stock option results in a significant increase in the interest in the corporation that occurs as part of a series of transactions or events as part of which the dividend was received.
c) The comments provided for question a) would remain the same. However, even if some comments provided for question b) would be applicable, the facts would be different. Therefore, it is possible that the CRA reaches a different conclusion in a particular situation.
Reasons: a) The meaning of the word "interest" in a corporation is broad and can encompass "economic interest". However, where there is a real contingency, the CRA would generally consider, for the purpose of paragraph 55(3)(a), that the economic interest has not been acquired before the exercise of the option.
b) Where the granting of the stock option did not constitute an increase in the interest in a corporation, there will be an increase at the time of the exercise of the stock option.
c) See reasons for questions a) and b).
FEDERAL TAX ROUNDTABLE 7 OCTOBER 2011
APFF CONFERENCE 2011
Question 12
Stock options - 55(3)(a)
Mr. X, who held all of the issued shares of the capital stock of an operating corporation, implements an estate freeze in favour of his children and a holding corporation. The control of the operating corporation is retained in the hands of Mr. X. During the same reorganization, a stock option plan is established for key employees. Options are issued to a key employee to purchase common shares for $1. The employee is not related to Mr. X, being the controlling shareholder of the holding corporation, which is the dividend recipient for the purposes of subsections 55(3) and (3.01).
For asset protection purposes, shares received during the estate freeze are transferred to the holding corporation and subsequently redeemed, creating a tax-free intercorporate dividend. This dividend is not fully covered by safe income on hand.
(a) Is the granting of the stock options to the key employee a triggering event under paragraph 55(3)(a) that causes the deemed dividend to be "recharacterized" as a capital gain under subsection 55(2)?
(b) In the event that the answer to (a) is negative, would the application of paragraph 55(3)(a) be triggered at the time of the exercise of the options?
(c) Would the answer be the same if the stock option plan was up and running before the estate freeze?
CRA Response to Question 12(a)
Pursuant to paragraph 49(1)(b), the granting of an option by a corporation to acquire shares of its capital stock does not constitute a disposition of property for the purposes of the Subdivision c of Division B of Part I of the Income Tax Act. Therefore, in this situation, subparagraphs 55(3)(a)(i), (iii) and (iv) would not apply to the granting of the option.
However, it is necessary to consider whether subparagraphs 55(3)(a)(ii) and (v) can be applied to the granting of the stock option and more particularly, it is necessary to consider whether, at the time of granting the option, there is a significant increase in direct interest in a corporation or in the dividend payer, as the case may be.
The term "interest" is not defined in the Act. In accordance with the CRA's position for many years with respect to the term "interest” in paragraph 55(3)(a), having an interest in a corporation has a broad meaning and is not limited to the holding of shares in that corporation. Instead it references the holding of an economic interest in the corporation. For example, the term "interest" could include certain types of debt. In determining whether a person has an economic interest, it is necessary to consider all the rights, privileges, conditions and restrictions attached to the financial instrument or security held by the person.
To respond to your question, it is important to know whether the granting of stock options represents an increase in an interest in a corporation and, more specifically, if a stock option is an interest before it is exercised. As previously stated, for purposes of that determination, the rights, privileges, conditions and restrictions attached to that stock option must be considered.
A stock option often has conditions that make the exercise of the option uncertain and contingent. Subject to the application of subsection 245(2), there would generally be no significant increase in the interest in a corporation at the time of such an option, the exercise of which is contingent in fact and in law.
However, the CRA may consider, in certain circumstances, that an increase in an interest in the corporation occurs when the stock option is granted rather than when the option is exercised. For example, this could occur in a situation such as that described, where a key employee, instead of an immediate receipt of shares in the corporation, receives a stock option with characteristics and price such that there is no real uncertainty or contingency as to the exercise of the stock option.
CRA Response to Question 12(b)
Taking into account the facts stated in the context of your questions and taking into account that an issuance of shares does not constitute a disposition of property pursuant to paragraph (m) of the definition of "disposition" in subsection 248(1), the exercise of the stock option would not result in the application of subparagraphs 55(3)(a)(i), (iii) and (iv). Subparagraphs 55(3)(a)(ii) and (v) should, however, be considered.
Where the CRA concludes that there is no increase in an interest in a corporation at the time of the granting of a stock option the exercise of which is contingent in fact and in law, there will be an increase in interest when the option is exercised.
To determine whether paragraph 55(3)(a) applies to a situation where the exercise of a stock option is the time of the increase in the interest in the corporation, it must be determined inter alia whether the exercise occurred as part of a transaction, event or series of transactions or events in which the dividend was received. In this situation, if the exercise of the stock option occurred as part of the same series of transactions or events in which the dividend resulting from the redemption of the freeze shares was received and if the increase in interest in the corporation was a significant increase, subsection 55(2) would apply to the deemed dividend received upon the redemption of the freeze shares.
In any particular situation, it will be necessary to consider all the facts to determine whether the exercise of a stock option is part of the same series of transactions or events in which the dividend from the redemption of the freeze shares has been received, taking into account the terms of subsection 248(10) and tests established by the courts in that regard.
In a situation, such as the one you describe, where a corporation grants a stock option to a key employee at the time of an estate freeze, it appears to us that there would be arguments for concluding that the granting and the exercise of the option were part of the same series of transactions or events in which the dividend from the redemption of the freeze shares was received.
CRA Response to Question 12(c)
The principles set out in Question (a) as to the timing of an increase in an interest in a corporation would also apply where a corporation grants a stock option before an estate freeze.
Furthermore, the CRA would consider the general principles set out in Question (b) in determining whether subsection 55(2) applies to the dividend resulting from the redemption of the freeze shares. However, since the facts are different from the example situation in Question (b), it is possible that the commentary in that response as to whether the granting and the exercise of the option occurred as part of the same series of transactions or events in which the dividend from the redemption of the freeze shares was received is not applicable, which could result in a different conclusion with respect to paragraph 55(3)(a).
Sylvie Labarre
(613) 946-5357
October 7, 2011
2011- 041216